Inheritance tax on trusts - Trust the taxman

Many newly-created trusts will be exposed to greater inheritance tax charges under the new Finance Act 2006 regime, warns Peter Rayney.

Trusts have been used for many centuries as a means of protecting family wealth and to guard against the spending habits of 'wastrel' offspring.

Hitherto, their use has also been bolstered by relatively favourable capital tax regimes.

Under the 'old' estate duty regime (which applied until 1975), the use of discretionary trusts generally avoided estate duties. Under a discretionary trust, the beneficiaries only receive distributions from the trust if the trustees exercise their discretion to make them. In contrast, interest in possession (IIP) or life interest trusts give beneficiaries an absolute entitlement to the income of the trust. In the past, IIP trusts were subject to estate duty when the beneficiary died.

Pre-FA 2006 charging regime

When Capital Transfer Tax (CTT) replaced estate duty in 1975, the distinction between these two main types of trust continued. However, under rules considered draconian at the time, discretionary trusts became subject to special CTT charges. These rules remain in place today under the inheritance tax (IHT) regime (the successor to CTT). Their broad objective is to treat a discretionary trust as though it were a separate individual, with tax being collected from it as though a gift of the property held by the trust had been made every generation. Given the need to collect the tax regularly, each discretionary trust is currently subject to IHT every 10 years at a maximum rate of 6%.

In practice, most trusts have tended to pay only modest amounts of IHT or nothing at all. This is due to the operation of the 'nil rate' band and/or important reliefs, such as business property relief or agricultural property relief. The general view is that these tax charges represent a reasonable toll for the privilege of keeping property in a separate trust as opposed to remaining in an individual's taxable estate.

Until the Finance Act 2006 changes, the IHT regime had taxed IIP trusts by treating the beneficiary enjoying the income as being beneficially entitled to the trust property (ie, the capital value generating the trust income). However, the 2006 legislation radically changed the fiscal environment for trusts. Since 22 March 2006, all newly-created trusts - irrespective of whether they are IIP or discretionary trusts - are subject to the same IHT regime (which follows the pre-FA 2006 rules for discretionary trusts).

This article reviews the main IHT consequences of setting up and running a new trust. The special transitional provisions that apply to existing trusts will be covered in a subsequent issue.

IHT treatment of new trusts

Under the FA 2006, subject to limited exceptions, the main IHT rules applying to all new trusts (which are treated as 'relevant property trusts') are as follows:

•    The creation of a relevant property trust (during the settlor's lifetime) represents a chargeable transfer for IHT purposes. Therefore any amount not covered by the transferor's available nil rate band (£285,000 for 2006/07, reduced by any chargeable transfers within the previous seven years), will be taxed at the 20% lifetime rate - with an appropriate increase if the transferor dies within seven years of the transfer. (Note that in some cases, as when shares in a private trading company are being transferred, the chargeable transfer can be wholly exempted under the business property relief rules.)

•    Relevant property trusts are subject to a 10-year anniversary charge (or periodic charge) (s64 IHTA 1984). This is set at a maximum rate of 6%, but is frequently less due to the availability of the nil rate band and/or other IHT reliefs.

•    Exit charges are levied when property leaves a relevant property trust (s65 IHTA 1984). During the first 10 years of the trust's existence, the exit charge is based on the effective IHT rate paid by the settlor when the trust was created. Thereafter, the IHT on property leaving the trust is based on the effective rate applied on the last 10-year charge.

While discretionary trusts have always been taxed on this basis, these rules represent a major change in the way IIP trusts are taxed. Before 22 March 2006, property transferred into an IIP trust was a potentially exempt transfer (PET) - this meant that the transfer was ignored for IHT provided the transferor survived for seven years. Moreover, pre-22 March 2006 IIP trusts do not incur any 10-year charges but their underlying capital value is subjected to IHT when the life tenant beneficiary dies - all this has now changed!

Note that a chargeable transfer is now created even where the settlor transfers property to an IIP trust for:

•    their own benefit (under the FA 2006 regime, the transferor is no longer treated as being beneficially entitled to the trust property); or

•    their spouse's benefit (since the spouse is no longer treated as being beneficially entitled to the trust property, the normal IHT spouse exemption no longer applies in this case).

Where the settlor is able to benefit under the trust, the value of the trust property will still remain in the settlor's estate under the gift with reservation of benefit (GROB) rules. However, any tax payable under the GROB rules should be relieved under the special 'double charge' rules where the settlor dies within seven years of the transfer.

CGT hold-over relief

Care should be taken with the capital gains tax effect where chargeable assets are being transferred to a trust. The transfer of property to a trust will normally represent a deemed 'market value' disposal for CGT purposes. However, provided the transfer is a chargeable one for IHT purposes (which will now invariably be the case), the transferor can jointly elect with the trustees to hold over the gain (except where the trust is a settlor-interested one - see below). By making a s260 TCGA 1992 election, the transferor avoids a CGT charge and the trustees inherit the property at its (indexed) base cost. Although it is possible to avoid valuing the transferred asset for CGT purposes, a proper valuation will normally be required for IHT.

It is no longer possible to claim CGT hold-over relief where the recipient trust is 'settlor-interested'. Historically this would be where either the settlor or their spouse is able to benefit under the trust. However, in the FA 2006 a subtle change was made to the settlor-interested definition, which was widened to include the settlor's dependent children (ie, broadly those under the age of 18). This means that, for transfers after 6 April 2006, no hold-over relief can be claimed where the actual beneficiaries of the trust include the settlor's dependent children. (Pre-6 April 2006 transfers are not affected by this extended definition.)

Exit charges on property leaving the trust

All relevant property trusts will be subject to an IHT exit charge when the property leaves the trust, typically by way of a capital distribution to a beneficiary. The exit charge is calculated by applying an effective IHT rate to the value of the property leaving the trust. (Boxes 1 and 2 explain and illustrate how the exit charge is calculated.)

The treatment of new IIP trusts gives rise to a number of other tax consequences.

Thus, from a CGT perspective, there is no uplift to market value on the death of the life tenant of a new IIP trust. However, since the property leaving the IIP trust at this point would be a chargeable transfer for IHT purposes, CGT hold-over relief should be available under TCGA 1992, s260.

Where the assets of an IIP trust are subsequently appointed on a discretionary trust, this is now effectively a 'non-event' for IHT purposes and hence no 'exit' charge arises. (This is because discretionary and post-21 March 2006 IIP trusts fall within the same 'relevant property' trust regime.)

First 10-year charge

Interest in possession trusts set up after 21 March 2006 and discretionary trusts are 'relevant property' trusts. Both these trusts are therefore subject to a 10-year anniversary (or periodic) charge. The 10-year anniversary is taken from when the trust started. (If the trust is created under a will, the date of testator's death is treated as the commencement date.)

IHTA 1984, ss64 to 66, provides for the calculation of the 10-year charge, which is summarised in box 3.

Will trusts for spouses

Many wills provide for the surviving spouse to be given a life interest in the residue etc. Thus, the surviving spouse would become entitled to an interest in possession on their spouse's death. Before the Budget 2006, the creation of such a life interest trust would have qualified for the spouse exemption, so that the value passing into the trust escaped IHT.

The original Budget 2006 proposals intended that the spouse exemption would cease to apply in this situation - so that the property destined for the 'life interest' will trust would have attracted IHT. However, in June 2006, the government backed down and introduced special relieving provisions for life interest trusts created on death, which have become known as Immediate Post-Death Interest (IPDI) will trusts. These beneficial rules do not apply where life interest trusts are set-up inter-vivos (ie, during the settlor's lifetime).

IPDI trusts are effectively taxed under the old rules. In effect, the life tenant of an IPDI trust is treated as owning the underlying trust assets. Thus, where an IPDI is left in favour of a surviving spouse (or civil partner), the assets passing into the trust do not attract any IHT (due to the operation of the spouse exemption). In other cases, the relevant assets would attract IHT as part of the deceased's chargeable estate.

However, during the life of an IPDI, there are no 10-year or exit charges.

When the IPDI comes to an end on the death of the life tenant, the underlying trust assets will be included within the deceased's chargeable estate and subject to IHT (as under the pre-FA 2006 IIP regime).

Peter Rayney is BDO Stoy Hayward's national tax technical partner. He is author of Tax Planning For Family & Owner Managed Companies 2006/07, recently published by Tottel


(a) Take the value of the hypothetical transfer into the trust by the settlor - this is the value actually transferred into the trust (and any additions made to the trust before the relevant capital distribution and the initial value of any 'related' settlement (see s62 IHTA 1984)).

(b) The IHT liability on the total hypothetical transfer (in (a)) is found by applying the lifetime rate of 20% to that value (reduced by any 'nil rate' band available to the settlor). The effective rate is the IHT calculated as a percentage of the total hypothetical transfer.

(c) The effective rate is then time apportioned by applying the fraction q/40 where:

•    q = the number of complete quarters between the start of the trust and the day before the distribution

•    40 = the number of complete quarters in the 10-year period.

(d) The actual IHT rate to apply to the capital distribution is found by taking 30% of the apportioned effective rate in (c)

(e) If 100% business property relief (BPR) applied on the original transfer into the trust, it cannot be used to reduce the value of the shares initially received by the trust - the trustees will not have held them for the requisite two years. However, once the shares have been held for the relevant 'two-year' period, 100% BPR can be applied against the value of the shares subject to a distribution or exit charge.

(f) No exit charge arises within the first three months of the start of the trust (or a subsequent 10-year charge).

(g) If the trustees pay the tax, the IHT due has to be 'grossed-up' for the relevant IHT.


On 20 November 2006, Patricia transferred a 30% shareholding in her property investment company (Caputo Properties Ltd) to The Patricia Caputo 2006 Trust. The trust was primarily for the benefit of her daughter, Annina (aged 21), who was entitled to the income of the trust. (Note: The gain on the transfer of the shares was held over under s260 TCGA 1992. Hold-over relief is available since the trust was not a settlor-interested one - Annina is over 18 years old.)

The value of the shares settled into the trust was agreed with Revenue & Customs at £450,000. At the time of the transfer, Patricia had made chargeable transfers of £200,000 within the previous seven years.

On 5 September 2008, the trustees advanced capital of £100,000 to Annina.

The IHT payable on the exit charge would be £789, calculated as follows:

Value of hypothetical chargeable transfer:  
Value of 30% shareholding at 20 November 2006* 450,000
Total of previous chargeable transfers 200,000
Cumulative chargeable transfers 650,000
IHT at lifetime (half-death) rates for 2008/09  
First £312,000 x 0% -
Next £338,000 x 20% - 67,600
Less: Tax on previous chargeable transfers  
- Tax on assumed chargeable transfer 67,600
Effective rate: £67,600/£450,000 x 100 15.0222%

* No business property relief is available since Caputo Properties Ltd is an investment company Number of complete quarters between start (Nov 2006) and exit (Sept 2008) = 7 Rate chargeable: 15.0222% (effective rate) x 7/40 x 30% = 0.7887% IHT payable: £100,000 x 0.7887% £789


(a) Compute the chargeable amount - this is based on the value of the trust property immediately before the 10-year anniversary. The trust property includes the capital and the accumulated income of the trust and is reduced by any trust liabilities. Where the trust property includes shares in an owner-managed company, they are likely to qualify for 100% business property relief (after two years) which can be deducted in arriving at the chargeable amount.

(b) Calculate the actual rate of tax to apply to the value of the trust in (a). This is 30% of the effective IHT payable on a notional transfer consisting of:

•    the total chargeable transfers made by the settlor of the trust within the seven years before they created the trust

•    the total of any capital distributions that have been subject to an exit charge within the last 10 years (before the relevant anniversary).

The actual tax is calculated by reference to the prevailing nil rate band at the relevant 10-year anniversary.

(c) 100% BPR is available on the value of any qualifying shares provided the trustees satisfy the relevant BPR conditions at the relevant 10-year anniversary date.

(d) If the value of the other trust assets falls within the nil rate band, there will be no 10-year charge.

(c) The 10-year charge is payable by the trustees (but there is no 'grossing-up').

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