Time to treat trusts with neutrality and fairness

  • Describe the importance of using trusts in financial planning
  • List the problems that changes to tax charges might create
  • Describe the impact of periodic charges

Discretionary trusts can be particularly useful when used in a will, enabling family members most in need of financial assistance to receive it, and protecting against the risk of profligate beneficiaries squandering cash. 

How are lifetime IIP/discretionary trusts taxed?

Lifetime IIP trusts (created post-March 22 2006) and discretionary trusts are subject to the ‘relevant property regime’ for IHT purposes.

This regime charges IHT at 20 per cent of the value of property settled into the trust after any exemptions and reliefs, and deduction of the IHT nil-rate band (currently £325,000).

Thereafter, an IHT charge arises every 10 years up to a maximum of 6 per cent of the value of the trust assets (‘periodic charge’), as well as a proportion of the periodic charge every time property leaves the trust (‘exit charge’). 

The aim of the relevant property regime is to equalise, as far as possible, the IHT that would be payable were property to be passed on to the next generation every 30 years (an approximation for the length of a generation) on death, as compared with leaving assets in trust.

The comparison with the tax payable at 30-year intervals on the death of an individual is misleading, however, since individuals have lifetime tax planning opportunities that do not exist for trusts – for example, the ability to make potentially exempt transfers for IHT purposes.

There are also other disadvantages to bear in mind. 

Relevant property trusts suffer IHT at a maximum of 38 per cent during the first 30 years of their existence – just under the 40 per cent death rate of IHT for individuals.

However, trusts do not benefit from a capital gains tax uplift on the death of a beneficiary (contrary toassets that are retained in outright ownership).

The need to raise cash to fund periodic charges and exit charges, and the administrative costs associated with reporting the liability, carry a significant opportunity cost and can be disproportionate to the size of the trust.

For trusts that hold only or mainly illiquid assets, the periodic charge can mean there are insufficient funds available to settle the charge.

Non-trust assets may often need to be added or loaned to the trust to pay for periodic charges, which leads to further complexity.

In the case of discretionary trusts, although these factors are evidently negative, they can fairly be seen as the price to be paid for the benefit of the flexibility, protection and control they offer.

The government’s consultation suggests at least a possibility that the IHT periodic charge rate for relevant property trusts may increase.

Any proposal to increase the periodic charge rate should be considered very carefully. If the rate were to increase, this could cause substantial problems for a number of trusts, including long-running family trusts.