Back to Square one - Malcolm Gunn FTII, TEP discusses tax planning with reverter to settlor exemptions.

Back to Square One
Malcolm Gunn FTII, TEP discusses tax planning with reverter to settlor exemptions.
Now and again, it is good practice to have a completely wild idea. This article is my wild idea for this week. Others, I am sure, might have chosen to commute to work by World War 2 tank for the day or (in the case of my deputy) suddenly to turn up in the most extraordinary wig together with werewolf fangs (yes it is true!), but in my sad little world this is as wild as I get!
It's their fault!
What started it all off? It all goes back to one or two items which have appeared from time to time in our Meeting Points column which have made rather ingenious use of the reverter to settlor exemption in both the capital gains tax and inheritance tax legislation. I thought therefore it would be worth exploring these exemptions a little further to see if any hidden possibilities might appear. I am not going to start suggesting that dozens of them have popped out of the woodwork, but perhaps there will be something here which will stimulate a few useful ideas.
What is it?
Reverter to settlor? What on earth is he talking about is the question which will be resounding around those offices where there are plenty of trysts out the back but trusts are unheard of.
Suppose that I have too much money (this would be another of my wild ideas) and I decide to use it to help out another person whom I shall call Mr Loser. I do not want to give him the money because, on past experience, he would not have it anymore after six months and in any event I want my children to have it eventually. What I might do therefore is to put the money into a trust with Mr Loser as the life tenant to take the income and on his death, or on some other stated event, the money is then either to come back to me or, if I am not still alive, it will go straight to my children. I am the settlor of the trust and if the funds come back to me there is reverter to settlor. The money goes round in a circle and ends up back at square one.
Enter the taxman
There is no special treatment on setting up this sort of trust. Any gift in settlement is a disposal for capital gains tax purposes and if it is a life interest trust for inheritance tax purposes there is a potentially exempt transfer.
However, the legislation has recognised that it would be rather hard to have the normal tax results apply at the other end of the trust, if and when the money goes back to the settlor.
As a result, the capital gains tax legislation contains a special provision (section 73, Taxation of Chargeable Gains Act 1992) which applies in the following circumstances:
(i) there is the death of a person entitled to an interest in possession in the settled property (normally a life interest, but it could be an entitlement to the income for a certain period);
(ii) on that occasion another person becomes absolutely entitled to the trust fund;
(iii) that other person is the settlor,
then the capital gains tax notional disposal on that occasion is to be on a no gain, no loss basis. It does not matter that there might be some other exemption available, for example principal private residence relief if a property were put in the trust which was Mr Loser's home; no gain, no loss is the rule and so the settlor receives his money back with a base cost equal to that which applied to the trustees. In some cases, the settlor would therefore receive back the trust assets at a base cost equal to the market value of the assets when he first put them in the trust, that being the disposal proceeds which applied for his own tax position at that time.
Normally, there is a recapture of any holdover relief which might have been given on the making of the settlement when a beneficiary becomes absolutely entitled to the trust funds on the death of a life tenant (section 74, Taxation of Chargeable Gains Act 1992). On my reading of section 74, as it interacts with section 73, this recapture is overridden by the no gain, no loss disposal rule when there is a reverter to settlor. Section 74 limits any chargeable gain to the amount of the held-over gain, but if there is no chargeable gain in the first place then there is nothing to limit.
The inheritance tax legislation contains a sort of parallel provision in section 54, Inheritance Act 1984. It applies where:
(i) a person is entitled to an interest in possession in settled property;
(ii) that person dies;
(iii) on that occasion the trust fund reverts to the settlor,
the value of the trust fund is to be left out of account for inheritance tax purposes on the death of the life tenant. So there is no liability on the trust fund and the life tenant's own estate pays inheritance tax (if any) without counting in the value of the funds in the trust.
Some differences
Although the capital gains tax and inheritance tax rules are both driving in the same direction, there are some differences.
First, the inheritance tax legislation goes on to allow the same treatment to apply if it is the settlor's spouse who becomes beneficially entitled to the trust fund, so long as the spouse is domiciled in the United Kingdom. The capital gains tax legislation only allows reverter to the settlor in person.
Second, inheritance tax legislation also goes on to allow the same treatment if the settlor has died less than two years previously and reverter is to the settlor's widow or widower. Once again this is not contemplated by the capital gains tax provision.
Third, the capital gains no gain, no loss provision applies only where, on the life tenant's death, the settlor takes the trust fund absolutely. The inheritance tax provision operates where the settlor becomes 'beneficially entitled' to the trust fund on the death of the life tenant, and this is inheritance-tax-speak for both an absolute interest or an entitlement to the income of the fund.
Lastly, the inheritance tax relief does not apply if the settlor (or the spouse, widow, etc.) purchased the reversionary interest in the trust, whereas the capital gains legislation is untroubled if that is the mechanics by which the settlor receives his or her money back.
One similarity between the two sets of provisions is that one has to do no more than look to see what actually happens at the relevant event in the life of the trust. So it does not appear to matter if the reverter to settlor is the result of the application of the provisions in the trust deed, or the application of general trust law, or because the trustees have previously exercised a power of appointment in favour of the settlor to take effect on the death of the life tenant.
Planning
Astute planners have spotted a tax-free pathway through these separate provisions. Suppose that on the death of the life tenant, the trust fund reverts to the settlor in the form of an entitlement to the income of the fund. In that event, the capital gains tax no gain, no loss rule does not apply because it operates only where the settlor becomes absolutely entitled. The ordinary capital gains tax death of life tenant rule in section 72 of the Act therefore operates, this being that on the death of the life tenant there is a notional disposal at market value with no capital gains tax being payable, i.e. a tax free uplift in base costs to market value (except in so far as there was a hold-over claim on the making of the settlement). The reverter to settlor inheritance tax exemption does, however, apply so that one can get the best of all worlds no inheritance tax, no capital gains tax and a new capital gains tax base cost for the future.
If this sounds outrageous enough to bring Lord Templeman back from retirement, then be warned that there are some technical hitches which we shall come to in a moment. First, a few practical examples might not go amiss.
Estate planning
The idea which has cropped up in the Meeting Points column relates to estate planning and the family home. Nowadays, a husband and wife with relatively modest estates may not be able to use the inheritance tax nil rate band on the death of the first to die by means of cash legacies to children or other members of the family. Their main asset may be the family home and so an inheritance tax problem may be brewing on the death of the survivor. The common answer is for the couple to hold their home as tenants in common so that each can leave his share in it direct to the children of the marriage, thereby using up the nil rate band. This, however, runs considerable risks because everything depends on continuing goodwill all round and on the hope that none of the children will get into severe financial difficulty. The solution is set out in Example 1.
Example 1: estate planning
Arthur and Agnes own their home, Rodents Rest, in one-half shares as tenants in common. Arthur dies, leaving his one-half share to the two children. The children thereupon transfer their shares in Rodents Rest into a trust (or probably better, one separate trust each) in which the life tenant is Agnes and on her death the trust fund reverts in equal shares to the children for an interest in possession with power for the trustees to appoint the capital out to them at their discretion.
There should be no capital gains tax liability on the making of the settlement because the children's interests in Rodents Rest will be newly acquired at market value. The children will be making potentially exempt transfers but hopefully they are young enough not to be concerned about this. On the mother's death there is inheritance tax reverter to settlor exemption and a tax free uplift in the base cost of the property for capital gains tax purposes. It could subsequently be sold and the capital appointed by the trustees out to the children.
In Example 1, if Agnes survives Arthur she will feel a little more secure about her position with Rodents Rest. The situation is, however, still not ideal because until the children actually make the settlement, she will be relying on their goodwill. All the same, if the family falls out during Arthur's life, he could always change his will.
If Agnes wants to move after Arthur dies and the trust has been set up, this will be quite feasible. On the trustees selling their interest in Rodents Rest, the capital gains tax main residence election in section 225, Taxation of Chargeable Gains Act 1992 should be available.
Divorce
If, in a divorce situation, one party to the marriage has to provide a home for the other, simply buying a house and making it available will lose the benefit of the capital gains tax main residence exemption. If, however, the house is provided in the form of a trust, with reverter to settlor, the main residence exemption will be available under section 225, Taxation of Chargeable Gains Act 1992. If, on the death of the former spouse living at the property, it reverts to the settlor, then the inheritance tax exemption will apply, and the capital gains tax situation can also be preserved with a short-term continuing trust after the death.
Unfortunately, with divorce lawyers being ever eager to pour in some acrimony and get a good argument going even when the parties themselves are in agreement, the advisers are likely to point out that matters will not necessarily follow expectations and if the spouse providing the home dies first, there may be no reverter to settlor exemption and the duty position in the other spouse's estate will then be adversely affected. So be it; that is the price for being provided for.
More planning
Example 2 endeavours to extend the ideas already discussed into more general tax planning, particularly for anticipated capital gains.
Example 2: washing out a development gain
Bill is about to buy some scrub land for £50,000. He believes that it might be possible to get planning permission for the land and to make a substantial profit out of it. His mother, Billie, is aged 92 and her health is beginning to fail.
Bill forms a settlement for Billie's benefit with £50,000 cash and the trustees buy the land as a trust asset. In the course of time, the trustees succeed in getting planning permission for the land. Billie dies when she is 96, after which there is a short continuing trust in Bill's favour. The funds in the trust are then appointed back to Bill.
The consequences of this arrangement are:
(i) Bill makes a potentially exempt transfer of £50,000 when the settlement is made;
(ii) When Billie dies the inheritance tax reverter to settlor exemption applies;
(iii) Also when Billie dies, the land is written up tax free to a market value base cost;
(iv) When Bill receives the land back out of the trust, he can sell it with minimal tax liability.
The example is all very well as it stands, but it also illustrates why I described this article as my wild idea for the week. People's lives do not unfortunately run like trains down railway tracks. Billie might have lived on until she was 106. In the meantime how would the trustees justify keeping all the trust assets in a non-income producing form when she is the life tenant? If they were to sell the land during her life, capital gains tax would be payable (upon which more in a moment).
Quite apart from all this, Billie might not appreciate being no more than the elderly stooge who has to fall off her perch reasonably quickly so that Bill can save some tax.
More remote ideas
So far the ideas discussed have all revolved around land not producing any income. For discussion purposes, therefore, Example 3 takes things a step further with an arrangement involving shares.
Example 3: internet millionaire
Edmonds hears about a new company being formed for internet trading and is offered the opportunity to subscribe for some shares. He would also like to provide for his godson, Blobby, who is 17 and suffers from a chronic illness, although his concern is only for Blobby himself and so he would not want any funds to go to Blobby's children. Edmonds would either like the money back in due course, or would want it to go on to his own children.
Edmonds therefore forms an accumulation and maintenance trust for Blobby until he is 25 when he is to take the income for the rest of his life. On Blobby's death, the funds will either revert to Edmonds or will go direct to Edmonds' children. Edmonds transfers some funds into the settlement and the trustees use part of them to subscribe for the internet shares.
The internet shares rapidly acquire enormous value. If Blobby's illness brings about a premature death, there will be a tax free uplift in the base cost of the shares for capital gains tax purposes if there is a continuing trust, or if on that occasion the funds pass out direct to Edmonds' children. If Edmonds is still alive and is the beneficiary under the continuing trust, there will be inheritance tax reverter to settlor exemption. If he is not alive, then, in any event, 100 per cent business property relief may apply for any unquoted shares in the trust which satisfy the detailed rules.
If the trustees decide not to hold on to the internet shares after they have become valuable, then the same rate of taper relief is due to them, under the Finance Act 2000, as would be available to Edmonds himself.
Other uses
Two ingenious reverter to settlor trust schemes were mentioned by Kevin Prosser QC at this year's Key Haven Oxford conference.
The first is designed to secure inheritance tax business property relief for buildings or machinery used by a family company. If the controlling shareholder is willing to settle his shares on the owner of the buildings or machinery, the latter can then be given away with the benefit of 50 per cent business property relief. After the gift, the shares could revert to the settlor free of inheritance tax (100 per cent business property relief being available). If required, capital gains tax hold-over relief should be available in and out of the settlement, restricted however if there are non-business assets, but the taper relief clock will be reset.
The second idea is to help those who have made a gift which is caught by the inheritance tax gift with reservation provisions. The donee could solve this problem by settling the assets concerned on trust for the original donor with reverter to settlor on his or her death. Kevin freely admits, however, that it would be better not to make the gift with reservation in the first place!
Fitzwilliam and all that
The much celebrated inheritance tax/Ramsay case of Countess Fitzwilliam v Commissioners of Inland Revenue [1993] STC 502 made use of another inheritance tax reverter to settlor scheme. This was blocked by an amendment to what is now section 53, Inheritance Tax Act 1984 and the reverter to settlor exemption is now no longer available where it depends upon a reversionary interest in another settlement being transferred into an individual's own trust which is to revert to him or her in due course.
Technical hitches
Clients who are interested in exploring further the possibilities with reverter to settlor trusts will need to be warned that such trusts will be caught by certain anti-avoidance provisions.
Capital gains tax
Most of these types of trust will be caught by either section 77 (for onshore trusts) or section 86 (for offshore trusts), Taxation of Chargeable Gains Act 1992 as being settlements in which the settlor has an interest. The definition of what constitutes a retained interest is drafted very widely and certainly includes any expected reversion of the funds to the settlor. It even includes any possibility, however remote, that the trust funds might one day be due back to the settlor.
It may in some cases be possible to take advantage of two of the exceptions from these provisions. There is one exception for a reversion on the death of the child of a settlor who had become beneficially entitled to the property at an age up to 25. This seems to have in mind the situation where the child has become entitled to a life interest in an accumulation and maintenance trust and, on his or her death, the funds revert to the settlor.
The second exception is for similar types of trust where the child has not yet attained the age of 25 and whilst he or she is alive there is no possibility of any interest reverting to the settlor. There could, however, be a possible reversion on the death of the child and that would be acceptable.
However, it seems that neither of these exceptions is likely to assist the tax planner looking at possible uses of reverter to settlor trusts and so if any gains are realised during the life of the trust, they will be taxable on the settlor, with a right of recovery from the trustees. The arrangement in Example 1 is therefore particularly suited to a reverter to settlor trust as any gains during the life of the trust are covered by a separate exemption in the legislation.
Income tax
One hits a similar problem under the income tax legislation. Section 660A, Taxes Act 1988 contains an income tax provision which mirrors the capital gains tax provision mentioned above. Therefore in most reverter to settlor trusts any income is likely to be taxable on the settlor, with a right of recovery from the trustees.
Other points
One might wonder what the inheritance tax position will be if the settlor should die unexpectedly before the trust has run its course. Would there be a gift with reservation? The answer to this is that, so long as the trust is carefully set up, there is no gift with reservation. The point is that before making the settlement, the settlor has full and unfettered ownership of the assets concerned. After making a settlement of this type, he or she has the future right to recover the assets and in the meantime another beneficiary has beneficial enjoyment of them. What therefore constitutes the gift? It is the beneficial enjoyment of them given to the third party under the trust. The interest in reversion was never given away and was not therefore part of the gift so that there is no gift with reservation. This point appears to be accepted by the Revenue in the CTO Advanced Instruction Manual at paragraph D73. The position does not appear to be affected by the fact that the trustees may have power to appoint the settlement funds back to the settlor at any time, or indeed that the settlor himself may retain a general power of appointment over the settlement. In either case, the settlor has given away an interest in possession in the settled property for so long as it lasts.
Note, however, that under section 48(1), Inheritance Tax Act 1984 a reversionary interest in favour of either the settlor or his spouse is not excluded property and accordingly the more substantial any rights are which are retained by the settlor, the greater the value of the reversionary interest will be. That value will be liable to inheritance tax if the settlor should die during the life of the trust. However, as I understand it, the Revenue accepts that if the trustees have power to appoint capital out of the trust at any time to a variety of beneficiaries the value of any reversionary interest in the fund is nil, and so that could be a way of managing the problem.
The continuing trust
For the capital gains tax planning reasons already mentioned, reverter to settlor arrangements should involve a continuing trust in favour of the settlor. It should be remembered that a trust with only one beneficiary is a bare trust for capital gains tax purposes. The continuing trust therefore needs a variety of possible beneficiaries.
The bottom line
What all this boils down to is that the reverter to settlor trust arrangement works very well with the inheritance tax scheme mentioned in our Meeting Points column (Example 1) but it will not often be an arrangement which will help out in other situations. So I have broadly ended up myself back at square one with this idea but not quite: just occasionally it may fit the bill very neatly in other circumstances, and then it could possibly produce some spectacular savings.

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