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A Matter of Trust – Tax and Trusts

A Matter of Trust – Tax and Trusts

The 2006 Finance Act became law last month, and it contains very wide ranging (and damaging) changes to the way trusts are taxed.


A “Trust” (or a “settlement” – for most practical purposes, these two words mean the same thing) is a legal entity that has existed in English law for many years.


Trusts first developed at the time of the Crusades – if Sir Jasper Whatnot was going to be absent from his English estates for several years of continental raping and pillaging, some legal structure was needed for his property to be managed while he was away.


What is a Trust?


The essential elements of a Trust are:


  • A “Settlor” – this is the person who provides the property which becomes the:
  • “Trust Fund” – that is, the property held by the Trust. This is also called the “settled property”.
  • A“Trustee” or Trustees – usually, two or three people, appointed by the Settlor and named in the Trust document. The Trustees are responsible for administering the Trust Fund. They are the legal owners of the Trust Fund (in the case of land, their names will appear on the Title Deeds, for example), but they are required to deal with the property not for their own benefit, but for the benefit of:
  • The “Beneficiaries” – these are the people who are entitled to benefit from the Trust Fund. The way they can benefit depends on what type of Trust is involved.


It is possible for the same person to be the Settlor, a Trustee, and a Beneficiary of the same Trust.


Types of Trust


The commonest types of Trust are:


  • A “Bare Trust” – this is a Trust where the Trustees are merely the legal owners of the Trust Property, but one or more beneficiaries are “absolutely entitled” to that property. The commonest examples are a Bare Trust for a child (because a child cannot legally own most types of property in his or her own name), or a partnership (where some of the partners will be the legal owners of, say, the partnership’s office building, but as Bare Trustees for the other partners).
  • An “Interest in Possession Trust” – this is a Trust where one or more of the beneficiaries have a right to be paid the income from the Trust Property, or possibly to the “enjoyment” of it, such as by living in a house owned by the Trust.
  • A “Discretionary Trust” – in this type of Trust, the Trustees do not have to pay the income to any of the Beneficiaries as it comes in – instead, they can use their “discretion” as to what they do with the Trust Property and the income from it. They must, however, act in the best interests of the Beneficiaries, and only in their interests.
  • An “Accumulation and Maintenance Trust” – this is really a specialised form of Discretionary Trust, and was typically set up by grandparents to help pay for the education of their grandchildren, and then give them a lump sum when they became adults. As the name implies, the Trustees are required to “accumulate” the income of the Trust rather than pay it out to the Beneficiaries, but they have the “discretion” to spend it on the “maintenance” of a Beneficiary if they wish. As a result of the 2006 tax changes, I suspect we shall see few (if any) new “A & M” Trusts set up.


Trusts have been used for many purposes – and not just for avoiding tax, as Gordon Brown seems to believe – such as:


  • Holding property for a changing group of people such as a partnership
  • Holding property for those who are too young either to have legal ownership themselves, or too young to be trusted with full control of the property
  • Making sure that property “stays in the family”, by being passed down from one generation to the next
  • Dealing with a deceased person’s property as he wished it to be dealt with
  • Providing for someone without actually giving him the property concerned – such as allowing him to occupy a house owned by the Trust.


Taxation of Trusts


The way that Trusts are taxed is extremely complicated, and I am not going to try to explain it in this article. If you are contemplating setting up a Trust, or if you are a Trustee, you must get good legal advice on the documentation, and good tax advice on the way the Trust will be taxed.


What I want to do here is to highlight just two of the many pitfalls that have been produced by the 2006 Finance Act:


Inheritance Tax (“IHT”)


Until March 2006, if a person put property into a Trust, this was treated as a “potentially exempt transfer” (“PET”), and provided that the Settlor survived for seven years, the property put into the Trust was ignored when calculating his IHT liability when he died.

The exception to this was a transfer to a Discretionary Trust, which was treated as chargeable to IHT when it was made (yes, IHT is not only a tax on death!). If the value of the property transferred was greater than the “nil rate band” for IHT (£285,000 for 2006/07), then IHT was payable on the excess, at the “lifetime rate” of 20%.


From March 2006, ALL transfers to ANY of the Trusts described at the start of this article (except for Bare Trusts) are subject to the lifetime charge to IHT described above.


It doesn’t end there – every ten years, the Trust will suffer a further IHT charge of up to 6% of the value of the Trust Property.


Will Trusts


Does your Will go something like this:


“I leave (description of the property concerned) to my spouse for his/her lifetime, and after his/her death, the property is to go to our children. If any of our children die before my spouse, then their share is to be held for their children until they reach the age of 21.”


That is a pretty basic and simplified version of one of the commonest forms of Will Trust drafting for a married couple, and until March 2006, there would have been no IHT to pay on your death, because the fact that your property was initially left to your spouse would mean that the “spouse exemption” applied on your death.


As a result of the FA 2006 changes, wording like that above now means that when you die, THERE WILL BE NO SPOUSE EXEMPTION AND IHT AT 40% WILL BE PAYABLE IF YOU LEAVE MORE THAN THE NIL RATE BAND (currently, £285,000).


It is still possible to draft a similar Will that will qualify for the spouse exemption under the new rules, but it is very unlikely that your existing Will qualifies. This is because the restrictions that now apply to this form of Trust are so tight that most Wills drafted before the 2006 Budget would not comply with them.


HMRC have claimed that we Tax Advisers are being “alarmist” when we say that thousands of Wills now need to be redrafted as a result of the FA 2006 changes. They claim that the new rules “will only affect a very small number of very wealthy people”.


This statement is only true if you consider that Mr Jones here is a “very wealthy person”:


Mr Jones owns (in his sole name) a house worth £380,000, and has investments worth another £100,000. His Will leaves the house and the investments to his wife and then to his children and grandchildren, using wording similar to that described above. If Mr Jones had died before 22 March 2006, there would have been NO IHT payable on his death, and his wife would have had the house to live in for life, and the income from the £100,000 to live on.


If Mr Jones dies now, IHT of £78,000 will be payable – leaving his wife with only £22,000 worth of investments to live on.


Although Mr Jones is not a poor man, I do not think he would agree with HMRC that he is “very wealthy”, and I am quite certain his wife would say she had been “affected” by these new rules.


What must be done?


  • Existing Wills that set up any kind of Trust (such as the one described above) need to be checked (and almost certainly redrafted) NOW to ensure that the spouse exemption will still be available
  • All existing Trusts (except Bare Trusts) need to be reviewed to check if they will now fall within the ten year charge described above – in some cases, it may be possible to take action to avoid this, but it needs to be done before April 2008
  • Where someone has died since 22 March 2006, it may be possible to take action to minimise the damage done by the changes to the rules, but again there is a two year deadline for doing this.