Trusting Trusts - II

RALPH RAY FTII, BSc(Econ), TEP, tax consultant, solicitor in Wilsons Solicitors, Salisbury considers the rules relating to interest in possession trusts.

(Statutory references are to the Inheritance Tax Act 1984 unless otherwise stated. The current nil rate band for 2002-2003 is £250,000.)

FOR INHERITANCE TAX purposes, a person beneficially entitled to an interest in possession in settled property is treated as beneficially entitled to the property in which the interest subsists. The full value of the assets is therefore part of his or her estate in relation to inheritance tax. An interest in possession includes enjoyment of the assets. The House of Lords' decision in Pearson v Commissioners of Inland Revenue [1980] STC 318 defined such an interest in possession as 'a present right to present enjoyment'. A mere power to accumulate prevents the existence of an interest in possession.

Such a trust can, however, be harmless, for example in so far as the transfer into and out of such a trust is, since 17 March 1997, normally subject to the potentially exempt transfer régime. Furthermore, when a beneficiary becomes absolutely entitled to trust assets, there is no inheritance tax charge at that stage.

As regards capital gains tax, prior to 6 April 1998 such trusts made in lifetime or by will on death, were treated very favourably in that, where the trustees made chargeable disposals of the trust assets, the rate of capital gains tax was equal to the basic rate of income tax; an exception was (and still is) where settlor or spouse is directly or indirectly interested in the settlement when capital gains are treated as being the settlor's and taxed at the rate applicable to his or her gains (see sections 77 to 79, Taxation of Chargeable Gains Act 1992). Since that date, the rate for non settlor-interested trusts has been increased to 34 per cent, in line with discretionary and accumulation and maintenance trusts. That rate is still preferable to the 40 per cent rate, although more tax can be payable than applies for a beneficiary liable at the lower or basic rate tax.

Business/agricultural property relief

Where a client has business or agricultural assets eligible for 100 per cent inheritance tax business property or agricultural property relief, the following estate planning steps might be considered.

(1) The estate owner transfers the assets into a flexible interest in possession trust, i.e. one with wide powers of appointment.

(2) Inheritance tax on the transfer is nil in any event because of the 100 per cent business or agricultural property relief.

(3) It is frequently possible to hold over any capital gain on making the settlement under section 165, Taxation of Chargeable Gains Act 1992, although there are detailed conditions for this relief and there could be tax disadvantages such as loss of taper relief.

(4) Termination of the life interest on death will likewise be free of inheritance tax. The decision in Fetherstonhaugh v Commissioners of Inland Revenue [1984] STC 261 illustrates that business property relief, normally at 100 per cent discount, is available in respect of life interests; namely where there is a transfer (or deemed transfer) of a life tenant's business or interest in a business, including assets such as farm land of which he was life tenant and which were used in that business.

(5) The capital gains tax exemption and market value uplift will apply under section 73, Taxation of Chargeable Gains Act 1992, except that capital gains tax will be payable on the lower of any held-over gain and the actual gain, if holdover relief has been claimed (see section 74 of that Act). It may, however, be possible to hold over this capital gains tax liability subject to loss of taper relief. If there is a holdover election, taper relief ceases and the trustees' period of ownership starts afresh and cannot be tacked on to the settlor's period of ownership.

Will trust flexibility

A life interest trust set up by will should be drawn flexibly. In particular the executors/trustees should be given wide, overriding powers of appointment, so that they can either appoint the capital in whole or part to the surviving spouse absolutely, and/or terminate the life interest in whole or part, and appoint the capital to one or more of the other beneficiaries named or referred to in the will. This type of life interest will is likely to be particularly effective for tax and other purposes for the following reasons.

Gifts with reservation provisions

If a surviving spouse inherits assets absolutely which he or she then settles so as to reserve a benefit personally, for instance as a discretionary beneficiary, the assets remain in his or her estate for inheritance tax purposes (see section 102 of, and Schedule 20 to, the Finance Act 1986) unless this can be done as a deed of variation under section 142. The spouse will also be a 'settlor' for capital gains tax purposes under sections 77 to 79, Taxation of Chargeable Gains Act 1992, and for income tax purposes under section 674, Taxes Act 1988.

A life interest gift in a will can overcome the gift with reservation problem. Thus a testator could leave a life interest to his widow coupled with wide powers in the trustees to terminate that interest, whereupon the surviving spouse could benefit in a different capacity. Thus if the trustees did terminate the life interest, the asset in question could thereupon fall into a discretionary trust in which the surviving spouse could be one of the discretionary beneficiaries. However, this would not be a potentially exempt transfer and it may be appropriate to route via the children using their respective nil rate bands. In those circumstances, the surviving spouse would not have reserved a benefit as above because she had made no gift; the only gift would be that made by the testator (via the trustees' power of appointment). Moreover, that arrangement would be specifically excluded from the gift with reservation provisions by virtue of section 102(5)(a), Finance Act 1986.

Note that normally there is no capital gains tax notional disposal on changing the trusts within a settlement from life interest to discretionary.

Instruments of variation

In the 1989 Budget, there were proposals for instruments of variation under section 142 to be severely curtailed. But in a statement by the then Financial Secretary to the Treasury, Norman Lamont, on 20 June 1989, these proposals were abandoned, although he warned that he would be keeping the matter under review and could introduce a more targeted specific measure to counter abuse the following year. Thus, for example, disclaimers, particularly partial and staggered variants, may also be attacked. Although no substantive anti-avoidance arrangements have been introduced to date, it is not beyond the realms of possibility that they may resurface in a future Budget.

The inclusion of a flexible life interest will, as referred to above, largely overcome these restrictions. As wide powers of appointment are written into the will itself, it will not be necessary to rely on the section 142 powers of variation.

Reversionary interests

Reversionary interests are normally excluded property for inheritance tax (see section 48), and there can be considerable scope for resettling such interests. For example, where a settlor or testator has given a life interest to his widow with remainder over to his son, the son would have a reversionary interest during his mother's lifetime and could make a gift of that interest, say, to his own children free of inheritance tax and capital gains tax (see section 76, Taxation of Chargeable Gains Act 1992). If the reversionary interest is vested in the son, he has the comfort of knowing that he, or his estate, is entitled to it, and the flexibility of being able to pass it on in whole or in part during the life tenant parent's life without any tax repercussions.

The above inheritance tax advantage is subject to an exception; where the reversionary interest is owned by the settlor or spouse, it is not excluded property for inheritance tax purposes (section 48(1)(b)).

Example:

Adam settles property on daughter Jessica, for life, with remainder to Adam's wife, Eve. Eve dies before Jessica. Eve's reversionary interest is part of her chargeable estate for inheritance tax purposes, valued on an actuarial basis.

Practical use of life interests

There is an important practical use of life interests in retaining the capital assets in the estate for the eventual benefit of the testator's children. This is particularly relevant in circumstances where it cannot be guaranteed what the course of subsequent events may be; for example where there are stepchildren, or in circumstances where the spouse remarries, when there is a danger that the assets will be diverted to the new husband or wife or their side of the family.

However, care must be taken. For instance, the decisions in Commissioners of Inland Revenue v Lloyds Private Banking Ltd [1998] STC 559; Woodhall [2000] STC (SCD) 558 (SpC 261) and C R Faulkner (Trustees of R C Adams) [2001] STC (SCD) 112 (SpC 278) indicated that if the donee is given a degree of security of tenure of the home, additional inheritance tax is likely because such security may well constitute the granting of an interest in possession.

Taper relief

A settlement in which the settlor creates an interest in possession for himself may be useful to maximise business taper relief following the changes to taper relief effective on 6 April 2000. After two years in the trust (originally ten, then four years), maximum taper relief should be available.

This contrasts with the position where an individual continues to hold the shares personally and did not satisfy the business requirements until 6 April 2000. In such a situation, the non-business apportionment will continue to taint the relief by two years of non-business asset taper.

The possible downside is that the likely use of holdover relief will stop accrued taper and, if there is an early sale by the trustees, more tax may be payable.

Gifts with reservation

A strategy for avoiding the gifts with reservation benefit provisions is for one spouse, say the husband, to make a gift to a trust under which the wife takes an initial interest in possession for life or six months, whichever is the shorter. Thereafter discretionary trusts continue for the family, including the settlor. Alternatively the trustees could be given wide powers to terminate the life interest and appoint on varied trusts, although if this was clearly the original design - and it may be difficult to refute such a suggestion once the whole scheme is reviewed by the Revenue - the application of the inheritance tax associated operations provisions could remove the benefits of the arrangement. The husband and wife will be capable of benefiting in the discretionary trusts and in practice the income may be paid routinely to them.

The recent Special Commissioners' decision in Essex [2002] STC (SCD) 39 has upheld the strategy, as has an appeal in the High Court in Commissioners of Inland Revenue v Eversden [2002] STC 1109, although the Revenue has appealed that decision.

The exemption from the gift with reservation rules by means of a settled gift to the spouse will come into play only if the gift in settlement constitutes a transfer of value and one which is exempt by virtue only of the spouse exemption. A gift of excluded property, for example, would not constitute a transfer of value at all. It is also necessary to ensure that the maintenance exemption contained in section 11 does not apply.

Robert Venables QC does not agree with the argument (suggested by McCutcheon on Inheritance Tax 1988 edition at 6-17 and also adopted by the Capital Taxes Office) that the settlor has made two separate gifts: one to the spouse which is exempt, the other of the reversion to the discretionary or interest in possession class which is not exempt. The settlor has disposed of one piece of property (which has become the underlying trust property), so as to create several different items of property, namely the equitable interests of the beneficiaries. The single gift exemption was upheld in the Essex case referred to above, and on appeal in the Eversden case.

The associated operations provisions in paragraph 6(1)(c) of Schedule 20 to the Finance Act 1986 should not apply, either because there is no gift with reservation at all, or because there is only one operation, namely the making of the settlement. Nor should the Ramsay principle apply, as there is no pre-ordained series of transactions and there are no commercial concepts to take into account . Moreover, the anti-avoidance provisions in section 104, Finance Act 1999 should not counter the above, because the inter-spouse exemption for gifts with reservation are preserved, and the termination of an interest in possession is a deemed transfer of value but not a gift.

This idea could be used to avoid a gift with reservation on the home, although the question mark here is whether the husband and wife would acquire an interest in possession in it by remaining in residence. More suitable are insurance policies where there need be no capital gains tax or income tax disadvantages.

Beware, however, in case a future Budget amends the legislation.

Precedent analysis

The Butterworths Encyclopaedia of Forms and Precedents 2002, fifth edition reissue volume 40 (1) contains a wide and useful selection of interest in possession trust precedents and analysis, in particular:

• Form 5 - containing principal trusts; wide overriding powers of appointment among a wide class of beneficiaries; ultimate trust; administrative powers; charging, protection, and exclusion clauses, etc.

Issue: 3882 / Categories: