Ritson Smith hot topic: Trusts tax alignment

 
The following article has been prepared by David Dowell, senior tax manager with Aberdeen-based accountancy practice Ritson Smith.

In what has been described as “the greatest stealth tax since the dividend credit grab” (for which he was also responsible), Chancellor Gordon Brown used the 2006 Budget to introduce a clampdown on the use of accumulation and maintenance (A&M) trusts and interest in possession (IIP) trusts, although he never actually made any reference to this in his speech.

A&M settlements have commonly been used to provide for children’s school fees, house deposits and similar payments.  Before the Budget, in order to enjoy a favourable inheritance tax regime, the beneficiaries only had to become entitled to the assets or the income of the trust by age 25.

Following the Budget, however, for existing A&M settlements to continue to benefit from the favourable regime, the trusts will have to provide for the beneficiaries to become entitled to the assets (and not just the income) by age 18.  Existing trusts whose rules do not provide for this will have until 6 April 2008 to amend their provisions.

Thus, settlements that do not meet the new provisions will be treated as discretionary trusts with inheritance tax levied on set-up (at up to 40% on death or up to 20% on lifetime transfers), every 10 years (at up to 6%) or on capital distributions therefrom (at up to 6%).

IIP trusts are those where a beneficiary is entitled to the income but where the trustees can decide who receives the capital.  This form of trusts is often set up in wills where one spouse wants the other to have a right to income but wishes the capital to pass to the children.  One particularly nasty implication is that the inter-spouse exemption would no longer apply.

Discretionary trusts

Where existing IIP trusts come to an end and the capital is held on new trusts, it appears that the new trusts will be treated as discretionary trusts with the inheritance tax consequences outlined above.  Thus, it appears that all new family trusts created are likely to be taxed in a manner similar to the pre-budget discretionary trusts, with the exception of:

• trusts established for disabled persons
• trusts created on the death of a parent for a minor child (who will become entitled to the trust assets at age 18)
• trusts created on death on irrevocable non-successive IIP trusts.

The government has been roundly criticised for claiming that existing life policies are exempt from the new regime, a matter disputed by both the Law Society and insurance companies.  They claim to have identified some clear examples of retrospective effect on life policies written into trust before Budget day and give, as an instance, a beneficiary of a life policy written into trust before the Budget who then dies and finds his or her share of the proceeds could face a 6% tax charge.  This uncertainty appears to be because existing life policies are often written into a type of interest in possession trust.

Claims have also been raised that death-in-service benefits could be hit with a 6% tax charge on the value above the IHT threshold of £285,000 if a will states that they should be paid into a certain type of trust on death, for example an interest in possession trust.

The main thing to remember, however, is that the impact of these changes will only apply where the value of the policy/benefits exceed the IHT threshold of £285,000.  You should also be aware that there is a grace period until 6 April 2008 during which trustees of settlement/life policies and lawyers for wills can look into altering the terms of the arrangements.  Unfortunately, an added cost at the taxpayer’s expense!

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