As you will be aware, the Chancellor took advantage of the Pre-Budget Report (PBR) to announce changes in legislation aimed at what it described as two artificial IHT mitigation schemes involving trusts, which had come to the attention of the Treasury.
The first scheme took advantage of the loophole caused by poor drafting of one particular part of the legislation introduced on 22nd March 2006. It is this scheme that will be considered here.
Planning with interests in possession
To explain. Before the changes, it was possible to create an interest in possession trust and have the transfer treated as a potentially exempt transfer (PET). The downside of this type of trust was that the full value of the trust fund was treated, for IHT purposes, as being in the estate of the beneficiary entitled to the income. Since IHT is primarily intended to tax assets once a generation, treating the interest in possession in this way ensured that aim.
Example: John created flexible interest in possession trust for the wider benefit of his family (excluding himself) but with his daughter Emily entitled to any income generated by the trust fund.
Under a discretionary trust, however, no beneficiary has a right to income and so IHT is not dependent on the life of a beneficiary. You could consider the discretionary trust as having an artificial life of its own – a transfer in is a chargeable lifetime transfer (CLT) and periodic and exit charges also potentially apply.
Example: John created a discretionary trust for the wider benefit of his family (excluding himself), under which no one individual was entitled to either income or capital.
In order to avoid a potential double charge to IHT under any new interest in possession trust, it was necessary to make a change in the legislation. The legislation introduced in 2006 provided that a new interest in possession created after that date would not form part of the Settlor’s estate for IHT purposes.
It is worth repeating that: a new interest in possession created after 22nd March 2006 will not form part of the Settlor’s estate for IHT purposes.
That is the crux of the planning in this scheme.
Planning with reversionary interests
Before 2003, if a Settlor created a discretionary trust for the benefit of his family, it was possible to claim capital gains tax (CGT) holdover relief. The rationale for this being that if IHT was payable when creating the trust, CGT should not be so.
Those seeking to achieve the advantage of CGT holdover relief without actually incurring an IHT liability were advised to create trusts under which they retained a valuable right. This valuable right depressed the value of the transfer for IHT purposes, meaning no IHT was actually payable but secured CGT holdover relief nonetheless.
Example: John created a discretionary trust as before, with shares worth £1m having gains of £300k. The value of the CLT was £9,990k. No IHT is payable. CGT holdover relief was claimed in respect of the £300k gains, no CGT was payable at this time.
Clearly this was unacceptable to the Revenue and, having lost in the test case of Melville, legislation was introduced to combat this perceived abuse. However, it was accepted that the mechanism of depressing the initial value for IHT purposes achieved its aim.
Putting the two together!
Settlors were encouraged to create trusts under which they retained a reversionary interest but that reversionary interest was not in the full trust fund but in an interest in possession in it, i.e. a right to income for a specified period, typically 99 years. The initial transfer into trust, although being a CLT, was depressed by the significant value of the reversionary interest, i.e. it was negligible.
When the reversionary interest fell in and the interest in possession vested, at the end of whatever period the Settlor had determined, the full value of the trust fund fell out of his estate!
If he died, there would be no liability to IHT on the trust fund.
If he gave away his interest in possession, there would be no transfer of value. Further, there would be no value in the estate of the donee who received the interest in possession – and so on and so on, ad infinitum!
The “solution”
Whilst it had been anticipated that the Treasury would take steps to prevent interests in possession being treated in this way, i.e. to address the poor drafting which allowed this planning, as we have seen, the measures introduced have gone far further than this, impacting on the tax treatment of reversionary interests in general.
The impact for those caught
Bearing in mind that the changes introduced in 2006 intended to ensure that transfers into trusts that were within the relevant property regime actually gave rise to an IHT liability when the sums transferred were in excess of the available nil rate band, the “solution” might seem apt.
If a Settlor has created such a trust under which his reversionary interest has not yet fallen in or been given away, he will face a charge to IHT at lifetime rates when one or other of those events occurs.
The last word
In the PBR it was announced that “The Government announces it is also examining wider solutions to the problem of trusts being used to avoid inheritance tax charges.” It is understood that what is meant by this statement is that the Government will review the legislation introduced in 2006 to ensure, as far as possible, no other unintended “loopholes” exist. Clearly, we will have to keep an eye on developments!
Deborah Moon is technical manager for Royal London 360°
