Discretionary Trusts - The Ten-Year Itch

MALCOLM GUNN FTII, TEP discusses ten-year inheritance tax charges on discretionary trusts and offers some planning ideas.

There was a time in the dim distant past when discretionary trusts were one of the most tax efficient devices available in capital tax planning. The funds in the trust were not in anybody's estate and so they escaped estate duty liability, so long as they were transferred in well before the death of the settlor so as to escape the charge on gifts inter vivos. Of course, under English law, a discretionary trust cannot continue in perpetuity but, all the same, the applicable rules could be extended for a considerable period of time by the use of what were known as 'royal lives clauses'.

The heyday of discretionary trusts began to wane with the Finance Act 1969 when the first estate duty attack on them was instituted and, on the introduction of capital transfer tax in 1974, a very harsh régime was set up. I well remember the late seventies when we spent much time unscrambling existing discretionary trusts to take advantage of a transitional relief.

Just as a pendulum swings to and fro, so the legislature relented in 1982 and the original harsh capital transfer tax régime on discretionary trusts was somewhat relaxed. Tax planners were once again back in business setting up the trusts, instead of dismantling them!

This is not in any way to suggest that the régime has reintroduced the virtual tax haven status of discretionary trusts which existed up to 1969. Far from it; the idea of the current rules is that over a generation, ten-yearly charges should broadly equate to the tax which might have been paid if the funds had been held privately outside the trust. Even so, these trusts offer their opportunities and there can be nothing wrong with making the best of what Parliament has prescribed. As a result, discretionary trusts are now commonly found in wills to provide for a surviving spouse, or else they are set up by a post death deed of variation. They are also very useful vehicles for holding assets which are likely to appreciate in value, particularly if they can be put in trust long before the value has accrued. Nowadays, this applies less to business assets because of the very generous capital gains tax and inheritance tax reliefs, but any other assets not so qualifying might be considered for a family discretionary trust.

By way of clarification, the discretionary trusts considered here are those which contain 'relevant property' within the meaning of section 58, Inheritance Tax Act 1984. Most children's trusts have a strong discretionary element to them but normally they fall within the accumulation and maintenance provisions of section 71 of that Act and so they are outside the scope of the 'relevant property' régime. I shall first take a look at the formula for calculating ten-yearly charges and then consider some methods of planning for reducing them.

The ten-yearly charge

The formula to calculate the ten-yearly charge looks a little complicated in the verbose provisions of section 66, Inheritance Tax Act 1984, but in most cases it boils down to something reasonably simple. What it wants the trustees to do is to treat themselves as having made a chargeable transfer of their funds, as the highest part of a stated cumulative total; then to work out the tax which will be payable on a transfer of that amount; then to work out what the effective rate of the tax liability is on the funds in trust; then to apply 30 per cent of that effective rate to the value of the funds on the ten-year anniversary of the trust. I will now look at these various elements in turn.

The deemed chargeable transfer

The chargeable transfer which the trustees are deemed to make on the ten-year anniversary is primarily the market value of the property subject to the discretionary trusts on that date.

To this must be added in as well certain other trust property (if there is any) not subject to the discretionary trusts. In this category is firstly any property which, when it was transferred into the settlement, was not subject to the discretionary trusts and has not subsequently become subject to them, while still remaining comprised in the settlement. This is probably fairly unusual, or at least it is in my experience. The best plan with discretionary trusts is to keep them separate from other tax planning.

The second type of trust property which must be added in is the value of the property in a related settlement immediately after that settlement was made. Related settlements are quite simply settlements made by the same settlor on the same day as each other (disregarding charitable trusts). So they are easily avoided by having different dates for each settlement, but of course this can have different inheritance tax consequences since the later settlements will be made after the transfers of value to the previous settlements. Related settlements are not as uncommon as one might think because where a discretionary trust is set up by a deed of variation under a will, if the will also contains other trusts (but not that for the widow or widower as life tenant) they will all be deemed to be made on the same day, this being the date of death. The trusts are then related settlements and the value at the date of death of the funds bound for the non-discretionary trusts will be added in on each ten-yearly date when the discretionary trusts suffer a tax charge.

Related settlements do not have to be trusts of the same kind. They can be accumulation and maintenance trusts or life interest trusts. Transfers to such trusts are often potentially exempt, so it is somewhat harsh to count them in as the cumulative total of discretionary trustees.

Notwithstanding these complications, for many discretionary trusts there are no related settlements or non-discretionary sub funds and so what one is looking at is simply the value of the discretionary trust property on the date of the ten-yearly charge.

Prior chargeable transfers

This is not quite the end of the story in working out the amount liable to tax. Inheritance tax works on the basis of aggregating chargeable transfers and this is carried into the charge on discretionary trusts. At the ten-yearly event, the trust is assumed to have acquired an inheritance tax cumulative total of transfers equal to the chargeable transfers made by the settlor in the seven years ending with the day before the settlement was made (but excluding any made before 27 March 1974). Many settlors will have made potentially exempt transfers in this seven-year period and these are not counted in unless they become chargeable transfers through the untimely death of the settlor. A settlor with a history of chargeable transfers is less common and so once again this addition may not be something which impacts in many cases.

What may be more common is the second amount to be treated as part of the cumulative total of the discretionary trustees on the date of the event. Under this heading are the amounts of any capital distributions by the discretionary trustees in the ten years before the anniversary concerned. Capital distributions may of course be outright payments of capital to a beneficiary, or they may be appointments to a new sub fund within the trust on accumulation and maintenance trusts, or giving a beneficiary an interest in possession.

Calculating the tax

Once one has added up any amounts which are treated as forming the cumulative total of the trustees on the date of the ten-yearly charge (as under the last heading above) and then worked out the total value of the deemed transfer (as under the heading previous to that), it is then a case of working out the inheritance tax payable on the latter, as a top slice of the full cumulative total. The tax is calculated at the lifetime rates of inheritance tax. One then works out what the effective rate of tax is and the value in the trust is then charged to inheritance tax at thirty per cent of that effective rate.

Example 1 provides an illustration of all these principles in figures. The trust concerned is the Gunn Discretionary Trust which unfortunately does not exist, but it was nice dreaming whilst putting the figures together.

Added property

Some settlors feed more funds into an existing discretionary trust from time to time. Worse still, the husband or wife of a settlor may also add property in and this can compound the complications, because the assets settled by the husband or wife have to be treated as a separate settlement – if 'the circumstances so require!' according to section 44, Inheritance Tax Act 1984. I do not know when the circumstances would not require one to treat the property added by a spouse as not being in a separate settlement; perhaps this is some kind of oblique reference to artificial manoeuvres prior to making the settlement whereby funds are transferred from one to the other so that a different spouse can allegedly make the settlement. Normally, however, funds added by a spouse to a settlement made by the other spouse will be treated as a separate settlement for inheritance tax purposes and will have its own ten-year charge date.

Another point concerning added property affects the amount to be counted in in respect of chargeable transfers made by the settlor in the period of seven years before the date of the settlement. If the settlor's cumulative total when adding property is greater than it was when the settlement was made, then this higher cumulative total is substituted in the formula set out above, in place of the settlor's cumulative total at the date the settlement was made. In looking to see which is the higher of the two cumulative totals, one deducts any amount attributable to funds transferred into the trust insofar as this features in the cumulative total at the time of any additions.

Short term appointments

It may be that, in between ten-year charges on a trust, property has been appointed on trust for a beneficiary for life without leaving the settlement; subsequently on the untimely death of that beneficiary the funds fall back into the discretionary pool. Alternatively, the trustees may make a revocable appointment for a beneficiary which results in funds ceasing to be 'relevant property' for a while and then falling back into the discretionary pool.

This could result in an adverse tax position. In principle there is an inheritance tax charge when the appointment is made, because funds are leaving the discretionary trust in inheritance tax terms. Then on the next ten-yearly anniversary the same amount is one of the ingredients in the trustee's assumed cumulative total, as described above, whereas in the events which happened the funds appointed out are back in the discretionary pool being charged to tax. To deal with this situation, section 67(6), Inheritance Tax Act 1984 reduces the total charged to tax on the ten-yearly event by the lower of the amount on which tax was charged when the appointment was made and the value of those particular funds on the date of the ten-yearly event.

This sounds simple as a matter of theory, but of course in practice when funds go back into a discretionary pool they tend to lose their identity and so it may not be quite so easy to decide what actually represents the previously appointed funds at the date of the ten-yearly event.

Significant milestones

Ten-yearly anniversaries should be regarded as milestones in the life of a discretionary trust. The reason for this is that after any such anniversary a different rate of tax applies to any capital appointments out to beneficiaries. After any ten-year anniversary, the effective rate of tax paid on that anniversary is the rate which applies to capital appointments for the next ten years.

Before the first ten-year anniversary of a settlement the rule is, in very broad terms, based on the initial value of the settled property at the time when the settlement was made. It would be surprising if this value were higher than the value at the first ten-yearly charge date and so, disregarding special factors which relate to business and agricultural property, if trustees are expecting to make any capital appointments at some stage, it will often be the case that lower inheritance tax will be paid before a ten-yearly anniversary, as compared to after it.

As a result, an impending anniversary date in a discretionary trust is a time for a review of long-term strategy.

Planning for an anniversary

If a ten-year anniversary date is looming, what can be done by trustees to mitigate the liability, bearing in mind that it is a form of wealth tax and for trusts which are not in a liquid form there might be problems in raising the money? There are various possibilities for trustees to consider, ranging from some very straightforward matters to more advanced planning; techniques for the latter will involve either (i) temporarily lowering the value of the settled property by a suitable commercial operation (keeping an eye on capital gains tax consequences), (ii) converting some of the trust property into excluded property, or (iii) taking trust assets out of the scope of that which constitutes 'relevant property'.

Income accumulations

First, there is one simple point to be made. The Revenue's Statement of Practice SP8/86 announced that undistributed and unaccumulated income in a trust should not be treated as a taxable trust asset for inheritance tax purposes. Exactly how this applies in any particular case will be a question to decide by reference to the terms of the settlement deed and any trust accounts which have been drawn up. In many cases, it is open to the trustees to leave income undistributed, or to accumulate it so that it becomes trust capital so that there is no particular timescale by which they must decide what to do with the income. In that event, so long as the trust accounts show that the income remains on income account, it will not be taken into account for the purposes of any ten-yearly charge.

The same Statement of Practice indicates that income which has been accumulated is to be treated as becoming a taxable trust asset at the time of the decision to accumulate. This also mitigates the rate of inheritance tax payable on it at the anniversary date (see section 66(2), Inheritance Tax Act 1984).

Foreign property

Inheritance tax works by treating all property everywhere as being potentially within its grasp; only excluded property is taken out.

Accordingly, another simple point is that the residence of discretionary trustees is entirely irrelevant for the purposes of the periodic charges on the trust. Non-resident discretionary trustees are therefore just as liable to the inheritance tax charges of all assets in the trust as are resident trustees.

The excluded property rule is in section 48(3), Inheritance Tax Act 1984. If the settlor was not domiciled in the United Kingdom when the settlement was made, any settled property which is situated outside the United Kingdom is excluded property. There is therefore no inheritance tax charge if that property leaves the settlement, nor is it counted in for the purposes of a ten-yearly charge. Strangely, however, excluded property is counted in when working out the initial value of the trust for the purposes of any exit charge before the first ten-year anniversary. (The same point applies as regards business and agricultural property.)

With excluded property, it does not matter that the domicile of the settlor has changed since the time the settlement was made, nor that he may have become deemed domiciled in the United Kingdom in the meantime. All that matters is the domicile of the settlor on the day that the settlement was created.

It will be a bit late to start thinking about this just before a ten-year anniversary, but trustees can, where the settlor was a non-domiciliary, put the excluded property rule to good use. Switching from United Kingdom investments to overseas investments will take the value of those investments outside the scope of the inheritance tax periodic charges. Alternatively, holding United Kingdom investments or other assets through an offshore company will likewise ensure that the value of those assets is under the umbrella of excluded property.

No inheritance tax charge arises on a conversion of trust assets into excluded property, but of course there may be capital gains tax considerations. Hence, planning in this area is much better dealt with on a long term basis rather than as a last minute panic before a ten-year anniversary, but as a matter of theory it is sufficient to convert the trust assets into excluded property on the day before the anniversary date. I recently heard that a case may be heard before the Special Commissioners in the next few months involving an exchange of trust assets, presumably securities of some type, for a specialty debt outside the United Kingdom. In the case of a United Kingdom private company shares, planning may be much easier; they could be converted into bearer shares (at a stamp duty cost) and taken to a foreign location.

Government securities

All government securities are now excluded property in a discretionary trust if all possible beneficiaries are resident and domiciled overseas. In this case it does not matter that the settlor is, or was, domiciled in the United Kingdom. So in broad terms, if all the beneficiaries of a settlement are overseas, reinvestment of the settled property into exempt government securities would avoid a ten-year charge.

The test for this exemption is, however, quite stringent. The condition, as set out in section 48(4)(b), Inheritance Tax Act 1984 is that it must be shown that 'all known persons for whose benefit the settled property of income from it has been or might be applied … are persons of a description specified in the condition in question'. If a discretionary trust has some United Kingdom beneficiaries and some foreign beneficiaries and there have not been any distributions of capital or income to the United Kingdom beneficiaries, it is certainly the case that reinvestment in exempt government securities coupled with the exclusion of all United Kingdom beneficiaries from future benefit would enable the exemption to apply; so much was established many years ago in a case in which I had some involvement.

What is more debatable is the situation where United Kingdom beneficiaries have already received some benefit. If the only benefit was from capital, then there is an argument that by excluding those beneficiaries, and all other United Kingdom beneficiaries, from future benefit, the exemption for appropriate government securities can apply. Section 48(4) is dealing with the settled property at the time of the charge to inheritance tax, and therefore the suggestion is that capital which has already been appointed out does not come into the reckoning. It would be interesting to know if any readers have succeeded with such an argument in any particular case.

Distributions prior to ten-year anniversary

If it suits the policy of the trustees, a distribution of capital from a discretionary trust before a ten-year anniversary event, even if only a matter of days, may produce worthwhile reductions in inheritance tax liabilities. Note, however, that it is a fallacy to assume that if a distribution can be made to reduce the value of the funds in a simple case down to £242,000 then the charge on a ten-yearly event will be eliminated. The formula does not work like this. Example 2 carries forward the figures from Example 1 and illustrates the impact of a distribution of capital from the trust shortly prior to the first ten-year anniversary. Often it will not be as great as one might have expected.

Formation of sub-trusts

Action by the trustees does not need to be as drastic as appointing funds out of the trust completely. They may prefer to give a beneficiary an interest in possession in all or part of the trust property. If this is done prior to a ten-year anniversary, the results are similar to the outright distribution illustrated in Example 2.

The new sub-trust could be an accumulation and maintenance trust, but there is nothing to prevent this giving rise to an exit charge on the trustees, whereas of course if the settlor had made such a trust in the first place it would have been a potentially exempt transfer.

An appointment of an interest in possession to a beneficiary could be revocable and once the ten-year anniversary date has passed the trustees could exercise the power of revocation. Such action would, however, constitute a chargeable transfer by the beneficiary, and a significant tax liability could occur if the value of the fund exceeded the beneficiary's available nil rate band; quick succession relief would be given, but this is in terms of the tax paid (if any) on the initial appointment. Revocable appointments out of a discretionary trust are therefore rather tricky things to play with, but in smaller trusts if everyone is satisfied that the value of the funds concerned will not exceed the beneficiary's available nil rate band, this could be a possible strategy.

Unravelling the past

There is no income tax charge as such on loans by discretionary trustees similar to that which applies to loans made to employees. Accordingly, one idea with resident discretionary trusts might be to make income distributions to beneficiaries, such as infants, who have no other income (so that they can make tax repayment claims) and to make loans repayable on demand to adult beneficiaries to avoid additional income tax charges in their hands. Where there is dividend income in the hands of the trustees, this should work well enough, but of course the chickens come home to roost at the time of a ten-year anniversary as the making of the loans could arguably be regarded as an accumulation of the income; it is then no longer undistributed income in hand to be left out of account by virtue of the Revenue's Statement of Practice. It may be the case therefore that the monies loaned are liable to the ten-yearly charge which might undo some of the past tax savings.

Ahead of the anniversary date, trustees should therefore consider what to do with the loans. One plan is to confirm that the money on loan is accumulated as capital in the trust and the loan then written off as a distribution to the beneficiary. Obviously trustees would only do this if the result would be a lower tax liability than if the loans were left in place, or as compared with what would have been paid all round if, instead of loans, income distributions had been made.

Business and agricultural property

Trustees have entirely different considerations to bear in mind where they have property qualifying for either business or agricultural property relief. Due to a quirk in the rules relating to the exit charge formula before the first ten-year anniversary of a trust, as is well known, business and agricultural property reliefs are not taken into account in working out the rate of tax to be applied to capital distributions before the anniversary. It would seem that this was an oversight in the legislation, because the reliefs are taken into account after the first ten-year anniversary, but the quirk has remained in place for some considerable time and so we have to live with it. The quirk produces various results as follows:

(1) If a trust comprises both business property and other assets and the other assets are distributed before the first ten-year anniversary, the rate of tax payable on the distribution takes no account of the business property relief available within the trust. The trustees have to tot up their cumulative total (see page 35), add on the initial value of the trust, work out the effective rate of tax and apply it to the distribution.

(2) On the other hand, if the business property qualifies for 100 per cent relief, it can be distributed before the first ten-year anniversary date without any tax charge because although the effective rate of tax is still worked out as in (1) above, the value against which that tax is applied is nil, due to the 100 per cent relief on the distribution.

(3) If the business property qualifies for only 50 per cent relief, it might well be better for any distribution of that property to be made after the first ten- year anniversary rather than before it. It will be a question of working through the figures, but before the anniversary date the full effective rate of tax is applied to one half of the value of the property; after the anniversary date the effective rate of tax might possibly be lower because of the impact of business property relief on the cumulative total charged to tax at the anniversary date.

Finally

Just to complete the picture, it perhaps needs to be said that in relation to the charges on discretionary trusts it makes no difference if the settlor has an interest in the trust or is a potential beneficiary. This would clearly be a gift with reservation but that concept was invented after the introduction of the discretionary trust régime. As a result, it has been dealt with by means of double charges regulations which do not permit adjustment of charges already levied on a trust.

Nor does it make any difference if funds are appointed across to a different settlement. A strange rule in section 81, Inheritance Tax Act 1984 treats the funds as still being part of the settlement from which they first came, although defying reality in this way could no doubt present some practical problems in the longer term.

Malcolm Gunn contributes the chapter on Discretionary Trusts in Tolley's Tax Planning, the 2001/02 edition of which has just been published.

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