Briefings
Inheritance tax planning for existing trusts - the deadline approaches
Personal
Personal Tax, Trusts and Probate
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| September 2008 |
There is a one-off inheritance tax planning opportunity for certain trusts before 5 October this year. The opportunity is available to most interest in possession trusts that were in existence on 22 March 2006 ("qualifying trusts"), and is not restricted to UK trusts or trusts with UK beneficiaries.
Qualifying trusts are taxed according to the "old" inheritance tax regime ("IHT"), meaning that the trust is not subject to ongoing IHT charges. Most new interest in possession trusts created after 22 March 2006 are taxed under the "new" regime, subjecting the trust assets to a 20% IHT charge when they enter the trust and an ongoing 6% IHT charge every 10 years.
Transitional Serial Interests ("TSI"s) are an exception to the new regime and are available until 5 October this year. In creating a TSI, the life tenant can pass trust assets down a generation, while still keeping them in a qualifying trust and removing those assets from his own taxable estate without any IHT charge, provided he survives seven years.
Does the opportunity apply to all trusts?
No, but it is available to most interest in possession trusts that were in existence on 22 March 2006. These trusts are referred to in this note as "qualifying trusts".
What is an interest in possession trust?
An interest in possession trust broadly gives somebody, usually known as the "life tenant", an immediate right to all of the income from the trust assets. The life tenant will also often have the right to live in a trust property or otherwise enjoy the use of trust assets rent-free. The life tenant's right to the trust income is generally referred to as his "life interest" in the trust. There could be more than one life tenant, meaning that the trust income would be divided between them, but this note assumes there is only one life tenant, entitled to all of the trust income.
How and when would a qualifying trust have been created?
Most qualifying trusts will have been created before 22 March 2006, either during an individual's lifetime or on their death (whether by will or intestacy). However, interest in possession trusts created before 22 March 2008 by variation of a will, or by the trustees of a discretionary will trust, in relation to the estate of someone who died before 22 March 2006 will also be treated as qualifying trusts.
How are qualifying trusts taxed?
Qualifying trusts benefit from favourable inheritance tax ("IHT") treatment because they are taxed according to the "old" IHT regime. That means the trust is not subject to ongoing IHT charges. Instead the life tenant is treated as if he owns the trust assets, even though in practice he is only entitled to the income from those assets. Although ongoing tax charges are avoided, on the life tenant's death the assets in a qualifying trust will be subject to IHT at 40%, unless the trust assets then pass to his widow outright or the widow takes a subsequent life interest in those assets.
What is the new IHT regime for trusts?
Any new interest in possession trusts created after 22 March 2006 (other than on death) have been subject to the "new" regime, meaning that the trust assets are no longer within the life tenant's estate for IHT purposes. Whilst that may sound good, the trust assets will instead be broadly subject to a 20% IHT charge when they enter the trust and an ongoing 6% IHT charge on their value every 10 years.
What is the urgent planning opportunity?
TSIs are an exception to the new regime but are only available until 5 October this year. Where the life tenant of a qualifying trust gives up some or all of his life interest in favour of other beneficiaries (for example, his children) before the 5 October 2008 deadline, the successive life interests (the TSIs) will continue to benefit from the old IHT regime.
What are the advantages?
In creating a TSI, the life tenant can pass trust assets down a generation and remove those assets from his own taxable estate without any IHT charge provided he survives seven years. The assets would still be within a flexible and tax-efficient trust for his children, meaning that the children would continue to enjoy the IHT benefits of the "old" regime. There would be no 20% IHT entry charge when creating the trust and no 10-yearly 6% charges.
Importantly, the children would be protected from outright ownership of the assets. There may be good reasons why a life tenant would not wish his children to receive potentially valuable assets outright, particularly if the children are young or vulnerable.
Are there other tax issues to consider?
There should be no capital gains tax consequences in creating a TSI as the assets remain in trust. The value of the trust assets will be within the child's own IHT estate and would be liable to IHT at 40% on the child's death unless the assets then pass outright to the child's surviving spouse or civil partner. Of course, the risk of the child dying young is usually low.
Are TSIs relevant for offshore trusts or trusts with non-resident or non-domiciled life tenants?
TSIs can certainly be relevant in these situations, even where the trust assets are situated outside the UK. What matters is whether the trust assets will be subject to IHT on the existing life tenant's death. Many offshore trusts, or trusts with overseas life tenants, are still within the IHT net and in those cases a TSI may be a very important tax-planning opportunity.
Who should consider creating a TSI?
The life tenant of a qualifying trust should urgently consider creating a TSI where he:
- can afford to give up part or all of his life interest
- is likely to survive seven years
- wishes to benefit the next generation
- is reluctant to pass the trust assets outright to the next generation.
Please note the deadline is 5 October and it will take some time to prepare the relevant documentation hence the need for urgent action.