It has been just over a decade since changes to trust taxation were introduced on 22 March 2006. As a result, many more new trusts are within the relevant property regime, and are therefore potentially subject to an inheritance tax periodic charge on each 10th anniversary of the trust’s establishment. The first of the trusts set up under the new rules are now reaching this anniversary.
Before looking at the detail, it is worth mentioning that any jointly settled trust is effectively treated as two settlements, with separate calculations for each half (usually) of the trust. For a loan trust, the amount of any outstanding loan is deducted from the gross value of assets in determining the value of the trust.
The calculation of the periodic charge depends upon:
• The value of the trust assets immediately before the 10th anniversary,
• Whether there are any related settlements (other trusts set up on the same day as the one for which the calculation is being carried out),
• Whether any other chargeable transfers were made in the seven years before the trust was established,
• How much capital* has been distributed from the trust in the previous 10 years.
Investment bonds are, of course, treated as non-income producing assets so any distributions from bonds will be treated as capital rather than income payments.
*Note that where income rather than capital has been distributed from a trust it does not have to be taken into account for the purposes of the periodic charge. Income that is not distributed may be treated as capital by HM Revenue & Customs after a certain period has elapsed. Specialist tax advice will be required if trustees are unsure about the status of any accumulated trust.
The calculation
The purpose of the periodic charge calculation is to establish the tax rate on the assets in the trust. Whatever rate is established will be applied to the value of the trust assets.
The basic calculation takes the value of the trust assets at the 10-year anniversary and calculates the lifetime tax that would be due if that amount were transferred into a relevant property trust at that time.
The actual tax rate is then 30 per cent of the lifetime rate that would apply. As the lifetime rate of tax on chargeable transfers is 20 per cent, the maximum possible tax rate at a 10-year anniversary is 6 per cent (30 per cent of 20 per cent).
In working out what the lifetime rate would be:
• Any chargeable transfers in the seven years before the trust was established have to be taken into account,
• Any capital distributions out of the trust in the previous 10 years are also included,
• So it is not possible to avoid a periodic charge by making distributions from the trust just before the anniversary,
• But it may sometimes be possible to avoid tax altogether by winding up the trust before an anniversary.
Exit charges
An exit charge may apply where capital is distributed from a trust. This exit charge is based on the rate of inheritance tax paid at the last periodic charge, the time elapsed since the last periodic charge and the amount being distributed from the trust.
If there is no periodic charge then there will be no exit charge in the subsequent 10 years. In the first 10 years of a trust the exit charge will often be zero, because there was no immediate lifetime charge to tax when the trust was set up.
Where a periodic charge was payable at a 10-year anniversary, though, the appropriate tax rate will be used to establish the size of any exit charge; the number of complete calendar quarters since the 10-year anniversary will also be taken into account, so that the actual tax payable is higher the closer you get to the next 10-year anniversary.
So, for example, using the example above, a rate of 1.3 per cent will be applied to capital distributions in the next 10 years, with the actual tax being 20/40 of that amount if the distribution happens between five years and five years three months after the 10-year anniversary, for example 20 complete quarters later.
Discounted gift trusts
Some special considerations apply where the discretionary trust is a discounted gift trust (DGT).
Trust value
The value of DGT assets at a 10-year anniversary is effectively the net value: in the same way that there is a discount at outset, based on the market value of the income rights the settlor reserves, a similar deduction will apply at a 10-year anniversary.
The discount is likely to be less than at outset because the settlor is 10 years older and therefore the value of an income for the rest of their life will be less. If the settlor is in poor health the discount could be very small or even zero.
Income payments to settlor
The regular instalments of income to which a DGT settlor is entitled do not count as capital distributions from the trust because this portion of the original capital is never treated as part of the settled property – it is carved out from the outset.
Therefore these payments do not have to be taken into account for the purposes of calculating a periodic charge and similarly would not attract exit charges.
Example case study
Jack set up a discretionary trust in June 2006.
• Value of chargeable transfer (after any available exemptions) – £200,000,
• Chargeable transfers in the seven years before June 2006 – £50,000,
• Capital distributions from the trust between June 2006 and June 2016 – £40,000,
• Value of trust assets immediately before the 10-year anniversary – £300,000
Calculation of periodic charge,
• The amount of £300,000 + £50,000 + £40,000 = £390,000 notional transfer value,
• A lifetime transfer of £390,000 in June 2016 would result in an Inheritance tax charge of £13,000: (£390,000 - £325,000) x 20 per cent = £13,000 (which is 4.333 per cent of the value of the trust);
• The periodic charge at the 10-year anniversary is 30 per cent of the above: £300,000 x 4.333% x 30% = £3,900,
• The amount of £3,900 represents 1.3 per cent of the trust fund of £300,000.
Note that the tax rate is less than the headline figure of 6 per cent.
The 6 per cent rate would only apply to the trust assets if the trust did not benefit from any nil rate band (NRB), for example if the previous chargeable transfers used up the current NRB.
Danny Cox is a chartered financial planner at Hargreaves Lansdown
