Technical Connection’s John Woolley looks at discretionary trusts and the IHT relevant property regime
Clients who have set up a discretionary trust, a discretionary discounted gift trust, a loan trust – or those who have placed a protection plan in a discretionary trust since 22 March 2006 – will need to take action to assess the impact of the inheritance tax (IHT) periodic charge on their trust and understand the reporting requirements.
A periodic charge can arise on the 10-year anniversary of a trust. Where existing investments are transferred into a trust, the 10-year periodic charge anniversary will be the date that the trust commenced, not the date the investment started. Similarly, when a pre-22 March 2006 trust started off life as an interest in possession (non-relevant property) trust but has been brought into the relevant property regime by, say, the addition of further property or funds to the trust, a periodic charge can arise on the 10-year anniversary of the actual start date of the trust – not the anniversary of when the property fell into the relevant property regime.
Trustees are responsible for calculating the charge and, where relevant, will need to submit an IHT100 form to HMRC and pay any tax that is due.
Where there is a joint settlor trust, by virtue of Section 44 IHT Act 1984, HMRC will regard this as two settlements, each created by one of the settlors. Therefore, the rules on when a return needs to be made and the tax calculations outlined below need to be applied to each of those trusts separately.
1. How is the tax charge calculated?
The process by which one establishes whether an IHT100 return needs to be made and calculates any tax that is due can be complex, as it involves not only information about the trust in question but also factors in relation to the client’s other actions and gifts, of which the trustees may not be aware. To calculate the tax due, the trustees will require the following information:
- The value of the trust assets (net of business relief and agricultural relief) at the 10-year anniversary. ● Details of any chargeable lifetime transfers (CLTs) – including failed potentially exempt transfers – made by the settlor in the seven years before the trust was created.
- Details of any trusts created by the settlor on the same day (and, since 10 December 2014, whether the settlor has added funds to two or more existing trusts on the same day).
- Details of any assets or cash that the trustees have distributed to the beneficiaries.
The charge is broadly calculated by deducting the available IHT nil rate band (NRB) threshold at the 10-year anniversary date from the value of the relevant trust property. In this respect, the value of the trust property will include the initial value of property transferred into any ‘related settlements’ when established. These are settlements established on the same day as the settlement/trust in question.
The available NRB that is available for the trustees to use is reduced by:
- Any previous CLTs made by the settlor in the seven years before the trust was created (but note that the seven-year timeframe can change as a result of added property – see point 3) -
- Any capital distributions made to beneficiaries from the trust in the previous 10 years.
If the value of the trust fund exceeds the available NRB, then tax may be due. But, irrespective of whether a tax charge arises, the trustees may still need to make a return to HMRC on an IHT100 form if the value of the trust exceeds certain specified amounts – see point 2 below.
2. When is it necessary to submit an IHT100 form?
Trustees will be required to notify HMRC of a 10-year anniversary under a trust by completing the IHT100 and IHT100d tax forms (and supplementary forms depending on the nature of asset(s) held within the trust). It is important to note that even when there is no tax liability, the trustees may still need to submit a return to HMRC (see below). The form(s) must be submitted within six months of the end of the month of the 10-year anniversary along with any tax due. If the form is not submitted in time, penalties will apply and (if tax is due) interest will be payable.
Most trusts will need to submit an IHT100 form at the 10-year anniversary. However, if all four of the following conditions are met, the trust does not need to submit an IHT100 form:
- The person who created the trust (the settlor) was UK-domiciled both when the trust was set up and at the 10-year anniversary (or at their death, if earlier).
- The trustees are all UK resident and have been so resident since the trust was created.
- The settlor did not create any other trusts on the same day (i.e. these are known as related settlements).
- The value of the trust on the day before the 10-year anniversary is less than 80% of the available NRB.
In this respect, the NRB is currently £325,000 and is frozen at this level until 2021. When considering whether the value of the trust property is above 80% of the available NRB, the trustees will, again, need to factor in:
- Any other CLTs made by the settlor in the seven years before this trust was set up;
- The total value of capital distributions paid out of the trust to any beneficiaries in the last 10 years (if any)…
…both of which will reduce the available nil rate band; and
- The initial value of any related settlements, which will be added to the value of the trust in question at the 10-year anniversary.
It should be noted that any deductions or reliefs that might be available to reduce the amount chargeable to IHT (for example, business relief or outstanding loans) are ignored for the purposes of determining whether a return is required at the anniversary date.
Clearly, as previous distributions need to be factored into the calculation, it is not possible to avoid the need to submit an IHT100 form by simply making a distribution to reduce the value of the trust to less than £260,000.
3. Added property
Where a settlor transfers property to an existing trust that they have established, this can constitute “added property” (Section 67 IHT Act 1984).
Added property will cause a reassessment of the seven-year period applicable to the trust. This will mean that it will be those CLTs made in the seven-year period before property is added to the trust that will be taken into account in calculating trust IHT charges, if that cumulative total exceeds the cumulative total of chargeable lifetime transfers made in the seven years before the trust was established.
This can obviously make a huge difference if the settlor has made other substantial chargeable lifetime transfers after establishing the trust.
Not all property will be added property – only property that is not covered by the annual and/or normal expenditure out of income exemptions.
At a 10-year anniversary that occurs after the addition of added property, the tax calculation gives credit for the fact that the added property has not been held in the trust for the whole 10-year period.
Trustees are responsible for calculating the charge and, where relevant, will need to submit an IHT100 form to HMRC and pay any tax that is due
4. When does the IHT100 form need to be sent to HMRC?
Trustees are responsible for submitting the IHT100 form to HMRC and paying any tax due within six months of the end of the month in which the 10-year anniversary falls. For example, if the 10-year anniversary falls on 15 March 2019, the deadline will be 30 September 2019.
Each of the trustees must sign the IHT100 form, so they will need to take early action to ensure that all trustees will be available to sign the form before the deadline. If the trust has not already been registered with HMRC under the Trust Registration Service, the trustees must register it before the IHT100 form can be submitted.
5. What happens if the deadline is missed?
If the form is not submitted on time, HMRC will apply a penalty. The current penalties are:
- £100 if the form is not submitted by the deadline.
- A further £100 if the form is more than six months late.
- A penalty of £200 plus a further £100 per month (to a maximum of £3,000) if the form is more than 12 months late.
If any tax that is due is received late, HMRC will charge interest on the amount due.
6. Who pays any tax that is due?
The trustees are responsible for ensuring that any tax due is paid. As this is a liability of the trust itself, the trustees should not use their own personal funds to pay the tax.
The issue of the payment of IHT may need careful advance consideration. If the trust is invested in illiquid assets – such as a property – or assets that will trigger a tax liability on encashment, it may be necessary for the trustees to resort to borrowing funds or seeking help from the settlor. The payment of further funds to the trustees by the settlor to enable them to meet an IHT bill can lead to a whole host of other tax implications, not least IHT as the further payment will be a CLT and may be treated as added property, which can affect ongoing periodic and exit charge calculations. Of course, the settlor could make a loan to the trustees to overcome this problem.
7. Example of calculation
On 6 November 2009, Steve paid £300,000 into a discretionary trust. As Steve had already used his £3,000 annual exemptions for 2008/2009 and 2009/2010 with a £6,000 gift he made in May 2009, this represented a £300,000 CLT. Prior to creating the trust, Steve had not made any other CLTs or created any other trusts. In May 2019, the trustees paid £50,000 to Steve’s grandson, Oliver, who is a beneficiary under the trust.
On 6 November 2019, the trust is worth £450,000. The 10-year periodic charge would be calculated as follows:
Had Steve made a CLT of £100,000 in the seven years before 6 November 2009, this would have used up a further £100,000 of the NRB, leaving only £175,000. The resulting IHT charge on the trust would then increase to about £16,500.
8. Loan trusts
A loan trust would normally be structured as a discretionary trust for maximum flexibility, so the relevant property provisions would potentially apply. However, with a loan trust, there are two points that will help prevent a 10-year charge:
- The value of the trust property at the 10-year periodic charge date would take account of the settlor’s outstanding loan and so reduce the value of the relevant property. However, it is important to note that in determining whether the details of the trust need to be reported on the IHT100, the outstanding loan is not deducted in determining whether the £260,000 reporting limit has been exceeded.
- Loan repayments to the settlor would not be treated as capital distributions (and so give rise to an exit charge) because they represent a payment of capital out of the trust to which the settlor is entitled as a creditor – not as a beneficiary. Therefore, these payments will not be deducted from the NRB available to the trust.
If, at outset and before the trust was established, it was perceived that the 10-year periodic charge rules could present a problem because of the size of the loan, the settlor could consider:
- Establishing the arrangement as a series of loan trusts genuinely established on different days, so each trust was entitled to an NRB.
- Using a bare trust to underpin the loan trust. A bare trust does not fall within the relevant property regime. However, use of a bare trust will mean that the trustees will sacrifice all flexibility in changing beneficiaries and their entitlements.
9. Discounted Gift Trusts (DGTs)
Although periodic and exit charges can arise in respect of discretionary trust-based DGTs, they are given favourable treatment by HMRC in that:
- Because the settlor’s right to cash payments is treated by HMRC as being held on bare trust for him or her, payments to the settlor are not treated as capital distributions and there will be no exit charge when payments are made to the settlor. These payments do not therefore have to be taken into account in determining the IHT NRB available to the trustees at the 10-year anniversary.
- In quantifying the market value of the relevant property for the purposes of the 10-year periodic charge, the value of the trust property can be reduced by the value of the settlor’s interest at that time (because HMRC treated this as being held on bare trust for him or her).
While any valuation should take account of the settlor’s life expectancy at the 10-year anniversary date (i.e. not the settlor’s life expectancy at commencement of the DGT), HMRC has confirmed that it will not require further underwriting if the settlor’s life was properly underwritten at outset. In such circumstances, in valuing the present value of the settlor’s future income stream, it will generally be the case that 10 years can be added to his or her age at outset.
However, if the settlor was given a “rated age” at outset, this will need to be taken into account in determining the value of the discount at the 10-year anniversary. So, if the settlor was 50 when he took out the plan but given a rated age of 54, his age for the purposes of the 10-year valuation will be 64. However, in cases where the settlor is known to be in serious ill health, his interest will then be of little or no value.
Where the settlor is terminally ill, there is still likely to be a discount on the bond value to reflect some degree of delay and a corresponding discount for potential income that would be payable to the settlor, but the precise details would depend on the prognosis and the withdrawal regime. For example, if the expectation was that the settlor had six months to live and withdrawals only took place annually, it is unlikely that the chance of a withdrawal taking place in a year’s time would be taken into account, but if the withdrawals were monthly then it would be reasonable to take six months’ worth of withdrawals into account. That having been said, HMRC would, understandably, not seek to challenge a valuation where the value was not discounted at all in these circumstances.
As mentioned earlier, on joint settlor cases, two trusts will exist for IHT purposes (Section 44 IHT Act 1984). In such cases, special rules apply for apportioning the discount at the 10-year anniversary to each settlement – see www.gov.uk/hmrc-internal-manuals/inheritance-tax-manual/ihtm20654
10. Joint settlor DGTs – one settlor deceased
The valuation of the settlor’s rights at the 10-year anniversary may need to take account of other factors where the case is a joint-settlor case and one of the settlors has died.
First, the fact that one settlor has died will not prevent two settlements continuing to exist for IHT purposes.
Equally, in joint-settlor cases where one settlor has died before a 10-year anniversary, it is thought that the 10-year valuation of the retained rights will be calculated based solely on the survivor’s right to the full continuing withdrawals. So, it will be the rated age of the survivor at outset increased by 10 years that will be used. This sum will be apportioned between each settlement in the proportion in which premiums were paid (normally 50/50). That apportioned value will then be deducted from 50% of the calculated value of the fund to determine the value of the relevant property of each settlement for the purposes of the 10-year charge.
HMRC broadly agrees with this approach but points out that the valuation of the expected withdrawals will need to take into account whether or not the full payments continue until the death of the survivor of both settlors.
So, if the full amount of the withdrawals does not continue to be payable to the survivor, the calculations will need to be adjusted accordingly.
In the run-up to a 10-year anniversary of a relevant property trust, trustees will have much to think about.
It is better for trustees to address these issues a good time before the anniversary and advisers can help trustees to deal with these issues. Failure to plan properly for these liabilities can lead to substantial problems.
John Woolley of Technical Connection
For further information on the IHT treatment of trusts, look at John Woolley’s book ‘Financial Planning with Trusts 2019/20’, published by Claritax