Matthew Hutton details the numerous changes to new and existing trusts in the inheritance tax regime

Budget notice BN25 caused shock waves through the professions and the country on 22 March this year. Happily, some amendments to the original provisions found their way into what is now schedule 20 to the Finance Act 2006. But the general rigour of this most significant change to the taxation of trusts remains in force.


On or after 22 March 2006, it became no longer possible to make a favoured accumulation and maintenance (A&M) trust. Nor will a gift to an interest in possession trust be a potentially exempt transfer (PET). Only a qualifying lifetime trust for one or more disabled persons receives such treatment.


Otherwise, any new lifetime trust (or addition to an existing trust) will be an immediately chargeable transfer, falling within the Finance Act 1975 'relevant property' regime for discretionary trusts. Therefore, to the extent that the chargeable transfer exceeds the transferor's nil-rate band (£285,000 for 2006/07), there will be up front inheritance tax (IHT) to pay at 20%, to increase to 40% if the transferor dies within the following seven years. And the system of ten yearly charges (up to a maximum of 6% of capital value) and exit charges (typically when property is advanced outright) will apply.


Transitional rules


The preferential treatment given to trusts within the A&M regime at 22 March 2006 will continue until 6 April 2008. At that point, however, unless the trusts have been changed (if necessary) to provide that capital vests no later than age 18, the trust assets will enter the 'relevant property' regime. If, as a fall back, the trusts are changed to provide that capital arises at or before age 25 (an 'age 18-to-25 trust'), the presumptive share of any beneficiary will not fall within the 'relevant property' regime until he attains the age of 18.


For interest in possession trusts in being at 22 March 2006, the treatment under section 49(1) of the Inheritance Tax Act 1984 continues to apply, whereby the beneficiary is treated as beneficially entitled to the underlying trust assets. If, on termination of that interest in possession, the property remains settled, it will then enter the relevant property regime. However, if that interest in possession is replaced by a successive interest in possession before 6 April 2008, section 49(1) treatment continues for such a 'transitional serial interest' (TSI) with the termination of the life interest being a PET. And this will also apply where the TSI arises to a surviving spouse who becomes entitled after 5 April 2008 on the death of the spouse with the prior interest in possession. Preferential treatment is also given to interest in possession trusts of life policy trusts in being at 22 March 2006 - and premiums paid by an individual to such trusts following Budget Day continue to be PETs.


Therefore, subject to these transitional rules, a number of trusts that were originally made as PETs and whether A&M or life interest and will now fall within the relevant property regime, with its system of ten-year and exit charges.


Disabled and will trusts


Trusts for a disabled person will continue to be treated under section 49(1), whether made by lifetime transfer or under a will. The definition of disability has been slightly extended, and a disabled person's interest will include an express interest in possession for a disabled person, as well as a trust made by someone on himself in the expectation of future disability.


An interest in possession given to a beneficiary under a will will continue to be treated under section 49(1) as an 'immediate post-death interest'. If the beneficiary is the surviving spouse, spouse exemption will apply (which will not be the case where a lifetime settlement is made on a spouse). When that interest comes to an end, whether inter vivos or on death, and the property remains settled, the relevant property regime will come into play, unless there is then either a disabled person's interest or a 'trust for a bereaved minor' made by the deceased parent (or step-parent or person with legal responsibility for the child) under which capital arises no later than age 18.


Alternatively, if there is an 'age 18-to-25' trust for a minor child, the relevant property regime will not apply to the share in capital until the child attains age 18.


Changes to the section 144 relieving provisions for discretionary will trusts include a reversal of the 'Frankland trap' for settled property. So if, for a death on or after 22 March 2006, an appointment is made out of a discretionary will trust within three months after death on a life interest for a surviving spouse, the appointment will be read back to the date of death and the spouse exemption will apply.


Capital gains


There will be knock-on implications of the new IHT regime. For example, the range of trusts that, in relation even to non-business property, attract the possibility of hold-over under section 260 of the Taxation of Chargeable Gains Act 1992 has been dramatically increased.


However, no such hold-over election can be made where the trust is 'settlor-interested' (which, following the Finance Act 2006, now includes a case where the minor unmarried children of the settlor can benefit). Also, the capital gains tax-free uplift on death will not apply to termination of a life interest that falls within the 'relevant property' regime.


If, typically under a will trust, a life interest of a beneficiary is removed in whole or in part and the beneficiary continues to occupy or enjoy the property, typically the family home, there were no reservation of benefit implications before 22 March 2006 because the beneficiary had made no disposition by gift; the deemed PET was occasioned by exercise of the trustees' power of appointment. Now, however, under new section 102ZA of the Finance Act 1986, the beneficiary will be treated as having made a gift with reservation of benefit.


The new regime repays careful study by all those advising private clients, including foreign domiciliaries in relation to excluded property settlements. There is a sea change in the way in which both professional advisers and their clients should be regarding trusts, both existing and new. There is something of a subtle balance of advantage (or disadvantage) between the section 49(1) regime and the relevant property regime and the latter, especially for trusts within or not far over the nil-rate band, but also for more valuable trusts, is certainly not Draconian. However, it would become much more so if there were future legislative changes to apply the death rather than the lifetime rates in calculating the ten-yearly charge.


The changes to the regime, introduced as they were without prior announcement, might fairly be described as outrageous; however, they certainly make for an increasingly interesting professional existence.


Solicitor Matthew Hutton is the author of Trusts and Estates