Revenue Law Principles and Practice

24th Ed.

General Editor: Natalie Lee LLB (Hons), Barrister

[*805]

33 IHT--settlements with an interest in possession: the old and new regimes

Updated by Natalie Lee, Senior Lecturer in Law, University of Southampton and Apania Nathan, LAS Ham, LLM, Barrister, Gray's Inn Tax

Chambers

I Basic principles [33.1]

II When is IHT charged? [33.21]

III The taxation of reversionary interests [33.61]

The Finance Act 2006 introduced substantial changes to the tax treatment of settlements with beneficial interests in possession. Broadly speaking, the tax treatment of settlements created after 22 March 2006 is aligned with the tax treatment of discretionary settlements. Consequently, with limited exceptions, the inter vivos creation of an interest in possession settlement will give rise to an immediate chargeable transfer, and property held within the settlement, which will not be deemed to form part of the life tenant's estate, will be subject to periodic and exit charges. The result of the changes is that, in effect, two sets of rules operate for trusts with interest in possession: one for those where the interest arose prior to 22 March 2006, and the other for those created on or after that date.

I BASIC PRINCIPLES

I General

a) Charging method

A person who became entitled to the income of a fund prior to 22 March 2006 (usually the life tenant) and someone who becomes entitled to particular types of interests in possession on or after 22 March 2006 (see [33.3]) is treated 'as beneficially entitled to the property in which the interest subsists' (IHTA 1984 s 49(1)). This rule is, of course, a fiction since a life tenant has no entitlement to capital. Although the section does not expressly provide for the deduction of trust liabilities, in practice it is the net value of the trust fund that is attributed to the relevant beneficiary.

As all the capital is treated as being owned by the life tenant, for IHT Purposes it forms part of his estate, so that on a chargeable occasion IHT is charged at his rates. The settlement itself is not a taxable entity, although Primary liability for IHT falls upon the trustees. [*806] Interest in possession trusts created on or after 22 March 2006 which do not fall within the limited exceptional categories will he treated in the same way as trusts with no interest in possession, which are considered in the next chapter. In short, the IHT levy on these other settlements operates by treating the settlement as a separate chargeable entity and by (generally) imposing a tax charge at regular intervals. Even before the changes made by FA 2006, Carnwath LJ in IRC v Eversden (2003) at para 25, suggested that there appeared to be no reason why this method, if it achieves tax 'neutrality', should not be applied across the board. It would appear that FA 2006 sought to do just that, but it is questionable whether there should exist neutrality between two fundamentally different concepts. [33.1]

b) Other interests

As the life tenant of a trust with an interest in possession is treated as owning all the capital in the fund (IHTA 1984 s 49), other beneficiaries with 'reversionary interests' own nothing. IHTA 1984 s 47 defines reversionary interests widely to cover:

'a future interest under a settlement, whether it is vested or contingent (including an interest expectant on the termination of an interest in possession which, by virtue of section 50 ... is treated as subsisting in part of any property)'.

Generally, reversionary interests are excluded property and can be transferred without a charge to IHT (see [33.61]). Despite the breadth of this definition, the term would not appear to catch the interests of discretionary beneficiaries since such rights as they possess (to compel due administration; to be considered; and jointly to wind up the fund) are present rights. Their interests are neither in possession nor in reversion. 'Settlement powers' (including a power to revoke the settlement) are not 'property' for IHT purposes and hence fall out of charge. [33.2]

2 Who is treated as owning the fund?

a) life interests

The beneficiary who:

(i) became entitled to an interest in possession prior to 22 March 2006; or

(ii) becomes entitled on or after 22 March 2006 to:

(a) an immediate post-death interest; or

(b) a disabled person's interest; or

where the interest is not a disabled person's interest or one for bereaved minor

is treated as being beneficially entitled to the trust property, or to an appropriate part of that property in which the interest subsists (IHTA 1984, s 49(1); if there is more than one beneficiary, it is necessary to apportion the, capital in the fund (IHTA 1984 s 50(1)).

EXAMPLE 33.1

Bill and Ben, beneficiaries under a family settlement created prior to 22 March1 2006, jointly occupy 'Snodtands', the ancestral home, which is worth £150,000. [*807] This capital value most he apportioned to Bill and Ben in proportion to the annual value of their respective interests. As their interests are (presumably) equal the apportionment will he as to £75,000 each.

It can he seen from the above that formerly all beneficiaries entitled to an interest in possession were treated in this way. One result f the changes introduced by FA 2006 is that the statutory fiction (that a person with an interest in possession is deemed to be beneficially entitled to the underlying property in which his interest subsists) is disapplied for interests in possession acquired on or after 22 March 2006, with limited exceptions. These exceptions are couched in defined terms (sec Chapter 32), and are illustrated by the following examples:

(1) Eddie died in September 2006, leaving his entire estate to his wife, Glarrie, for life, with remainder to his son William absolutely. Clarrie's interest is an immediate post-death interest and thus qualifies as an interest in possession for the purposes of IHTA 198,1 s 49. On Eddie's death, the transfer to Clarrie is exempt under the spouse exemption (IHTA 1984 s 18; see [31.41]); on Clarrie's death, the value of the capital in which her interest in possession subsists will he added to her free estate.

(2) In 1992, Phil left his residuary estate to his wife Jill for life, thereafter to his son David for life with remainder to his grandson Josh absolutely'. Jill dies in 2007. David's interest is a transitional serial interest (it arises in immediate succession on or after 22 March 2006 but before 6 April 2008 to an interest in possession subsisting before 22 March 2006 tinder a trust created before then), and thus qualifies as an interest in possession for the purposes of s 49.

(3) In 1996, Peggy settled her considerable holding of Marks & Spencer shares on her daughter Jenny for life, thereafter to jenny's husband Brian for life with remainder to Jenny and Brian's children. jenny dies on 1 May 2008. Brian's interest is a transitional serial interest and thus is an interest in possession for the purposes of s 49. If, rather than dying, jenny surrenders her interest on 1 May 2008, then Brian's interest would not be a transitional serial interest. If, instead, Jenny surrenders her interest in December 2007, Brian's interest will qualify as a transitional serial interest under (2) above.

Depending upon whether entitlement began before or on or after 22 March 2006, a beneficiary who has the right to the income of the fund for a period shorter than his lifetime (however short the period may he) is still treated as owning the entire settled fund. If the settlement does not produce any income, but instead the beneficiary is entitled to use the capital assets in the fund, IHTA 1984 s 49(1) suggests that he is treated as owning those assets. If the use is enjoyed by more than one beneficiary, the value of the fund is apportioned under IHTA 1984 s 50(5) in accordance with the 'annual value' of their respective interests. Annual value is not defined.

For a recent ease on life interests, see Oakley v IRC [2005] STC (SCD) 343. [33.3]-[33.4] [*808]

h) A beneficiary entitled to a fixed amount of income

Difficulties may arise where one beneficiary is entitled to a fixed amount of income each year (eg an annuity) and any balance is pair! to another beneficiary. If the amounts of income paid to the two were compared in the year when a chargeable event occurred, a tax saving could he engineered. Assume, for instance, that the annuity interest terminates so that IHT is charged on its value. The proportion of capital attributable to that interest and, therefore, the IHT would he reduced if the trustees had switched investments into assets producing a high income in that year. A relatively small proportion of the total income would then be payable to the annuitant who would be treated as owning an equivalently small portion of the capital. When a chargeable event affects the interest in the residue of the income (eg through termination) the trustees could switch the assets into low income producers, thereby achieving a similar reduction in IHT.

IHTA 1984 s 50(3) is designed to counter such schemes by providing that the Treasury may prescribe higher and lower income yields which take effect as limits beyond which any fluctuations in the actual income of the fund are ignored (see SI 2000/174).

EXAMPLE 33.2

The value of the settlement is £100,000; income £15,000 per annum, A is entitled to an annuity' of £5,000 pa; B to the balance of the income. If there is a chargeable transfer affecting the annuity, A is not treated as owning £33,333 of the capital ([£5000 ÷ £15,000] x £100,000) but instead a proportion of the Treasury higher rate' yield. Assume that the higher rate is 8% on the relevant day; the calculation is, therefore:

Notional income = 8% of £100,000 ÷ £8,000.

A's share of capital is, therefore, [£5,000 ÷ £8,000] x £100,000 = £62,500.

This calculation is used whenever the actual income yield exceeds the prescribed higher rate. The calculation cannot lead to a charge in excess of the total value of the fund!

When a chargeable transfer affecting the interest in the balance of the income occurs, if the actual income produced falls below the prescribed lower rate, the calculation proceeds as if the fund yielded that rate. If both interests in the settlement are chargeable on the same occasion, the prescribed rates do not apply because the entire fund is chargeable. [33.5]

c) A lease treated as a settlement

When a lease is treated as a settlement (eg a lease for life or lives: see [32.2]), the lessee is treated as owning the whole of the leased property save for any part treated as belonging u) the lessor. To calculate the lessor's portion it is necessary to compare what he received when the lease was granted with what would have been a full consideration for the lease at that time (IHTA 1984 ss 50(6), 170). [33.6]-[33.20]

EXAMPLE 33.3

(1) Land worth £100,000 is let to A for his life. The lessor receives no consideration so that � is treated as owning the whole of the leased property tic £100,000). The granting of the lease is a PET by the lessor of £100,000. [*809]

(2) As above, save that full consideration is furnished, The lease is not treated as a settlement (sec [32.2]). No IHT will he charged on its creation as the lessor's estate does not tall in value.

(3) Partial consideration (equivalent to 40% of hill consideration) is furnished so that the value of the lessor's interest is 40% of £100,000 = £40,000. The value of the lessee's interest is £60,000 and the granting of the lease is a PET of £60,000.

HMRC accepts that if A, the owner of Blackacre, were to sell it for full consideration arrived at on the basis that he reserves a lease for life, then that lease has been granted for full consideration and so does not involve the creation of a settlement. This approach is questionable.

II WHEN IS IHT CHARGED?

For interests in possession arising on or after 22 March 2006, with one limited exception, IHT is charged on a transfer of property to the settlement, on 10 year anniversaries and when property leaves the settlement (see Chapter 34 below). For settlements created prior to 22 March 2006 and in respect of a disabled person's interest created on or after that date, the pre-FA 2006 treatment continues, whereby IHT may he charged on the creation of the settlement and whenever an interest in possession terminates. This event may occur inter vivos or on death: whilst there will always be a charge on death (unless the event is subject to an exemption, such as the spouse exemption (IHTA 1984 s 18)), in the former case the settlor or beneficiary (as appropriate) will be treated as making a PET provided that the trust fund is not then held on discretionary trusts. There are arid-avoidance rules to prevent the indirect creation of discretionary trusts via short-lived interests in possession (see [33.31]). [33.21]

I Creation of interest in possession trusts

If the trust is set up on death the usual IHT charging regime operated (see Chapter 30). If created inter vivos, whether there is an immediate IHT charge will depend upon when the interest in possession was created. 1f it was prior to 22 March 2006, the settlor would have made a PET; if it was on or after 22 March 2006, there will be an immediate IHT charge in all cases except where the interest is a disabled person's interest (IHTA 1984 s 3A(1A) inserted by FA 2006 Sch 20, para 9). Where there is a PET, under general rules, a charge to TUT will only occur if the settlor dies within seven years; anti-avoidance rules may, however, trigger a charge by reference to the settlor's circumstances when he created the trust if the life interest ends within seven years, at a time when the settlor is still alive and the property then becomes held on trusts without an interest in possession (see [33.31] for a discussion of these rules). [33.22]

EXAMPLE 33.4

(1) Sam settles property on his daughter Sally for life, remainder to charity. The creation of the trust, if before 22 March 2006, is a PET by Sam and on Sally's [*810] death the fund will he exempt from charge (see IHTA 1984 s 23 for the charity exemption). 1f the property had been settled on 23 March 2006, there would have been an immediate chargeable transfer (at half the death rates), unless Sally qualified as a disabled person (see Chapter 32).

(2) Before 22 March 2006, Sid settles property on a stranger, Jake Straw, for life or until such time as the trustees determine and thereafter the property is to he held on discretionary trusts for Sid's family and relatives. The creation of the trust is a PET; a later termination of Jake's life interest will he a chargeable transfer and may trigger the anti-avoidance rules. As with (1) above, had the property been settled on 23 March 2006, there would have been an immediate IHT charge.

(3) Before 22 March 2006, Sam settles property on Susan, his daughter, for life, remainder to her twins contingently on attaining 21. Susan surrenders her life interest before 22 March 2006 when the twins are (i) 17, (ii) 18, (iii) 21.

The creation of the trust is a PET as is the surrender of Susan's life interest. If it is surrendered at (i), the fund is then held for A&M trusts (a PET); if surrendered at (ii), the transfer is to the twins as interest in possession beneficiaries (a PET); while, if surrendered at (iii), the twins are absolutely entitled and so it will be an outright gift which is a PET. (Note the differing CGT results, see Chapter 25). As with (1) and (2) above, if the property had been settled on 23 March 2006, there would have been an immediate IHT charge. Moreover, on the surrender of Susan's life interest (necessarily after 22 March 2006) at either (i), ii) or (iii), there would be an exit charge since her interest is treated in the same way as settlements with no interest in possession (see Chapter 34). Furthermore, the relief formerly afforded to A&M trusts is no longer available for trusts created on or after 22 March 2006 (see Chapter 34).

2 The charge on death

Where an interest in possession was created prior to 22 March 2006, and for a post-22 March disabled person's interest, an immediate post-death interest and a transitional serial interest, as the assets in the settlement are treated as part of the estate of the deceased interest in possession beneficiary at the time of his death, IHT is charged on the settled fund at the estate rate appropriate to his estate. The tax attributable to the settled property must be paid by the trustees. Although the trustees pay this tax, the inclusion of the value of the fund in the deceased's estate may increase the estate rate, thereby causing a higher percentage charge on the deceased's free estate. [33.23]

EXAMPLE 33.5

The settlement consists of securities worth £100,000 and is held for Albinoni for life with remainder to Busoni. Albinoni has just died and the value of his free estate is £170,000; he made chargeable lifetime transfers of £105,000. IHT will be calculated as follows:

(1) Chargeable death estate: £170,000 + £100,000 (the settlement) = £270,000.

(2) Join table at £105,000 (point reached by lifetime transfers which cumulate).

(3) Calculate death IHT (£36,000).

(4) Convert to estate rate:

tax 36,000

------- x 100: ie x ---------- x 100 = 13.33% [*811]

estate 270,000

(5) IHT attributable in settled properly is 13.33% of £100,000 = £3,330.

3 Inter vivos terminations

The termination of an interest in possession occurring during-the life of the relevant beneficiary is a transfer of value which was, until the Finance Act 2006 changes, a PET provided that the property was, after that event, held for one or more beneficiaries absolutely (so that the settlement was at an end), or for a further interest in possession or on A&M or disabled trusts. IHT was only payable in such cases if the former life tenant died within seven years of the termination. Otherwise (eg where after the termination the fund was held on discretionary trusts), there was an immediate charge to tax.

Following FA 2006, the only post-22 March 2006 termination that will qualify as a PET is the coming to an end during his lifetime of the interest of a person whose interest is an immediate post-death interest when the settled property becomes, at the same time, subject to a trust for a bereaved minor (see Chapter 32 and Chapter 34) (IHTA 1984 s 3A(3A) inserted by FA 2006 Sch 20, para 9). [33.24]

a) Actual terminations

Any charge will be calculated on the basis that the life tenant had made a transfer of value of the assets comprised in the trust fund when the interest terminates (IHTA 1984 s 52(1)). [33.25]

EXAMPLE 33.6

(1) £100,000 is held on trust for Albinoni for life or until remarriage and thereafter for Busoni. If Albinoni had remarried before 22 March 2006, his life interest would have terminated and he would have been treated as having made a transfer of value which would have been a PET. Accordingly, should he die within seven years, IHT will be charged on the value of the fund at the time when his interest ended. (The trustees should hear this in mind before making any distribution to Busoni). If his interest had been created prior to 22 March 2006, but he remarries on or after that date, there would be an immediate IHT charge on the termination of his interest. Note, had the interest been a post 22 March 2006 interest, then it would he treated in the same way as trusts with no interest in possession, which are discussed in the next chapter.

If Albinoni never remarried, but consented (before 22 March 2006) to an advancement of £50,000 to Busoni, his interest in that portion of the fund would have ended and he would have made a transfer of value which was a PET of £50,000. Assume that three years later (still prior to 22 March 2006), Albinoni surrendered his life interest in the fund, worth at that time £120,000. This is a further transfer of value which was a PET; IHT may therefore be charged (if he dies in the seven years following the advancement) on £170,000. Notice that in all eases any tax charge is levied on a value transferred which is 'equal to the value of the property in which his interest subsisted' (see s 52(1)). The principle of calculating loss to donor's estate (see 28.61]) does not apply. Had the advancement and the surrender

occurred on or after 22 March 2006, there would have been an immediate IHT charge. [*812]

(2) Claude owns 49% of the shares in his family investment Company, Money Box Ltd, and is the life tenant under a settlement which owns a further 12% of those shares. The remainder beneficiary under the trust is Claude's daughter. No dividends are paid by the company. The tax position if Claude had surrendered his interest in possession prior to 22 March 2006 is as follows:

(a) The surrender of a beneficial interest in a settlement is generally tree from CGT (TCGA 1992 s 76(l)). Assuming that the settlement ends, there will he a deemed disposal under TCGA 1992 s 71(1); see Chapter 25.

(b) For IHT purposes, Claude would have been treated as making a transfer of value which was a PET, but the value transferred is limited to the value of the shares in the settlement (IHTA 1984, s 52(1)). Thus only the value of a 12% minority holding will he subject to tax us the event of Claude's death within seven years.

On Claude's death his estate will then comprise only a 49% minority shareholding (assuming that Claude acquired his interest in the settlement before 22 March 2006 or, if later, the interest was an immediate post-death interest, a disabled person's interest or a transitional serial interest).

The merit of this arrangement was that the substantial loss to Claude's estate resulting from his loss of control of the company did not attract a tax charge; instead, both shareholdings were valued separately. Surrender of the life interest could have occurred on Claude's deathbed but the advantages would not, of course, have been obtained if the life interest had been retained and the 49% holding given away Had the surrender occurred on or after 22 March 2006, it would have attracted a charge, and the arrangement would thereby lose its merit.

b) Deemed terminations

IHTA 1984 s 51(1) provides that if the beneficiary disposes of his beneficial interest in possession, that disposal 'shall not be a transfer of value but shall be treated as the coming to an end of the interest The absence of gratuitous intent does not prevent an IHT charge on the termination of beneficial interests in possession. As with actual terminations, the life tenant would normally be treated as having made a transfer of valise which, before the changes introduced by FA 2006, would have been a PET so that tax will only be charged if he dies within seven years. [33.26]

EXAMPLE 33.7

(1) Albinoni assigns by way of gift his life interest to Cortot IHT will be charged as if that life interest had terminated. Cortot becomes a tenant pur autre vie and when Aibinoni dies Cortot's interest in possession terminates so raising the possibility of a further IHT charge. Assuming that both events occur before 22 March 2006, both Albinoni and Cortot have made PETs (for quick succession relief, see 33.42]).

(2) If, instead of gifting his interest, Albinoni sold it to Cortot for £20,000 (full value) on 1 March 2006 and the trust fund was then worth £100,000, Albinoni's interest would have thereby terminated so that he made a transfer of value of £100,000. However, as he had received £20,000, he made a PET equal to the fall in his estate of £80,000 (£100,000 - £20,000; IHTA 1984 s 52(2)). [*813]

e) Partition

A division of the trust fund between life tenant and remainderman causes (lie interest in possession to terminate and IHT may be charged (in the case of a PET, if the life tenant dies within seven years) on that portion of the fund passing to the remainderman (IHTA 1984 s 53(2)). [33.27]

EXAMPLE 33.8

On 1 March 2006, Albinoni and Busoni agreed to partition the £100,000 trust fund in the proportions 40:60. Albinoni would have been treated as making a PET of £60,000 (£100,000 - £40,000). Any IHT would have been payable out of the fund which is divided,

d) Advancements etc to life tenant

If all or part of the capital of the fund is paid to the life tenant, or if he becomes absolutely entitled to the capital, his interest in possession will determine pro tanto, but no IHT will he charged since there will he no fall in the value of his estate (IHTA 1984 s 53(2)). [33.28]

e) Purchase of a reversionary interest by the life tenant (IHTA 1984 ss 10, 55(1))

As the life tenant who acquired his interest before 22 March 2006 or, if later, the interest was an immediate post-death interest, a disabled person's interest or a transitional serial interest is treated as owning the fund, his tax bill could he reduced were he to purchase a reversionary interest in that settlement. Assume, for instance, that B has £60,000 in his bank account and is the life tenant of a fund with a capital value of £100,000. For IHT purposes he is treated as owning an estate worth £160,000. 1f B were to purchase the reversionary interest in the settlement for its market value of £60,000, the result would be as follows: first, B's estate has not fallen in value. Originally it included £60,000: after the purchase it includes a reversionary interest worth £60,000 since, although excluded property, the reversionary interest must still he valued. Secondly, B's estate now consists of the settlement fund valued at £100,000 and has been depleted by the £60,000 paid for the reversionary interest so that a possible charge to IHT on £60,000 has been avoided.

To prevent this loss of tax, IHTA 1984 s 55(1) provides that the reversionary interest is not to he valued as a part of B's estate at the time of its purchase (thereby ensuring that his estate has fallen in value) whilst IHTA 1984 s 10 (see [28.21]) is excluded from applying thereby ensuring that the fall in value may be subject to charge even though there is no donative intent. Hence, by paying £60,000 for the reversionary interest B has made a PET which will he taxed if he dies in the following seven years. [33.29]

f) Transactions reducing the value of the property

When the value of the fund is diminished by a depreciatory transaction entered into between the trustees and a beneficiary (or persons connected with him), tax is charged as if the fall in value were a partial termination of the interest in possession (IHTA 1984 s 52(3)). A commercial transaction lacking gratuitous intent is not caught by this provision. [*814] In Macpherson v IRC (1988) the value of pictures held in a trust fund was diminished by an arrangement with a person connected with a beneficiary as a result of which, in return for taking over care, custody and insurance of the pictures, that person was entitled to keep the pictures for his personal enjoyment for some 14 years. Although this arrangement was a commercial transaction, lacking gratuitous intent when looked at in isolation, it was associated with a subsequent operation (the appointment of a protected life interest) which did confer a gratuitous benefit so that the exception in s 10 did not apply and the reduction in value of the fund was subject to charge. [33.30]

EXAMPLE 33.9

Trustees grant a 50-year lease of a property worth £100,000 at a peppercorn rent to the brother of a reversionary beneficiary As a result the property left in the settlement is the freehold reversion worth only £20,000. The granting of the lease is a depreciatory transaction which causes the value of the fund to fall by £80,000 and as it is made with a person connected with a beneficiary, 1HTA 1984 s 52(3) will apply and IHT may, be levied as if the life interest in £80,000 had ended. (Contrast the position if the lease had been granted to the brother on fully commercial terms.)

4 Anti-avoidance (IHTA 1984 s 54A and s 54B)

Note that whilst these provisions apply in respect of all interest in possession trusts created prior to 22 March 2006, where the beneficiary became entitled to the interest in possession on or after that date, s 54A applies only where that interest is a disabled person's interest or a transitional serial interest (IHTA 1984 s 54A(2) inserted by FA 2006 Sch 20, para 16).

a) When do the rules apply?

The three prerequisites are that:

(1) an interest in possession trust is set up by means of a PET;

(2) it terminates either as a result of the life tenant dying or by his interest ceasing inter vivos; and

(3) at that time a no interest in possession trust (other than an A&M trust) arises.

If the termination occurs within seven years of the creation of the original interest in possession trust and at a time when the settlor is still alive, the anti-avoidance rules then apply. [33.31]

b) Operation of the rules

The IHT charge on the property at the time when the interest in possession ends is taken to be the higher of two alternative calculations. First, the IHT that would arise under normal charging principles, ie by taxing the fund as if the transfer had been made by the life tenant at the time of termination. The rates of charge will be either half rates (when there is an inter vivos termination) or full death rates when termination occurs as a result of the death of the life tenant. The alternative calculation involves deeming the

[*815] settled property to have been transferred at the time of termination by a hypothetical transferor who in the preceding seven years had made charge- able transfers equal in value to those made by the settlor in the seven years before he created the settlement. For the purpose of this second calculation half rates are used. [33.32]

EXAMPLE 33.10

In 2003 Sam settled property worth £90,000 on trust for Pam for life or until remarriage and thereafter on discretionary trusts for Sam's relatives and friends.

His cumulative total at that time was £200,000 and he had made PETs of £85,000. Pam remarried one year later at a time when she had made chargeable transfers of £50,000, PETs of £45,000; and when the settled property was worth £110,000.

(1) The anti-avoidance provisions are relevant since the conditions for their operation are satisfied.

(2) Normally IHT would have been calculated at Pam's rates, ie on a chargeable transfer from £50,000 to £160,000. Alternatively under these provisions the tax could have been calculated by taking a hypothetical transferor who had Sam's cumulative total at the time when he created the trust; ie the £110,000 would have been taxed as a chargeable transfer from £200,000 to £310,000. In this example the second calculation would have been adopted since a greater amount of IHT results. Tax must be paid by the trustees.

(3) Assume that either Sam or Pain died after the termination of the interest in possession trust. This may result in a recalculation of the LUT liability (in this example PETs made by that person in the seven years before death would become chargeable). So far as the anti-avoidance rules are concerned, however, there is no question of disturbing the basis on which the IHT calculation was made in the first place. Hence, as was shown in (2) above, the greater tax was produced by taking the hypothetical transferor and, therefore, the subsequent death of Pam is irrelevant since it cannot be used to switch the basis of computation to Pam's cumulative total. By contrast, the death of Sam may involve additional IHT liability since his PETs of £85,000 will now become chargeable and thus included in the hypothetical transferor's total when the settlement was created.

e) How to avoid the rules

First, if the interest in possession continues for seven years these rules do not apply.

Secondly, they are not in point if the settlement was created without an immediate interest in possession (eg there was an A&M trust which subsequently became an interest in possession trust), or if the settlement was created by means of an exempt transfer (eg if a life interest was given to the settlor's spouse and that interest was subsequently terminated in favour of a discretionary trust).

Thirdly, trustees can prevent the rules from applying if, within six months of the ending of the interest in possession, they terminate the discretionary trust either by an absolute appointment or by creating a further life interest.

Fourthly, it is always possible to channel property into a discretionary trust by a PET, if an outright gift is made to another individual (a PET) who then settles the gifted property on the appropriate discretionary trusts (a chargeable transfer but taxed at his rates). Of course the transferor will have no legal right to force the donee to settle the outright gift. [*816]

Finally, the rules are only triggered by a PET. Hence a settlement on the settlor's spouse is not caught. [33.33]

5 Exemptions and reliefs

a) Reverter to settlor/spouse (IHTA 1984 s 53(3)-(5))

If, on the termination of an interest in possession, property reverts to the settlor, there is no charge to IHT unless that interest had been acquired for money or money's worth. This exemption also applies when the property passes to the settlor's spouse or (if the settlor is dead) to his widow or widower so long as that reverter occurs within two years of the settlor's death (for the CGT position, see Chapter 25). [33.34]

EXAMPLE 33.11

(1) In 2004, Janacek created a settlement of £100,000 in favour of K for life (a PET). When K dies and the property reverts to the settlor no IHT will be charged.

Contrast the position, if the settlement provided that the fund was to pass to L on the death of K, hot the settlor's wife had purchased that remainder interest and given it to her husband as a Christmas present. On the death of the life tenant, although the property will revert to the senior, the normal charge to IHT will apply. (For the CGT position, see Chapter 25.)

(2) Bert and his wife, Bertha, own their house as tenants in common. On Bert's death in 2004 he left his share to his daughter, Bettina. In 2005, she settled it on trust for her mother (Bertha) for life; remainder to herself (Bettina) for life with remainders over.

On Bertha's death in February 2006, Bettina was still alive and the IHT reverter to settlor exception applied. Because Bettina only enjoys a life interest, the CGT uplift on death was available (which it would not have been if Bettina had then become absolutely entitled). The arrangement provides added security for Bertha without forfeiting any life benefits (contrast IRC v Lloyds Private Banking Ltd (1998) at [32.3]).

b) Use of the life tenants exemptions

The spouse exemption is available on the termination of the interest in possession if the person who then becomes entitled, whether absolutely or to another interest in possession, is the spouse of the former life tenant. In addition, IHTA 1984 s 57 permits the use of the life tenant's annual (£3,000 pa) exemption and the exemption for gifts in consideration of marriage on the inter vivos termination of an interest in possession if the life tenant so elects (see IHTA 1984 s 57(3), (4)). The exemptions for small gifts (£250) and normal expenditure out of income cannot be used.

EXAMPLE 33.12

Orff is the life tenant of the fund. His wife and son are entitled equally in remainder. If he surrenders the life interest, there will be no tax on the half share passing to his wife (spouse exemption). The chargeable half share passing to his son is a PET (provided the surrender March 2006) and, [*817] should it become chargeable because of his death within seven years, the annual exemption and, if surrender coincides with the marriage of the son, the £5,000) marriage gift relief will be available.

Although the making of a PET is no! reported, the appropriate notice should be givers to the trustees by the life tenant indicating that he wishes the transfer to he covered by his relevant exemption (the annual or marriage exemptions) so that it can then be submitted (if needed) to HMRC as required by s 57(4) (and see SI 2002/1731). [33.35]

c) The surviving spouse exemption

The carry-over of this estate dusty relief is discussed at [30.158]. The first spouse must have died before 13 November 1974 and the relief ensures that IHT is not charged on the termination of the surviving spouse's interest its the property whether that occurs inter vivos or on death (IHTA 1984 Sch 6 para 2). [33.36]

d) Excluded properly

If the settlement contains excluded property, IHT is not charged on that portion of the fund (IHTA 1984 ss 5(1), 53(1)). [33.37]

e) IHTA 1984 s 11 dispositions

If the interest in possession is disposed of for the purpose of maintaining the disponer's child or supporting a dependent relative, IHT is not charged (see [31.7]). [33.38]

f) Charities

Tax is not charged if on the termination of the interest in possession the property is held on trust for charitable purposes. [33.39]

g) Protective trusts

The forfeiture of a protected life interest is not normally treated as the terminations of an interest in possessions (see [34.117]). [33.40]

h) Variations and disclaimers

Dispositions of the deceased may be altered after his death by means of an instrument of variation or disclaimer and treated as if they had been made by the deceased. Disclaimers are possible in the case both of settlements created by the will or intestacy of the deceased (IHTA 1984 s 142) and pre-existing settlements in which the death has resulted in a person becoming entitled to an interest in the settled property (IHTA 1984 s 93). Variations are only permitted for settlements created on the relevant death, not for settlements in which the deceased had been the beneficiary. 1f an interest in possession is created under a variation made on or after 22 March 2006 and is deemed to arise on the deceased's death pre-22 March 2006, it will be treated as an [*818] interest in possession in existence before that date, and so will be subject to the pre-22 March 2006 rules, Where the deceased dies on or after 22 March 2006, the new interest in possession will be an immediate post-death interest and, accordingly, it should still be possible to obtain the spouse/civil partnership exemption for interests in possession created by deed of variation within s 142 whenever the deceased might die. [33.41]

EXAMPLE 33.13

Poulenc, the life tenant of a settlement created by his father, has just died. His brother Querrus is now the life tenant iii possession and if he assigns his interest within two years of Poulenc's death, the normal charging provisions will apply, (Note: (1) he could disclaim his interest without any IHT charge (IHTA l984 s 93); (2) see [30.155] for problems caused to trustees when or her property of the deceased is varied or disclaimed.)

i) Quick succession relief (IHTA 1984 s 141)

This relief is similar to that for unsettled property (see [30.144]). The first chargeable transfer may he either the creation of the settlement or any subsequent termination of an interest in possession (whether that termination occurs inter vivos or on death). Hence, it can be voluntarily used (by the life tenant surrendering or assigning his interest) whereas in the case of unsettled property it is only available on a death. The calculation of the relief in cases where there is more than one later transfer is dealt with in IHTA 1984 s 141(4). [33.42]

EXAMPLE 33.14

(1) A settlement is created in January 2000; (2) the life interest ends in half of the fund in March 2002; (3) the life interest ends in the rest of the fund in February 2003. Assume that both PETs become chargeable because of the death of the life tenant within seven years.

Quick succession relief is available at a rate of 60% on event (2); and again at a rate of 40% on event (3). Generally, relief is given in respect of the earlier transfer first ((2) above). To the extent that the relief given represents less than the whole of the tax charged on the original net transfer ((1) above), further relief can then be given in respect of subsequent transfers ((3) above) until relief equal to the whole of the tax (in (1) above) has been given.

j) Business reliefs

In a settlement containing business property that relief is available to the life tenant provided that he fulfils the conditions for relief (IHTA 1984 ss 103-114). Note that the relief appears to he unaffected by the changes introduced by FA 2006.

EXAMPLE 33.15

Satie is the life tenant of the settlement. He holds 30% of the shares in the trading company Teleman Ltd, and the trust holds a further 25%. Further, the trust owns the factory premises which are leased to the company. On the death of Satie, IHT business relief is available as follows: [*819]

(1) On the shores: the relief (assuming that the two-year ownership condition is satisfied) is at 100% on Satie's shares and on those of the fund. The life tenant is treated as having controlled the company since he held 30% (his own) and is treated as owning a further 25% of the shares.

(2) 0n the land: the relief is at 50% since the asset is used by a company controlled by the life tenant. (But see Fetherstonehough v IRC (1984).)

Similar rules operate for agricultural relief. ie the life tenant must satisfy the conditions of two years' occupation or seven years' ownership (ownership by the trustees being attributed to the life tenant). Because the interest in possession beneficiary is treated as owning the trust fund (rather than it being owned by the trustees) problems can arise in the case of both APR and BPR when, for instance, a beneficiary under an A&M trust obtains an interest in possession (see, in the context of clawback, Example 31.15(4)). [33.43]-[33.60]

III THE TAXATION OF REVERSIONARY INTERESTS

a) General rule: excluded property

Reversionary interests are generally excluded property so that their assignment or transfer does not lead to an IHT charge. (The purchase of a reversionary interest by the life tenant has been considered at [33.29].) [33.61]

EXAMPLE 33.16

A fund is settled on trust for A for life (A is currently aged 88); B for life (B is 78);

and C absolutely (C, A's son, is 70).

This settlement is likely to be subject to three [HT charges within a fairly short period. The position would he much improved if B and C disposed of their reversionary interests:

(1) B should surrender his interest. Taking into account his age it has little value and is merely an IHT trap.

(2) C should assign his interest to (ideally) a younger person. He might for instance have minor grandchildren and an A&M trust in their favour would be an attractive possibility. (Note the changes made by FA 2006 to such trusts established on or after 22 March 2006: see Chapter 34.)

The result of this reorganisation is that the fund is now threatened by only one IHT charge (on A's death) in the immediate future.

b) Exceptions

In four eases reversionary interests are not excluded property. This is to prevent their use as a tax avoidance device.

First, the sale of a reversionary interest to a beneficiary under the same trust, who is entitled to a prior interest (see [33.29]).

Secondly, the disposition of a reversionary interest which has at any time, and by any person, been acquired for a consideration in money or money's worth. (For special rules where that interest is situated outside the UK, see [35.85].) [*820]

EXAMPLE 33.17

Umberto sells his reversionary interest to Vidor (a stranger to the trust) for its market value, £20,000. 1f the general rules operated the position would he that:

(1) Umberto is disposing of excluded property so that no IHT is chargeable.

(2) Vidor has replaced chargeable assets (20,0O0) with excluded property so that were he to die or make an inter vivos gift IHT would he avoided.

IHTA 1984 s 48(1) (a) and s 48(3) prevent this result. The reversion ceases to be excluded property once it has been purchased (even for a small consideration) so that a disposition by Vidor may lead to an IHT charge.

Thirdly, a disposition of a reversionary interest is chargeable if it is one to which either the settlor or his spouse is, or has been, beneficially entitled (IHTA 1984 s 48(1)(b)).

EXAMPLE 33.18

In 2003 Viv settled property worth £100,000 on trust for his father Will for life (Will is 92). Viv retained the reversionary interest which he then gave to his daughter Ursula. If the general rules were not modified the position would be that:

(1) The creation of the settlement would have been a PET by Viv but the diminution in his estate would have been very small (the difference between £100,000 and the value of a reversionary interest in £100,000 subject only to the termination of the interest of a 92-year-old life tenant!).

(2) The transfer of the reversion by Viv would have escaped IHT since it is excluded property.

IHTA 1984 s 48(1) (b) ensures that the transfer of the reversion is a PET so that Viv achieved no tax saving (and, indeed, was left with the danger of a higher IHT bill than if he had never created the settlement since the death of Will is a chargeable event).

This may be used to the taxpayer's advantage in a 'Melville type' scheme: namely, where it is desired to create a discretionary trust in order to obtain hold-over relief whilst ensuring that any IHT transfer of value is kept within the nil rate hand (see [32.52]).

Fourthly, the disposition of a reversionary interest is chargeable where that interest is expectant upon the termination of a lease which is treated as a settlement (typically one for life or lives; IHTA 1984 s 48(l)(c). The lessor's reversion is treated in the same way as a reversionary interest purchased for money or money's worth so that on any disposition of it, IHT may be charged. [33.62] [*821]

34 IHT-relevant property: settlements without an interest in possession and those treated as settlements without an interest in possession

Updated by Aparna Nathan, LLB Hons, LLM, Barrister, Gray's inn Tax Chambers and Natalie Lee, Barrister, Senior Lecturer in Law, University of Southampton

I Introduction and terminology [34.1]

Il The method of charge [34.21]

III Exemptions and reliefs [34.51]

IV Discretionary trusts created before 27 March 1974 [34.71]

V Accumulation and maintenance trusts (IHTA 1984 s 71) [34.91]

VI Trusts for bereaved minors and 18-25 trusts [34.101]

VII Other special trusts [34.111]

I INTRODUCTION AND TERMINOLOGY

Prior to the changes introduced by FA 2006, relevant property referred to property held in a settlement lacking an interest in possession. The method of charging settlements of this nature is totally different from that for settlements with an interest in possession (see Chapter 33). Instead of attributing the fund to one of the beneficiaries, the settlement itself is the taxable entity. Like an individual, a record of chargeable transfers must he kept although, unlike the individual, it will never die and so will only be taxed at half rates. Taking into account the recent changes, this chapter will discuss the rules by reference to relevant property. Until those changes, the discretionary trust was the most significant trust with relevant property. In fact the category is wider than discretionary trusts catching, for instance, the settlement in the Pilkington case ([32.24]) and trusts where the beneficiaries' interests are contingent. These rules will now also apply to a post-22 March 2006 trust with an interest in possession that is not a transitional serial interest, an immediate post-death interest or disabled person's interest (see Chapter 33). [*822]

EXAMPLE 34.1

(1) A fund of £100,000 is betel upon trust for such of A, B, C, D, E and F as the trustees may in their absolute discretion (which extends over both income and capital) think appropriate. The trust is one without an interest in possession.

(2) Dad settles property on trust for Sonny absolutely contingent on his attaining 30. Sonny is aged 21 at the date of the settlement and the income is to he accumulated until Sonny attains 30. There is no interest in possession.

(3) On 1 April 2006, Mum settles property on trust for her daughter Tamsin for life, with remainder to her grandson Victor absolutely. Although there is an interest in possession, it arises post-22 March 2006 and, not being a transitional serial interest, an immediate post-death interest or disabled person's interest (and nor is it a 'special trust' considered in Sections VI and VII of this Chapter), it will be subject to the same regime that applies to settlements where there exists no interest in possession.

IHT is charged on 'relevant property' (IHTA 1984 s 58(1)) defined, for pre-22 March 2006 trusts, as settled property (other than excluded property) in which there is no qualifying interest in possession, with the exception of property settled on the 'special trusts' considered in Sections V and VI, below.

A 'qualifying interest in possession' was one owned beneficially by an individual or, in restricted circumstances, by a company. If within one settlement there existed an interest in possession in a part only of the settled property, these rules applied to the portion which lacks such an interest. It has already been mentioned that the term 'relevant property' now applies to property settled on a post-22 March 2006 trust giving rise to an interest in possession that is not a transitional serial interest, an immediate post-death interest or disabled person's interest. There continues to be an exception for property on 'special toasts' considered in Sections VI and VII. [34.1]-[34.20]

II THE METHOD OF CHARGE

The central feature is the periodic charge imposed upon relevant property at ten-yearly intervals. The anniversary is calculated from the date on which the trust was created (IHTA 1984 s 61(1)). In the case of settlements initially established with a nominal sum (eg £10) it is from the date when that nominal sum is received by the trustees.

EXAMPLE 34.2

(1) Silas creates a discretionary trust on 1 January 1989. The first anniversary charge will fall on 1 January 1999; the next on 1 January 2009 and so on. If the trust had been created by will and he had died on 31 December 1988, that date marks the creation of the trust (IHTA 1984 s 53). A similar principle applies if the trust was established by an instrument of variation falling within 11-ITA 1984 s 142 (see [30.153]).

(2) Sebastian creates (in 1988) a settlement in favour of his wife Selina for life; thereafter for such of his three daughters as the trustees may in their absolute discretion select, Selina dies in 1989. For IHT purposes the discretionary trust is created by Selina on her death (IHTA 1984 s 80) although the ten-year anniversary runs from 1988 (IHTA 1984 s61(2)). [*823]

(3) The first anniversary charge in respect of the trust created by Mum for Tamsin (Example 34.1(3)) will fall on 1 April 2016.

Apart from the periodic charge, IHT is also levied (the 'exit charge') on the happening of certain events. In general, the IHT then charged is a proportion of the last periodic charge. Special charging provisions operate for chargeable events which occur before the first ten-year anniversary. No accounts need be filed by trustees of 'excepted settlements': see SI 2002/1732. In general the assets in the trust must be cash and the value of the settled property at the time of the chargeable event must not exceed £1,000. [34.21]

1 The creation of the settlement

This will, generally, be a chargeable transfer of value by the settlor for IHT purposes. The following matters should be noted: first, if the settlement is created inter vivos, grossing-up applies unless IHT is paid out of the fund (see Chapter 28).

Secondly, the cumulative total of chargeable transfers made by the settlor forms part of the cumulative total of the settlement on all future chargeable occasions (ie his transfers never drop out of the cumulative total). Therefore, in order to calculate the correct IHT charge it is essential that the trustees are told the settlor's cumulative total at the date when he created the trust. When as a result of the settlor's fraud, wilful default or neglect there is an underpayment of IHT, HMRC may recover that sum from the trustees outside the normal six-year time limit. In such cases the time limit is six years from the date when the impropriety comes to the notice of HMRC (IHTA 1984 s 240(3)). Obviously a problem would arise for trustees if at the time when the underpayment came to light they held insufficient assets to discharge the extra IHT bill since they could be made personally liable for the tax unpaid. HMRC have, however, previously stated that where the trustees have acted in good faith and hold insufficient settlement assets they will not seek to recover any unpaid tax from them personally (Law Society's Gazette, 1984, p 3517).

Thirdly, a 'related settlement' is one created by the same settlor on the same day as the trust with relevant property (other than a charitable trust). Generally such settlements should be avoided (see [34.27]). The use of 'pilot' settlements is considered at [34.35].

Fourthly, additions of property by the original settlor to his settlement may create problems although it is standard practice in the case of 'pilot' trusts (see [34.33]). If property is added by a person other than the original settlor, the addition will be treated as a separate settlement (see [32.7]).

Problems may arise for the trustees if the settlor dies within seven years of creating the trust. PETs made before the settlement was created and within seven years of his death then become chargeable so that tax on creation of the settlement and the computation of any exit charge made during this period may need to be recalculated. If extra tax becomes payable this is primarily the responsibility of the settlement trustees and their liability is not limited to settlement property in their hands at that time. Given this danger it [*824] will he prudent for trustees who are distributing property from the trust with relevant property within the first seven years to retain sufficient funds or take suitable indemnities to cover all contingent IHT liability. [34.22]

EXAMPLE 34.3

Sumar makes the following transfers of value:

May 1998 -- £200,000 to his sister Sufi (a PET).

May 1999 -- £70,000 to a family discretionary trust.

In May 2000 the trustees distribute the entire fund to the beneficiaries and in May 2003 Sumar dies.

As a result of his death, the 1998 PET is chargeable (the resultant 1(1) is primarily the responsibility of Sufi) and in addition tax on the creation of the settlement insist he recalculated.

When it was set up the PET was ignored so that the transfer fell within Sumar's nil rate hand. With his death, however, IHT must he calculated, at the rates in force in May 2003, on transfers from £200,000 to £270,000 (tax is £8,000). In addition it is likely that no IHT will have been charged on the distribution of the fund in 2000 and therefore a recomputation is again necessary with the trustees being liable for the resulting tax.

2 Exit charges before the first ten-year anniversary

a) When will an exit charge arise?

A charge is imposed whenever property in the settlement ceases to be 'relevant property' (IHTA 1984 s 65). For instance, if the trustees of a discretionary trust appoint property to a beneficiary or if an interest in possession arises in any portion of the fund, there will be a charge to the extent of the property ceasing to he held on discretionary trusts. Note that if an interest in possession arises on or after 22 March 2006, the property only ceases to he relevant property to the extent that it is a disabled person's interest (by definition, it cannot be an immediate post-death interest or a transitional serial interest). 1f the resultant IHT is paid out of the property that is left in the discretionary trust, grossing-tip will apply. A charge is also imposed if the trustees make a disposition as a result of which the value of relevant property comprised in the settlement falls (a 'depreciatory transaction'; see [33.30]: notice that in this case there is no requirement that the transaction must he made with a beneficiary or with a person connected with him).

The exit charge does not apply to a payment of costs or expenses (so long as it is 'fairly attributable' to the relevant property), nor does it catch a payment which is income of any person for the purposes of income tax (IHTA 1984 s 65(5)). [34.23]

h) Calculation of the settlement rate

The calculation of the rate of IHT is based upon half the full IHT rates, even if the trust was set up under the will of the settlor. The rate of tax actually payable is then 30% of those rates applicable to a hypothetical chargeable transfer.

Step 1 This hypothetical transfer is made up of the sum of the following:

(1) the value of the property in the settlement immediately after it commenced;

(2) the value (at the date of the addition) of any added property; and

(3) the value of property in a related settlement (valued immediately after it commenced (IHTA 1984 s 68(5)).

No account is taken of any rise or fall in the value of the settled fund and the value comprised in the settlement and in any related settlement can include property subject to an interest in possession.

Step 2 Tax at half rates on this hypothetical transfer is calculated by joining the table at the point reached by the cumulative total of previous chargeable transfers made by the settlor in the seven years before he created the settlement. Other chargeable transfers made on the same day as the settlement are ignored and, therefore, if the settlement was created on death, other gifts made in the will or on intestacy are ignored (IHTA 1984 s 68(4) (b)).

Step 3 The resultant tax is converted to an average rate (the equivalent of an estate rate) and 30% of that rate is then taken. The resultant rate (the 'settlement rate') is used as the basis for calculating the exit charge. [34.24]

EXAMPLE 34.4

Justinian settles £100,000 on discretionary trusts on 6 April 2003. His total chargeable transfers immediately before that date stood at £165,000. He pays the IHT. If an exit charge arises before the first ten-year anniversary of the fund (6 April 2013) the settlement rate would be calculated as follows:

Step I Calculate the hypothetical chargeable transfer. As there is no added property and no related settlement it comprises only the value of the property in the settlement immediately after its creation (ie £100,000).

Step 2 Cumulate the £100,000 with the previous chargeable transfers of Justinian

(ie £165,000). Taking the IHT rates in force in April 2003, tax on transfers between £165,000 and £265,000 is £2,000.

Step 3 The tax converted to a percentage rate is 2%; 30% of that rate produces a 'settlement rate' of 0.6%.

e) The tax charged

The charge is on the fall in value of the fund. To establish the rate of charge, a further proportion of the settlement rate must be calculated equal to one-fortieth of the settlement rate for each complete successive quarter that has elapsed from the creation of the settlement to the date of the exit charge. That proportion of the settlement rate is applied to the chargeable transfer (the 'effective rate').

EXAMPLE 34.5

Assume in Example 34.4 that on 25 March 2005 there was an exit charge on £20,000 ceasing to he relevant property. The 'effective rate' of IHT is calculated as follows:

Step 1 Take completed quarters since the settlement was created, ie seven.

Step 2 Take 7/40ths of the 'settlement rate' (0.6%) to discover the 'effective rate' = 0.105%.

Step 3 The effective rate is applied to the fall in value of the relevant property.

The IHT will, therefore, be 21 if the tax is borne by the beneficiary; or 21.02 if borne by the remaining fund. [*826] There is 110 charge on events that occur in the first three months after the settlement is created (IHTA 1984 s 65(4)) nor, in certain circumstances when the trust was set up by the settior on his death, on events occurring within two years of that death (see [30.145]). [34.25]

3 The charge on the first ten-year anniversary

a) What property is charged?

The charge is levied on the value of the relevant property comprised in the settlement immediately before the anniversary (ITHA 1984 s 64). Income only becomes relevant property, and thus subject to charge, when it has been accumulated (see SP 8/86). Pending accumulation it is not subject to the anniversary charge and can be distributed free from any exit charge (see [34.23]). Note that the income arising in a post-22 March 2006 interest in possession trust that now falls within the definition of relevant property will, by definition, not be accumulated; it will be paid to the beneficiary with an interest in possession. At what moment is income accumulated? Accumulation occurs once an irrevocable decision to that effect has been taken by trustees, and it may also occur after a reasonable time for distribution has passed (but see Re Locker (1977) in which income arising between 1965 arid 1968 was still available for distribution in 1977). The legislation gives no guidance on what property is treated as being distributed first; ie if an appointment is made by the trustees out of property comprised in the settlement, does it come out of the original capital or out of accumulations of income? As a reduced charge may apply to property which has been added to the trust (such as accumulated income: see [34.33]) this is an important omission (for the approach adopted in practice by the Revenue, see Capital Taxes News, vol 8, May 1989).

The assets in the fund are valued according to general principles and, if they include business or agricultural property, the reliefs appropriate to that property will apply, subject to satisfaction of the relevant conditions. Any IHT charged on such property may be payable in instalments. [34.26]

b) Calculation of the rate of IHT

Half rates will be used and, as with the exit charge, the calculation depends upon a hypothetical chargeable transfer.

Step 1 Calculate the hypothetical chargeable transfer which is made up of the sum of the following:

(1) the value of relevant property comprised in the settlement immediately before the anniversary;

(2) the value, immediately after it was created, of property comprised in a 'related settlement'; and

(3) the value, at the date when the settlement was created, of any non-relevant property then in the settlement which has not subsequently become relevant property.

Normally the hypothetical chargeable transfer will be made up exclusively of property falling within (1) above. (2) and (3), which affect the rate of IHT to be charged without themselves being taxed, are anti-avoidance measures. [*827] Related settlements are included because transfers made on the same day as the creation of the settlement are normally ignored and, therefore, advantage could be achieved if the settlor were to set up a series small funds rather than one large fund. Non-relevant property in the settler is included because the trustees could switch the values between the two portions of the fund.

Step 2 Calculate tax at half rates on the hypothetical chargeable transfer by joining the table at the point reached by:

(1) the chargeable transfers of the settlor made in the seven years before he created the settlement; and

(2) chargeable transfers made by the settlement in the first ten years. Where a settlement was created after 26 March 1974 and before 9 March 1982, distribution payments (as defined by the IHT charging regime in force between those dates) must also be cumulated (IHTA 1984 s 66(6).

Settlements with relevant property will, therefore, have their own total of chargeable transfers with transfers over a ten-year period being cumulated (contrast the seven-year period used for individuals). The unique feature of a settlement's cumulation lies in the inclusion (and it never drops out) of chargeable transfers of the settlor in the seven years before the settlement is created.

Step 3 The IHT is converted to a percentage and 30% of that rate is then taken and charged on the relevant property in the settlement.

The highest rate of IHT is 20% (half of 40%). The highest effective rate (anniversary rate) is, therefore, 30% of 20%, ie 6%. Where the settlement comprises business property qualifying for 50% relief, this effective rate falls to 3% and assuming that the option to pay in instalments is exercised, the annual charge over the ten-year period becomes a mere 0.3%. 1f the property qualities for 100% business or agricultural relief there is no charge. [34.27]

EXAMPLE 34.6

Take the facts of Example 34.5 (namely, original fund £100,000, exit charge on £20,000; previous transfers of settlor £165,000). In addition, assume Justinian had created a second settlement of £35,000 on 6 April 2003.

The fund is worth £105,000 at the first ten-year anniversary.

(1) Relevant property to be taxed is £105,000

(2) Calculate hypothetical chargeable transfer: £

Relevant property, as above 105,000

Property in related settlement 35,000

. -------

. 140,000

. =======

(3) Settlement's cumulative IHT total £

Settlor's earlier transfers 165,000

Chargeable transfers of trustees in preceding

ten years 20,000

(4) Tax from the IHT table (at half rates) on transfers from £185,000 to £325,000 (1140,000 + £185,000) = £10,000 so that, as a percentage rate IHT is 7.14%. [*828]

(5) the 'effective rate' is 30% of 7.14% 2.14%.

Tax payable is £105,000 x 2.14% = £2,250

4 Exit charges after the first anniversary charge and between anniversaries

The same events will trigger an exit charge after the first ten-year anniversary as before it. The IT-IT charge will be levied on the fall in value of the hind with grossing-up, if necessary The rate of charge is a proportion of the effective rate charged at the first ten-year anniversary. That proportion is one-fortieth for each complete quarter from the date of the first anniversary charge to the date of the exit charge (IHTA 1984 s 69).

EXAMPLE 34.7

Continuing Example 34.6, exactly 15 months later the trustees appoint £25.000 to a beneficiary. The IHT (assuming no grossing-up) will be:

£25,000 s 2.14%. x 5/40 (five quarters since last ten-year anniversary) = £66.88.

If the rates of IHT have been reduced (including the raising of the rate hands) between the anniversary and exit charges, the lower rates will apply to the exit charge and, therefore, the rate of charge on the first anniversary will have to be recalculated at those rates (IHTA 1984 Sch 2 pant 3). So long as the IHT rate bands remain linked to rises in the retail prices index (IHTA 1984 s 8) recalculation will be the norm.

No exit charge is levied if the chargeable event occurs within the first quarter following the anniversary charge. [34.28]

5 Later periodic charges

The principles that applied on the first ten-year anniversary operate on subsequent ten-year anniversaries. So far as the hypothetical chargeable transfer is concerned the same items will he included (so that the value of property in a related settlement and of non-relevant property in the settlement is always included). The cumulative total of the fund will, as before, include the chargeable transfers of the settlor made in the seven years before he created the settlement and the transfers out of the settlement in the ten years immediately preceding the anniversary (earlier transfers by the settlement fall out of the cumulative total). The remaining stages of the calculation are unaltered. [34.29]

6 Technical problems

The basic structure of the charging provisions in IHTA 1984 ss 58-69 is

relatively straightforward. The charge to IHT is built on a series of periodic charges with interim charges (where appropriate) which are levied at a fraction of the full periodic charge. [34.30]

a) Reduction in the rate of the anniversary charge

If property has not been in the settlement for the entire preceding ten years (as will be the case when income is accumulated during that period) there is [*829] a proportionate reduction in the charge IHTA 1984 s 66(2)). The reduction in the periodic rate is calculated by reference to the number of completed quarters that expired before the property became relevant property in the settlement.

EXAMPLE 34.8

Assume in Example 34.6 that £15,000 had become relevant property on 30 April 2009.

The IHT charge on the first ten-year anniversary (on 6 April 2013) would now be calculated as follows:

(1) £90,000 (£105,000 - £15,000) at 2.14% = fl,926.

(2) The £15,000 will be charged at a proportion of the periodic charge rate: namely 2.14% reduced by 24/40 since 24 complete quarters elapsed since the creation of the settlement (on 1 April 2003) to the date whew the £15,000 became relevant property. As a result the IHT charged is £15,000 x 0.85% (ie 2.14% s 16/40) = £128.40.

This proportionate reduction in the effective rate of the periodic charge will not affect the calculation of IHT on events occurring after the anniversary, ie any exit charge is at the full effective rate.

The legislation does rot contain provisions which enable specific property to be identified. Thus, the reduction mentioned above applies to the value of the relevant property in the fund at the ten-year anniversary 'attributable' to property which was not relevant property throughout the preceding ten years. Presumably a proportionate calculation will he necessary where the value of the fund has shown an increase. Furthermore, if accumulated income is caught by the anniversary charge, a separate calculation will have to be made with regard to each separate accumulation (see SP 8/S6: [34.26]). [34.31]

b) Transfers between settlements

IHTA 1984 s 81 prevents a tax advantage front switching property between settlements of relevant property, by providing that such property remains comprised in the first settlement. Accordingly, property cannot be moved out of a discretionary trust to avoid an anniversary charge; property cannot be switched from a fund with a high cumulative total to one with a lower total; and the transfer of property from one discretionary fund to another will not he chargeable. [34.32)

e) Added property

Special rules operate if, after the settlement commenced (and after 8 March 1982), the settlor made a chargeable transfer as a result of which the value of the property comprised in the settlement was increased (IHTA 1984 s K)7(1�. Note that it is only additions by the settlor that trigger these provisions and that it is the value of the fund which must be increased and not necessarily the amount of property in that fund. Transfers which have the effect of increasing the value of the fund are ignored if they are not primarily intended to have that effect and do not in fact increase the value hit more than 5%. [*830]

EXAMPLE 34.9

Sam, the settlor, creates in 2003 a discretionary trust of stocks and shares in Sham Ltd and the benefit of a life insurance policy on Sam's life.

(1) Each year Sam adds property to the settlement, equal to his annual LUT exemption.

(2) Sam continues to pay the premiums on the life policy each year. (3) Sam transfers further shares in Sham Ltd.

The special rules for added property will not apply in either case (1) or (2), since Sam is not making a chargeable transfer; the first transfer is covered by his annual exemption and the second by the exemption for normal expenditure out of income. The transfer of further shares to the fund, however, is caught by the provisions of IHTA 1984 s 67.

If the added property provisions apply the calculation of the periodic charge which immediately follows the addition will be modified. For the purposes of the hypothetical chargeable transfer, the cumulative total of the settlor's chargeable transfers will be the higher of the totals (1) immediately before creating the settlement plus transfers made by the settlement before the addition; and (2) immediately before transferring the added property, deducting from this latter total the transfer made on creation of the settlement and a transfer to any related settlement. The settlor should normally avoid additions, since they may cause more IHT to be charged at the next anniversary and it will be preferable to create a separate settlement. [34.33]

d) The timing of the exit charge

Assume, for example, that a discretionary trust has been in existence for nearly ten years and that the trustees now wish to distribute all or part of the fund to the beneficiaries. Are they better off doing so just before the ten-year anniversary or should they wait until just after that anniversary? Generally, it will be advantageous to distribute before an anniversary because IHT payable will be calculated at rates then in force but on historic values, le on the value of the fund when it was settled or at the last ten-year anniversary. By contrast, if the trustees delay until after the anniversary, IHT (still at current rates) will then be assessed on the present value of the fund. To this general proposition one major exception exists which may well be the result of defective drafting in the legislation. It relates to a fund consisting of property qualifying for either business relief or agricultural relief at 50%. In this situation trustees should not break up the fund immediately before the first anniversary. [34.34]

EXAMPLE 34.10

A discretionary settlement was created on 1 January 1992. At all times it has consisted of agricultural property which will qualify for 50% relief. Assume no earlier transfers by settlor and that the value of the property is £500,000 throughout. Consider the effect of agricultural property relief if:

(1) the trustees distribute the entire fund on 25 December 2001. The distribution occurs before the first ten-year anniversary. The entire value of the property in the settlement immediately after it commenced must be included in the hypothetical transfer of value since there is no agricultural property relief reduction. Therefore £500,000 must be included (IHTA 1984 s 111(5) (a)).

The rate thus calculated is then applied to the fund as reduced by business relief Hence, although the amount subject to the charge is only £250,000 (£500,000 minus 50% relief), a higher rate of IHT will apply. (Notice that if 100% relief were to be available in 2001 this trap would not arise.)

(2) the trustees distribute the entire fund on 3 January 2002. As the first ten-year anniversary fell on January there will he no exit charge because the distribution is within three months of that anniversary. So far as the anniversary charge is concerned the property subject to the charge will be reduced by 50% relief to £250,000; and for the purpose of calculating the hypothetical chargeable transfer the value of the property is similarly reduced by the relief.

7 Using discretionary trusts

Discretionary trusts are likely to remain attractive in the following situations:

(1) Small inter vivos discretionary settlements. Notice that Mo discretionary settlements can be used to create two nil rate band trusts when the transferor is transferring one and a half times his nil rate band.

EXAMPLE 34.11

A taxpayer transfers agricultural property (qualifying for 50% relief) into two discretionary trusts as follows:

Into Discretionary Trust I property which reduces his estate by £125,000 after 50% agricultural property relief.

Into Discretionary Trust 2 property which reduces his estate by £62,500 after 50% agricultural property relief.

In both cases, assume that the agricultural property is sold by the trustees. The result is that the first discretionary trust is worth £250,000 and, in working out any IHT charges, the settlor's cumulative total when the trust was created was nil. The second discretionary trust is worth £125,000 and was set up at a time when the cumulative total of the settlor was £125,000. Accordingly, the two trusts are nil rate hand trusts, but remember that, to avoid the related settlement rules, they should be created on separate days.

In appropriate cases a settlor can create a number of pilot settlements each with a full nil rate band.

EXAMPLE 34.12

S wishes to put £400,000 into discretionary trusts. He therefore creates four pilot trusts of £10 each on different days (so that they are not 'related settlements') and subsequently but on the same day pays £99,990 into each trust thus created. The trusts are not related since they are created on different days and each comprises £100,000. As transfers made on the same day are ignored in computing the settlors cumulative total, that total is either £10 or £20 or £30 when the relevant addition is made. Notice that although each settlement will enjoy a full nil rate band, the transfer of £400,000 into settlement will attract an immediate IHT charge at half rates. (Note Ensure that each settlement is independent of the others, eg different trustees, beneficial class and see the Rysaffe case, [32.4].)

(2) In will drafting, the use of the mini (£275,000) discretionary trust remains attractive for the smaller estate and, for flexibility the 'two-year' trust (see [30.145]). [*832]

(3) Until the FA 2006 changes, it was possible to set tip discretionary trusts by channelling property through an A&M trust (ie taking advantage of 'children of straw'). This will not he possible for inter vivos trusts created on or after 22 March 2006. [34.35]-[34.50]

III EXEMPTIONS AND RELIEFS

Many of the exemptions from IHT do not apply to trusts with relevant property, eg the annual exemption, the marriage exemption, and the exemption for normal expenditure out of income. There is no exemption if the settled fund reverts to either the settlor or his spouse (and note that if the settlor is a beneficiary, the reservation of benefit provisions apply, see Chapter 29). Business and agricultural property relief may, however, be available, provided that the necessary conditions for the relief are met by the trustees. There is no question of any aggregation with similar property owned by a discretionary or other beneficiary.

Exit charges are not levied in certain cases when property leaves the settlement, eg:

(1) Property ceasing to be relevant property within three months of the creation of the trust or of an anniversary charge or within two years of creation (if the trust was set up on death and the conditions in IHTA 1984 s 144(1) are satisfied) is not subject to an exit charge ([30.145]),

(2) Property may pass, without attracting an exit charge, to such privileged trusts as employee trusts (IHTA 1984 s 75); maintenance funds for historic buildings (IHTA 1984 Sch 4 para 16); permanent charities (IHTA 1984 s 76(1)); and political parties in accordance with the exemption in IHTA 1984 s 24 (IHTA 1984 s 76(1)(b); and see Chapter 31).

If a discretionary fund contains excluded property (arid property qualifying for 100% business or agricultural relief) the periodic and exit charges will not apply to that part of the fund. [34.51]-[34.70]

IV DISCRETIONARY TRUSTS CREATED BEFORE 27 MARCH 1974

Discretionary settlements created before 27 March 1974 are subject to special rules for the calculation of tax which generally result in less tax being charged (see generally IHTA 1984 ss 66-68). [34.71]

1 Chargeable events occurring before the first ten-year anniversary

The rate of IHT is set out in IHTA 1984 s 68(6). As the settlement is treated as a separate taxable entity only transfers made by the settlement are cumulated. Such chargeable transfers will either be distribution payments (if made under the regime in force from 1974 to 1982) or chargeable events under IHTA 1984 s 65. Once the cumulative total is known, the rate of tax will be calculated at half rate and the charge will be at 30% of that rate. [34.72] [*833]

2 The first anniversary charge

No anniversary charge applied before 1 April 1983. Thus, the first trust to suffer this charge was one created on 1 April 1973 (or 1963; 1953; 1943 and soon.).

The amount subject to the charge is calculated in the normal way. In calculating the rate of charge, however, it is only chargeable transfers of the settlement in the preceding ten years that are cumulated. (as the settlement predates CTT/IHT the senior has no chargeable transfers to cumulate). Property in a related settlement and non-relevant property in the settlement are ignored. As before, the rate of charge is reduced if property has not been relevant property throughout the decade preceding the first anniversary. The danger of increasing an IHT bill by an addition of property by the senior (sec [34.33]) is even greater with these old trusts. If such an addition has been made, the settlor's chargeable transfers in the seven-year period before the addition must be cumulated in calculating the rate of tax on the anniversary charge (IHTA 1984 s 67(4)). The effective rate of charge for the anniversary charge is (as for new trusts) 30% of the rate calculated according to half the table rates. [34.73]

3 Chargeable events after the first anniversary charge

The position is the same as for new trusts. The charge is based upon the rate charged at the last anniversary. [34.74]-[34.90]

EXAMPLE 34.13

In November 1975 Maggie settled £400,000 on discretionary trusts for her family. The following events have since occurred:

In May 1981: a distribution payment of £100,000.

In May 1984: trustees distribute a further sum of £85,000 (tax borne by

beneficiary).

In November 1985: the first ten-year anniversary. The value of relevant property then in the fund is £300,000.

IHT will be charged as follows:

(1) May 1984: The distribution is a chargeable event occurring before the first ten-year anniversary. IHT is calculated by cumulating the chargeable transfer of £85,000 with the earlier transfer made by the settlement (the distribution payment of £100,000). (Notice that there is no proportionate reduction in the effective rate for exit charges levied on old discretionary trusts before the first anniversary)

(2) November 1985: The anniversary charge will be calculated on the relevant property in the settlement (£100,000). The cumulative total of transfers made by the settlement is £185,000 (£100,000 plus £85,000).

V ACCUMULATION AND MAINTENANCE TRUSTS (IHTA 1984 s 71)

Finance Act 2006

FA 2006 has made significant changes in the area of A&M trusts. It has effectively put a stop to the creation of new A&M trusts after 22 March 2006, [*834] providing that IHTA 1984 s 71 does not apply to any property settled on or after that date. The result is that for A&M trusts subsisting on 22 March 2006 which do not come within the conditions for trusts for bereaved minors (see [34.102]), transitional relief is available so that they will continue to be exempt from the relevant property regime if first, the trust provides that the beneficiary will become absolutely entitled to the trust property at 18, or the terms are varied before 6 April 2008 to provide for this. If they do not so provide, the trust assets will become relevant property on 6 April 2008, from which time the periodic and exit charges will apply; or secondly, the trusts arise under the will of a deceased parent or step-parent in favour of his or her child and, before 6 April 2008, the child will become entitled to an interest in possession (for example, under the Trustee Act 1925, s 31 on attaining the age of 18), and the property is then held for the bereaved minor absolutely on attaining an age no greater than 25, with income and capital being applied only for his benefit in the meantime. What follows is therefore an analysis of the tax treatment of A&M trusts created before 22 March 2006.

1 Tax treatment for A&M trusts created pre-22 March 2006

a) inheritance tax

Rather than make outright gifts to minor children, it has been fairly common to settle the property in trust (often subject to the satisfaction of a contingency, eg 'attaining the age of 21') for their benefit. The reason for this special treatment was to avoid discriminating between gifts to adults and settled gifts to infants for IHT purposes.

EXAMPLE 34.14

Simon makes two gifts: one to his brother, Enrico, and one to his two-month-old granddaughter, Frederica.

(1) The gift to Enrico: The gift is a PET and therefore only subject to IHT if Simon dies within seven years.

(2) The gift to Frederica: In view of her age, it is felt necessary to settle the property on trusts which give the trustees the power to maintain Frederica, but which give her no interest in possession. Under general principles, the creation of that settlement will be a chargeable transfer of value and the discretionary trust charging regime will operate. As a result there would he anniversary charges and, when Frederica obtains either an interest in possession or an absolute interest in the settled fund, an 'exit' charge.

The object of the special provisions was to prevent this double charge. The inter vivos creation of an accumulation and maintenance (A&M) settlement was accordingly a PET and thereafter, so long as the property continues to be held on A&M trusts, the ten-year anniversary charge would not apply and there would be no proportionate periodic charge when the property left the trust. As a result, the taxation of gifts to minors was treated in the same way as gifts to adults. For all inter vivos trusts created on or after 22 March 2006 and for trusts for minors created by the will of someone other than a parent of the minor (in this case, see [34.102]) alter that date, discrimination now exists with the removal of these advantages. [34.91] [*835]

b) Other taxes

The privileged status of the A&M trust only applies for IHT purposes. So far as the other taxes are concerned, general principles operate. Unless the property settled comprises business assets, CGT hold-over relief is not available on the inter vivos creation of the trust and will only be available on its termination if a beneficiary becomes absolutely entitled to the assets on the ending of the accumulation period ([24.91]). For income tax, the creation of an A&M trust by a parent on behalf of his own infant unmarried children will result in any income which is distributed being taxed as his under the income tax settlement provisions (see ITTOIA 2005 s 629). The trustees will (generally) suffer income tax at the rate of 40% (TA 1988 s 686). [34.92]

2 The requirements of IHTA 1984 s 71

To qualify for privileged IUT treatment, an A&M trust has to satisfy the three requirements considered below. Failure to do so means that the normal charging system (either discretionary trust or interest in possession) applies. When the requirements cease to be satisfied IHT will not be charged save in exceptional cases (see [34.98]). [34.93]

3 Requirement 1

'One or more persons (... beneficiaries) will, on or before attaining a specified age not exceeding 25, become entitled to, or to an interest in possession in, the settled property or part of it' (IHTA 1984 s 71).

This is concerned with the age at which a beneficiary becomes entitled either to the income from the fund or to the fund itself. The age of 25 is specified as a maximum age limit and this is generously late when one considers that the justification for these rules is to deal with settlements for infant children.

EXAMPLE 34.15

(1) Property is settled (prior to 22 March 2006) upon trust 'for A absolutely, contingent on attaining the age of 18'. A (currently aged 10) will become entitled to both income and capital at that age so that Requirement 1 is satisfied. (2) Property is settled in 1982 upon trust 'for B absolutely, contingent upon attaining the age of 30'. At first sight Requirement 1 is broken since B (aged 8) will not acquire the capital in the fund until after the age of 25. However, it will be satisfied if the beneficiary acquires an interest in possession before 25; B will do so, because Trustee Act 1925 s 31 (if not expressly excluded) provides that when a beneficiary with a contingent interest attains 18, that beneficiary shall thereupon be entitled to the income produced by the fund even though he has not yet satisfied the contingency.

The requirement that a beneficiary 'will' become entitled does not require absolute certainty; death, for instance, can always prevent entitlement. The [*836] word causes particular problems when trustees possess overriding powers of advancement and appointment (dispositive powers) which, if exercised, could result in entitlement being postponed beyond 25. So long as the dispositive power can only be exercised amongst the existing beneficiaries (or other persons under the age of 25) and cannot postpone entitlement beyond the age of 25, Requirement l is satisfied. Accordingly, a power to vary or determine the respective shares of members of the class, even to the extent of excluding some members altogether, is permissible.

EXAMPLE 34.16

Property is held on trust for the three children of A contingent upon their attaining the age of 25 and, if more than one, in equal shares. The trustees are given overriding powers of appointment, exercisable until a beneficiary attains 25, to appoint the fund to one or more of the beneficiaries as they see fit. Requirement 1 is satisfied since the property will vest absolutely in the beneficiaries no later than the age of 25. The existence of the overriding power of appointment is irrelevant since it cannot be exercised other than in favour of the class of beneficiaries and cannot be used to postpone the vesting of the fund until after a beneficiary has attained 25.

The existence of a common form of power of advancement will not prevent Requirement 1 from being satisfied (see Lord Inglewood v IRC (1983)). However, such powers can be exercised so as to postpone the vesting of property in a beneficiary beyond the age stated in the trust document and, hence, beyond the age of 25 (see Pilkington v IRC (1962)) and they can, in exceptional cases, result in property being paid to a non-beneficiary (as in & Clore's Settlement Trusts (1966) where the payment was to the beneficiary's favourite charity). 1f the power is so exercised a charge to IHT will result.

The effect of powers of appointment which, if exercised, would break Requirement l is illustrated by the following example (and see SP El):

EXAMPLE 34.17

Property is settled in 1983 'for the children of E contingent on their attaining 25'.

The trustees are given the following (alternative) overriding powers of appointment.

(1) To appoint income and capital to F's sister F: The mere existence of this power causes the settlement to break Requirement 1. There is no certainty that the fund will pass to E's children since the power might be exercised in favour of F.

(2) To appoint income to F's brother G: The same consequence will follow since the mere existence of this power means that the income could be used for the benefit of G and, hence, break Requirement 2 (for details of this Requirement see below).

(3) To appoint capital and income to E's relatives so tong as those relatives are no older than 25: This power does not break Requirement 1 since whoever receives the settled fund, whether E's children or his relatives, will be no older than 25.

It may be difficult to decide whether or not the settlement contains a power of revocation or appointment which will break Requirement 1. In Lord Inglewood v IRC (1981), Vinelott J distinguished between events provided for in the trust instrument and events wholly outside the settlor's control: [*837]

'the terms of the settlement must be such that one or more of the beneficiaries, if they or one of them survive to the specified age, will he hound to take a vested interest on or before attaining that age ... Of course, a beneficiary may assign his interest, or he deprived of it, by an arrangement, or by bankruptcy, before he attains a vested interest. But he is not then deprived of it under the terms of the settlement, so these possible events, unlike the exercise of a power of revocation or appointment, must he disregarded ...' [1981] STC 318 at 322 (see also Fox LJ, in the Court of Appeal, [1983] STC 133 at 138).

EXAMPLE 34.18

Sebag creates a settlement (prior to 22 March 2006) in favour of his second daughter, Juno, under which she will obtain the property if she attains the age of 18. If she marries before that age, however, the property is to pass to Sebag's brother, Sebastian.

This provision in the settlement could operate to deprive Juno of the property in circumstances when, as a matter of general law, she would not he so deprived. The settlement does not satisfy Requirement 1 and so does not qualify for privileged treatment.

Two other matters should be noted in relation to Requirement I. First, even if a trust instrument fails to specify an age at which the beneficiary will become entitled to either the income or capital, so long as it is clear from the terms of that instrument and the known ages of the beneficiaries that one or more persons will in fact become entitled before the age of 25, Requirement 1 will be satisfied (ESC F8).

Secondly, for an A&M trust to be created there had to be a living beneficiary at that time. It was possible to set up a trust for a class of persons including some who were unborn ('the grandchildren of the settlor' for instance), but there had to be at least one member of the class in existence at the date of creation (IHTA 1984 s 71(7)). If the single living beneficiary dies, the trust (assuming that it was set up for a class of beneficiaries) will remain an A&M trust until a further member of that class is born. If a further class member is never born, it will eventually pass elsewhere and at that stage an IHT charge may arise. [34.94]

4 Requirement 2

'No interest in possession subsists in the settled property (or part) and the income from it is to be accumulated so far as a is not applied for the maintenance, education or benefit of such a person' (IHTA 1984 s 71).

There must be no interest in possession and once such an interest arises, the settlement breaks Requirement 2 and ceases to be an A&M trust.

If there is no interest in possession in the income, what is to be done with it? Two possibilities are envisaged; it can either be used for the benefit of a beneficiary (eg under a power of maintenance), or it can be accumulated. There must be a valid power to accumulate: accordingly once the accumulation period ends Requirement 2 will cease to be satisfied and the settlement will no longer be an A&M trust. [*838]

EXAMPLE 34.19

A trust is set up for Loeb, the child of the senior, contingent on his attaining the age of 25. So long as he is a minor the trustees will have a power to maintain him out of the income of the fond and a power to accumulate any surplus income (Trustee Act 1925 s 31). When Loch becomes 18 he will he entitled to the income of the fund so that an interest in possession will arise and the settlement will cease to be an A&M trust. The ending of the trust will not lead to any [HT charge. Care should he taken in choosing the appropriate period if the intention is to accumulate income beyond the minorities of the beneficiaries. Various periods are permitted under LPA 1925 ss 164 and 165 and under Trustee Act 1925 s 31, but some of them may cause the trust to fall outside the definition of an A&M settlement. In the case of an inter vivos trust, for instance, a direction to accumulate 'during the lifetime of the settlor' would mean that an interest in possession might not arise until after the beneficiaries had attained the age of 25; likewise, a provision to accumulate for 21 years when the beneficiaries are over the age of four would be fatal. [34.95]

5 Requirement 3

'Either

(i) not more than 25 years have elapsed since the day on which the settlement was made or (if later) since the time when the settled property (or part) began to satisfy Requirements 1 and 2, or

(ii) all the persons who are, or have been beneficiaries are, or were, either grandchildren of a common grandparent, or children, widows or widowers of such grandchildren who were themselves beneficiaries but died before becoming entitled as mentioned in [Requirement 1]' (IHTA 1984 s 71).

Requirement 3 was introduced to stop the A&M trust from being used to benefit more than one generation. There are two ways in which it can be satisfied. First, the trust must not last for more than 25 years from the date when the fund became settled on A&M trusts. The second (alternative) limb is satisfied if all the beneficiaries have a common grandparent.

EXAMPLE 34.20

(1) Property is settled for the children and grandchildren of the senior. As there is no grandparent common to all the beneficiaries, the trust must not last for longer than 25 years if an exit charge to IHT is to he avoided.

(2) Property is settled for the children of brothers Bill and Ben. As there is a common grandparent the duration of the settlement does not need to be limited to 25 years.

Two generations can be benefited tinder an A&M trust without the 25-year time limit applying in one case, namely substitution per stirpes is permitted where the original beneficiaries had a common grandparent and one of those beneficiaries has died. [34.96] [*839]

6 Advantages of accumulation and maintenance trusts

An A&M trust created prior to 22 March 2006 and still in existence may continue to enjoy the advantages outlined provided that it falls within one of the two categories discussed in [34.91]. For trusts created after 22 March 2006, these advantages will no longer apply. No IHT is charged when property from an A&M trust becomes subject to an interest in possession in favour of one or more of the beneficiaries, nor when any part of the fund is appointed absolutely to such a beneficiary (IHTA 1984 s 71(3), (4)). This exemption, together with the exclusion of the anniversary charge (IHTA 1984 s 58(l) (b�, means that once the property is settled on these trusts there should be no IHT liability whilst the settlement continues in that form and on its termination. Furthermore the inter vivos creation of the trust is a PET.

EXAMPLE 34.21

'... to A absolutely contingent on attaining 25'. This straightforward trust, created in 1990, will satisfy the Requirements so long as A is an infant. Consider, however,

the position:

(1) When A attains 18: he will he entitled to the income from the fund (Trustee Act 1925 s 31) and, therefore, Requirement 2 is broken. No IHT is charged on the arising of the interest in possession.

(2) When A attains 25: ordinary principles for interest in possession settlements apply; A's life interest comes to an end, but no IHT is payable since the life tenant is entitled to ail the property (see IHTA 1984 s 53(2)). Note that adverse CGT consequences may occur at this time: see [24.91].

(3) If A dies aged 19: II-IT will be assessed on the termination of an interest in possession.

As already discussed, there is nothing to prevent an A&M trust from being created for an open class of beneficiaries, eg 'for all my grandchildren both horn and yet to be horn'. If such a trust is to be created, it is important to consider whether the class of beneficiaries should close when the eldest obtains a vested interest in either the income or capital. Failure to do so will result in a partial divesting of the beneficiary with the vested interest when a further beneficiary is born, and, as a result, a PET. Class-closing rules may be implied at common law (see Andrews v Partington (1791)), but it is safer to insert an express provision to that effect.

IHTA 1984 s 71(4) (b) provides that 'tax shall not be charged ... on the death of a beneficiary before attaining the specified age'. It follows that, if the entire class of beneficiaries is wiped out, an A&M trust will cease on the death of the final member, but, whoever then becomes entitled to the fund, no IHT will be payable. When it is necessary to wait and see if a further beneficiary is born, however, this provision will not operate, since it is not the death of the beneficiary which ends the A&M trust in such a case, but the failure of a further beneficiary to be born within the trust period. [*840]

EXAMPLE 34.22

(1) Property is settled upon trust for Zed's grandchild, Yvonne, contingent upon her attaining 18. If she were to die aged 16, the property would (in the absence of any provision to the contrary) revert to Zed and no IHT would be payable.

(2) Property was settled upon trust for Victor's children contingent upon their attaining 21. and, if more than one, in equal shares absolutely. Victor's one child, Daphne, died in 2000 aged 12 and Victor himself has just died.

No charge to IHT arose on Daphne's death but the property continued to he held on A&M trusts until Victor died when the trust ended with a charge to IHT

The A&M trust could be drafted to achieve a considerable degree of flexibility. It was common for such a trust to contain the following provisions:

(1) Primary beneficiaries are present and future grandchildren with a class-closing provision.

(2) The trustees are given a revocable power of appointment among the beneficiaries (inapplicable once a beneficiary has attained 25).

(3) The A&M trust will end with beneficiaries being entitled to interests in possession (not absolute interests) and thereafter such a beneficiary is given power to appoint a life interest to his surviving spouse and divide up the capital as he sees fit between his children. However:

(4) The trustees retain an overriding power to determine the life interest of any beneficiary who has attained (say) 26 and appoint the property in favour of one or more secondary beneficiaries, often called discretionary beneficiaries.

As a result, this kind of settlement includes more than one generation of beneficiaries; has great flexibility; but still qualifies as an A&M trust when set

up. [34.97]

7 Occasions when an 'exit charge' IHT arise

It is rare for property to leave an A&M trust otherwise than by vesting in a qualifying beneficiary and so long as this happens no IHT is chargeable. Provision is, however, made for calculating an 'exit charge' in the following four circumstances (IHTA 1984 ss 70(6), 71(5)):

(1) When depreciatory transactions entered into by the trustees reduce the value of the fund (IHTA 1984 s71(3)(b)).

(2) When the 25-year period provided for in Requirement 3 is exceeded and the beneficiaries do not have a common grandparent.

(3) When property is advanced to a non-beneficiary or resettled on trusts which do not comply with the three Requirements.

(4) If the trust ends some time after the final surviving beneficiary has died (see Example 34.22(2)).

IHT is calculated in these cases on the value of the fund according to how long the property has been held on the A&M trusts:

0.25% for each of the first 40 complete successive quarters in the relevant period;

0.20% for each of the next 40;

0.15% for each of the next 40; [*841]

0.10% for each of the next 40; and

0.05% for each of the next 40.

Hence, on expiry of the permitted 25 years IHT at a rate of 21% will apply to the fund. Thereafter, normal discretionary trust rules will apply, so that five years later there will be an anniversary charge. [34.981-[34.100]

VI TRUSTS FOR BEREAVED MINORS AND 18-25 TRUSTS

In place of A&M settlements, FA 2006 has introduced two new trust regimes -- the 'trust for bereaved minors' and '18-25 Trusts'. The rules governing these trusts are contained in IHTA 1984 s 71A-G (introduced by FA 2006). [34.101]

I Trusts for bereaved minors

Broadly, a trust is a 'trust for bereaved minors' if property is held on statutory trusts for minors that arise on intestacy or on trusts established under the will of a deceased parent of the bereaved minor or on trusts established under the Criminal Injuries Compensation Scheme. Trusts of the last two types must fulfil additional conditions. First, the bereaved minor must, on attaining 18 years of age (if not earlier), become absolutely entitled to the settled property, any income arising from such property and any income from such property that has been accumulated before the bereaved minor turned 18. Secondly, while the bereaved minor is under the age of 18, any income or capital payment out of the settled property is provided for the benefit of the bereaved minor. Thirdly, while the bereaved minor is under 18 years of age, either the bereaved minor is entitled to all the income arising from any settled property or no such income may be used to benefit any other person. Where IHTA 1984 s 71A applies (ie there is a trust for bereaved minors) the general rule is that there is a charge to tax where settled property ceases to he property to which s 71A applies ('the exit charge' -- the authors' terminology), and where trustees enter into a depreciatory transaction. The exceptions to the general rule are that no charge arises:

- first, when the bereaved minor turns 18 or, if earlier, becomes absolutely entitled to the settled property and any arising or accumulated income;

- secondly, if the bereaved minor dies under the age of 18; or

- thirdly, when the settled property is paid or applied for the benefit of the bereaved minor. [34.102]

2 Age 18-25 trusts

18-25 trusts are established under IHTA 1984 s 71D, which applies to settled property (including property settled before 22 March 2006) if the property

- is held on trusts for the benefit of a person who is under 25 years of age;

- at least one of the person's parents has died;

- the trusts were established under the will of the deceased parent or under the Criminal Injuries Compensation Scheme; and

- the terms of the trusts satisfy the further conditions that first, the bereaved minor must on attaining 25 years of age (if not earlier), [*842]

become absolutely entitled to the settled property, any income arising from such property and any income arising from such property which has been accumulated before the bereaved turned 18; secondly, while the bereaved minor is under the age of 25, any benefit provided out of the settled property is provided to the bereaved minor; and finally, while the bereaved minor is under 25 years of age, either the bereaved minor is entitled to all the income arising from any settled property or no such income may be used to benefit any other person.

It should be noted that s 71D does not apply to any property to which ss 71 and 71A apply or where, if a person has an interest in possession in the settled property, that person became beneficially entitled to the interest in possession before 22 March 2006 or that interest in possession is an immediate post-death interest or a transitional serial interest and the person became entitled to it on or after 22 March 2006.

A charge to tax arises when settled property ceases to be property to which s 71D applies ('the exit charge' -- the authors' terminology), or where the trustees enter into depreciatory transactions (IHTA 1984 s 71E (1)). Exceptions from this charge seek broadly to tie in the charge under s 71D with the charge under s 71A (trusts for bereaved minors) (s 71E (2)-(4)). For instance, tax is not charged under s 71E on property ceasing to be property to which s 711) applies where this is the result of the bereaved minor becoming absolutely entitled to the settled property income arising and accumulated income at or under the age of 18, or where the bereaved minor dies under the age of 18.

Property subject to these trusts will be exempt from the relevant property regime, except that there will be a charge when the bereaved minor becomes absolutely entitled to the property on attaining the age of 18 (or if, after attaining the age of 18, the property is applied for his benefit or is by advancement, or if he dies between the ages of 18 and 25), with the maximum rate of charge being 4.2% if absolute entitlement is on attaining the age of 25 (IHTA 1984 s71G). [34.103]-[34.110]

VII OTHER SPECIAL TRUSTS

1 Charitable trusts

If a trust is perpetually dedicated to charitable purposes, there is no charge to IHT and the fund is not 'relevant property' (IHTA 1984 s 58). Transfers to charities are exempt, whether made by individuals or by trustees of discretionary trusts (IHTA 1984 s 76).

IHTA 1984 s 70 is concerned with temporary charitable trusts defined as 'settled property held for charitable purposes only until the end of a period (whether defined by a date or in some other way)' and ensures that when the fund ceases to be held for such purposes an exit charge will arise. That charge (which is calculated in the same way as for A&M trusts; see above) will never exceed a 30% rate which is reached after 50 years. [34.111]

2 Trusts for the benefit of mentally disabled persons and persons in receipt of an attendance allowance (IHTA 1984 s 89)

These trusts continue to enjoy their tax advantages even after the changes made by FA 2006.

A qualifying trust for a disabled person is treated as giving that person an interest in possession. As a result, the IHT regime for no interest in possession trusts does not apply. The inter vivos creation of this trust by a person other than the relevant beneficiary is a PET. There are no restrictions on the application of income which can therefore be used for the benefit of other members of the class of beneficiaries. This can he particularly useful where the application of income to the 'principal' disabled beneficiary could jeopardise his entitlement to state benefits. At least one half of any capital benefits must be paid to the 'principal' beneficiary. A charge to IHT will arise on the death of the disabled person whose deemed interest in possession will aggregate with his free estate in the normal way. Although disabled trusts can also obtain CGT advantages (eg a full annual exemption for the trustees), to qualify the disabled beneficiary must be entitled to at least one half of the income or be the sole income beneficiary (see TCGA 1992 Sch 1 para 1 and Private Client Business (1993) p 161). [34.112]

3 Pension funds IHTA 1984 s 151)

A superannuation scheme or fund approved by HMRC for income tax purposes is not subject to the rules for no interest in possession trusts. This exemption from IHT extends to payments out of the fund within two years of the member's death. It is common practice for the member to settle the 'death benefit' on discretionary trusts: this trust will be subject to normal charging rules although HMRC consider that IHTA 1984 s 81 applies to deem the property to remain comprised in the original fund: eg for the purpose of ten-year anniversary dates (see [34.23]). [34.113]

4 Employee trusts (IHTA 1984 s 86)

These trusts will not in law be charitable unless they are directed to the relief of poverty amongst employees (see Oppenheim v Tobacco Securities Trust Co Ltd (1951)). They may, however, enjoy IHT privileges. Their creation will not involve a transfer of value, whether made by an individual (IHTA 1984 s 28) or by a discretionary trust (IHTA 1984 s 75). Once created, the fund is largely exempted from the IHT provisions governing discretionary trusts, especially from the anniversary charge. To qualify for this treatment, the fund must be held for the benefit of persons employed in a particular trade or profession together with their dependants. These provisions are extended to cover newspaper trusts (see IHTA 198,1 s 87); approved profit sharing schemes and the FA 2000 employee share ownership plan. [34.114]

5 Compensation funds (IHTA 1984 ss 58, 63)

Trusts set up by professional bodies and trade associations for the purpose of indemnifying clients and customers against loss incurred through the default of their members are exempt from the rules for no interest in possession trusts. [34.115] [*844]

6 Maintenance funds for historic buildings (IHTA 1984 s 77, Sch 4)

IHT exemptions are available for maintenance funds where property is settled and the Treasury give a direction under IHTA 1984 Sch 4 para 1. Once the trust ceases, for any reason, to carry out its specialised function, an exit charge, calculated in the same way as for A&M trusts, occurs. [34.116]

7 Protective trusts (IHTA 1984 ss 73, 88)

A protective trust may he set up either by using the statutory model provided for by the Trustee Act 1925 (TA) s 33, or by express provisions.

These trusts have always been subject to special IHT rules and, as originally enacted, The rules offered scope for tax avoidance (see IHTA 1984 s 73 and Thomas v IRC (1981)). Accordingly, the rules were changed with effect from 11 April 1978 by providing that the life tenant is deemed to continue to have an interest in possession for IHT purposes despite the forfeiture of his interest (IHTA 1984 s 88). It follows that the discretionary trust regime is not applicable to the trust that arises upon such forfeiture. Should the capital be advanced to a person other than the life tenant, a charge to IHT will arise and on the death of the beneficiary the fund will be treated as part of his estate for IHT purposes (Cholmondeley v IRC (1986)). As a result of these rules there is the curious anomaly that, after a forfeiture of the life interest, the interest in possession rules apply to a discretionary trust although it should be borne in mind that ordinary rules apply for other taxes. Thus for income tax a 40% rate applies once the life interest is forfeited and there is no CGT uplift on the death of the principal beneficiary.

One cautionary note should be added; this system of charging only applies to protective trusts set up under the TA 1925 s 33 or to trusts 'to the like effect'. Minor variations to the statutory norm are, therefore, allowed; but not the inclusion of different beneficiaries under the discretionary trust (such as the brothers and sisters of the principal beneficiary) nor a provision that enables a forfeited life interest to revive after the lapse of a period of time. In such cases, the normal rules applicable to interest in possession and discretionary trusts apply (see Law Society's Gazette, 3 March 1976 and SP F7). [34.117] [*844]

35 IHT--excluded property and the foreign element

Updated by Aparna Nathan, LLB Hons, LLM, Barrister Gray's Inn Tax Chambers

I Domicile and situs [135.3]

II What is excluded property? [35.201

III Double taxation relief for non-excluded property [35.41]

IV Miscellaneous points [35.61]

V Foreign settlements, reversionary interests and excluded property [35.81]

1 Ambit of IHT

As a general rule, IHT is chargeable on all property situated within the UK regardless of its owner's domicile and on property, wheresoever situate, which is beneficially owned by an individual domiciled in the UK. [35.1]

2 Excluded property

Any transfer of 'excluded property' is not chargeable to IHT (IHTA 1984 ss 3(2) and 5(1)). The main example of excluded property is 'property situated outside the UK ... if the person beneficially entitled to it is an individual domiciled outside the UK' (IHTA 1984 s 6(1)). In determining whether property is excluded property relevant factors include not only the domicile of the transferor who is the beneficial owner of the property and the situation of the property (situs), but also the nature of the transferred property, since certain property is excluded regardless of its situs or the domicile of its owner. [35.2]

I DOMICILE AND SITUS

1 Domicile

a) General rules

An individual cannot, under English law, be without a domicile which connotes a legal relationship between an individual and a territory. There are three kinds of domicile: domicile of origin, domicile of choice and domicile of dependence. [*846]

A person acquires a domicile of origin at the moment when he is born. He will usually take the domicile of his father unless he is illegitimate or born after his father's death in which case he takes the domicile of his mother. A domicile of origin is never completely lost, but may be superseded by a domicile of dependence or choice; it will revive if the other type of domicile lapses.

A person cannot acquire a domicile of choice until he is 16 or marries under that age. Whether someone has replaced his domicile of origin (or dependence) by a domicile of choice is a question of fact which involves physical presence in the country concerned and evidence of a settled intention to remain there permanently or indefinitely (animus manendi).

Unmarried infants under the age of 16 (in England and Wales, younger in

Scotland) acquire their father's domicile of dependence and women who married before 1 January 1974 acquired their husband's domicile by dependence. [35.3]

b) Deemed domicile

If a person's domicile under the general law is outside the UK, he may he deemed to he domiciled in the UK, for IHT purposes only, in two circumstances (IHTA 1984 s 267).

First, if a person was domiciled in the UK on or after 10 December 1974 and within the three years immediately preceding the transfer in question, he will be deemed to be domiciled in the UK at the time of making the transfer (IHTA 1984 s 267(1)(a)). This provision is aimed at the taxpayer who moves his property out of the UK and then emigrates to avoid future IHT liability on transfers of that property. In such a ease he will have to wait three years from the acquisition of a new domicile of choice for his property to become excluded property under IHTA 1984 s 6(1) (see Re Clore (No 2,) (1984)).

Secondly, a person will be deemed domiciled in the UK if he was resident for income tax purposes in the UK on or after 10 December 1974 and in not less than 17 out of the 20 income tax years ending with the income tax year in which he made the relevant transfer (IHTA 1984 s 267(1)(b)). This catches the person who has lived in the UK for a long time even though he never became domiciled here under the general law. Residence is used in the income tax sense (see Chapter 18), and does not require residence for a period of 17 complete years. This is because the Act is concerned with a person who is resident in a tax year and such residence may be acquired if the individual concerned comes to the UK at the very end of that year (eg on 1 April) with the intention of remaining indefinitely in the UK In such a case, the individual will be resident for the tax year in which he arrived- albeit that it is about to end-and that will count as the first year of residence for the purpose of the 17-year test. Similarly, were he to leave the UK immediately after the commencement of a tax year, he would be treated as resident in the UK in that final tax year. Accordingly, in an extreme case, an individual could arrive in the UK on 1 April in one year, remain for the next 15 years and make a transfer on 10 April in year 17 and yet be caught by the 17-year test, even though only being resident in the UK for a little over 15 years. [35.4] [*845]

EXAMPLE 35.1

(1) Jack who was domiciled in England moved to New Zealand on 1 July 2001 intending to settle there permanently. 11e died on 1 January 200,3 when according to the general law he had acquired a domicile of choice in New Zealand. However, because Jack had a UK domicile and died within three years of losing it, he is deemed under s 267(1) (a) to have died domiciled in the UK Accordingly, all his property wherever situated (excluding gifts; see below) is potentially chargeable to IHT. Jack would have had to survive until 1 July 2004 to avoid being caught by this provision.

(2) On 5 June 2003, Jim who is domiciled under the general law in Ruritania and who is a director of BB Ltd (the UK subsidiary of a Ruritanian company) gives a house that he owns in Ruritania to his son. By virtue of his job Jim has been resident for income tax purposes in England since 1 January 1976, but he intends to return to Ruritania when he retires. For IHT purposes Jim is deemed to he domiciled in England under s 267(1) (h); the gift will, therefore, be subject to IHT if Jim dies within seven years.

(3) Boer, resident in the UK but domiciled in South Africa, forms an overseas company to which he transfers the ownership of all his UK property. He has exchanged chargeable assets (UK property) for excluded property (shares in the overseas company). (For the purposes of income tax, this arrangement would fall within the transfer of assets legislation: see [18.111].)

(4) François, a non-UK domiciliary, owns all the shares in a UK property dealing company. He converts that share capital into bearer shares holding the relevant certificates offshore. On his death the assets are not UK sites (note the stamp duty charge on an issue of bearer shares: see Chapter 49).

2 Situs

Subject to contrary provisions in double taxation treaties (and special rules for certain property) the situs of property is governed by common law rules and depends on the type of property involved. For instance:

(1) An interest in land (including a leasehold estate or rent charge) is situated where the land is physically located.

(2) Chattels (other than ships and aircraft) are situated at the place where they are kept at the relevant time.

(3) Registered shares and securities are situated where they are registered or, if transferable upon more than one register, where they would normally be dealt with in the ordinary course of business.

(4) Bearer shares and securities, transferable by delivery, are situated where the certificate or other document of title is kept.

(5) A bank account (ie the debt owed by the bank) is situated at the branch that maintains the account. (Special rules apply to non-residents' foreign currency bank accounts: [35.26].) [35.5]-[35.19]

II WHAT IS EXCLUDED PROPERTY?

1 Property situated outside the UK and owned beneficially by a non-UK domiciliary (IHTA 1984 s 6(1))

Property falling into this category is excluded regardless of its nature. [*848]

Settled property situated abroad will be excluded property only if the settlor was domiciled outside the UK at the time when he made the settlement (IHTA 1984 s 48(3): note that the position of the interest in possession beneficiary is irrelevant in this case). If the settlor retains an interest in possession either for himself or his spouse, and a discretionary trust arises on the termination of that interest, an additional test is imposed in determining whether property is excluded property. This test looks at where the senior or the spouse (if the interest was reserved for him) was domiciled when that interest in possession ended (IHTA 1984 s 82). As this provision only applies where the property is initially settled with a life interest on the settlor or his spouse, it may be circumvented if the trust commences in discretionary form and is then converted into a life interest. [35.20]

EXAMPLE 35.2

(1) Franc, domiciled in Belgium, intends to buy a house in East Anglia costing £500,000. If he buys it in his own name it will he subject to IHT on his death. If he buys it through an overseas company, however, he will then own overseas assets (the company shares) that fall outside the IHT net. Note that if he occupies the house and is a director of the overseas company, HMRC will tax him on an emolument equal to the value of the property each year under the provisions of ITEPA 2003 s 102 (see [8.116]). This charge will also arise if Franc is a shadow director of the company: see R v Allen; R v Dimsey (2001). As an alternative:

(a) the company could he owned by an offshore trust (a two-tier' structure) or;

(b) he could buy the property in his own name with a substantial mortgage charged on the house which will have the effect of reducing its IHT value.

The Revenue has confirmed that where a UK-resident individual is provided with rent-free accommodation by an overseas resident company and that company is for the purposes of the transfer pricing legislation (TA 1988 Sch 28AA: see [41.44]) under the control of the UK-resident individual, it will not be Revenue practice to impute rental income to the overseas resident company (see Tax Bulletin, April 2000, p 742).

(2) Erik, domiciled in Sweden, settles Swedish property on discretionary trusts for himself and his family. He subsequently acquires an English domicile of choice. The settlement is of excluded property for LUT purposes (IHTA 1984 s 48(3)), although the assets would appear to form part of the settlor's estate when he dies. Because of the reservation of benefit rules in FA 1986 s 102(3), IHRC currently accepts that the property remains excluded so that it will not be subject to any charge (Law Society's Gazette, 10 December 1986). The position is, however, different if Erik is excluded from all benefit during his life when a deemed PET occurs under s 102(4).

(3) Boris, domiciled in France, died in February 2003 and left his villa in Tuscany and moneys in his Swiss bank account to his son Gaspard, a UK resident and domiciliary. By a variation of the terms of his will made within two years of Boris' death the property is settled on discretionary Liechtenstein trusts for the benefit of Gaspard's family. For IHT reading back ensures that the settlement is of excluded property. Far CGT however, although the variation is not itself a disposal, Gaspard is treated as the senior of the trust and hence the provisions in TCGA 1992 s 86 will apply (see [27.91] and Marshall v Kerr (1994)).

2 Property that is exempt despite being situated in the UK

a) Government securities

Certain Government securities (gilts) owned by a person ordinarily resident outside the UK are exempt from IHT (IHTA 1984 s 6(2): see [18.77] -- FOTRA securities). The domicile of the taxpayer is irrelevant (see Advanced Instruction Manual at G33). If these securities are settled they will be excluded property if either the person beneficially entitled to an interest in possession (eg a life tenant) is not ordinarily resident in the UK, or, in the case of a discretionary trust, if none of the beneficiaries are ordinarily resident in the UK (IHTA 1984s48(4)).

IHTA 1984 s 48(5) contains anti-avoidance provisions:

(J) If gilts are transferred from one settlement to another they will only be excluded property if the beneficiaries of both settlements are non-UK ordinarily resident This prevents guts from being channelled from a discretionary trust where they were not excluded property (because some of the beneficiaries were UK ordinarily resident) to a new settlement with non-ordinarily resident beneficiaries only, where they would be excluded property (as was done in Minden Trust (Cayman) Ltd v IRC (1984)).

(2) When a close company is a beneficiary of a trust, any gifts owned by the trust will be excluded property only if all participators in the company are non-UK ordinarily resident, irrespective of the company's residence. This aims to prevent individuals from using a company to avoid IHT. [35.21]

b) Holdings in an authorised unit trust and shares in an open ended investment company

These securities are excluded property if the person beneficially entitled is an individual domiciled outside the UK (IHTA 1984 s 6(1A) inserted by FA 2003). If held in a settlement these assets will be excluded property unless the senior was domiciled in the UK at the time when the settlement was made (IHTA 1984 s 48(3A) inserted by FA 2003). [35.22]

e) Certain property owned by persons domiciled in the Channel Islands or Isle of Man

Certain savings (eg national savings certificates) are excluded property if they are in the beneficial ownership of a person domiciled and resident in the Channel Islands or the Isle of Man (IHTA 1984 ss 6(3), 267(4)). [35.23]

d) Visiting forces

Certain property owned in the UK by visiting forces and staff of allied

headquarters is excluded property (IHTA 1984 s 155). [35.24]

e) Overseas pensions

Certain overseas pensions (usually payable by ex-colonial governments) are exempt from IHT on the pensioner's death regardless of his domicile (IHTA 1984 s 153). [35.25] [*850]

f) Non-sterling bank accounts

On the death of an individual domiciled resident and ordinarily resident outside the UK there is no IHT charge on the balance in any 'qualifying foreign currency account' (IHTA 1984 s &57). This exemption does not apply to inter vivos gifts of the money in such an accountant.

For the inter-relationship of excluded property and settlements, see [35.81]. [35.26]-[35.40]

III DOUBLE TAXATION RELIEF FOR NON-EXCLUDED PROPERTY

Non-excluded property may he exposed to a double charge to tax (especially on the death of the owner); once to IHT in the UK and again to a similar tax imposed by a foreign country. Relief against such double charge may be afforded in one of two ways.

First, the UK may have a double taxation treaty with the relevant country when the position is governed by IHTA 1984 s 158. The provisions of the treaty will override all the relevant IHT legislation (e.g. the deemed domicile rule) and common law rules regarding the situs of property.

Under these treaties, the country in which the transferor is domiciled is generally entitled to tax all property of which he was the beneficial owner. The other country involved usually has the right to tax some of that property, eg land situated there. In such cases the country of domicile will give relief against the resulting double taxation. Most of these treaties also contain provisions to catch the individual who changes his domicile shortly before death to avoid tax.

Secondly, where no double tax treaty exists, unilateral relief is given in the form of a credit for the foreign tax liability against IHT payable in the UK (IHTA 1984 s 159). The amount of the credit depends on where the relevant property is situated; in some cases no credit is available if the overseas tax is not similar to IHT, although some relief is, effectively, given since, in calculating the reduction in the transferor's estate for calculating IHT, the amount of overseas tax paid will be disregarded (IHTA 1984 s 5(3)). This relief is less beneficial than a tax credit. [35.41]-[35.60]

IV MISCELLANEOUS POINTS

I Valuation of the estate-allowable deductions

Certain liabilities of a transferor are deductible when calculating the value of his estate for IHT purposes (see [30.13]). However, any liability to a non-UK resident is deductible as far as possible from a transferor's foreign estate before his UK estate. As a result, a foreign domiciliary who is chargeable to IT-IT on his UK assets cannot usually deduct his foreign liabilities from his UK estate. There are two exceptions to this rule. First, if a liability of a non-UK resident has to be discharged in the UK, it is deductible from the UK estate; secondly, any liability that encumbers property in the UK, reduces the value of that property. [35.61] [*851]

EXAMPLE 35-3

Adolphus dies domiciled in Ethiopia. His estate includes cash in a London bank account, shares in UK companies and a stud farm in Weybridge that is mortgaged to an Ethiopian glue factory. He owes a UK travel company £500 for a ticket bought to enable his daughter to travel around Texas and £200,000 to a Dallas horse dealer. TUT is chargeable on his UK assets. However, the mortgage debt is deductible from the value of his stud farm and £500 is deductible from the UK estate generally. There is no reduction for the debt of £200,000 assuming that he has sufficient foreign property

2 Expenses of administering property abroad (IHTA 1984 s 173)

Administration expenses are not generally deductible from the value of the deceased's estate. However, the expense of administering or realising property situated abroad on death is deductible from the value of the relevant property up to a limit of 5% of its value. [35.62]

3 Enforcement of tax abroad

On the death of a foreign domiciliary with UK assets, the deceased's PRs cannot administer his property until they have paid any IHT and obtained a grant of probate. However, the collection of IHT on lifetime transfers by a foreign domiciliary presents a problem if both the transferor and transferee are resident outside the UK and there is no available property in the UK that can be impounded. [35.63]

4 Foreign assets

If a foreign Government imposes restrictions as a result of which UK executors cannot immediately transfer to this country sufficient of the deceased's foreign assets for the payment of IHT attributable to them, they are given the option of deferring payment until that transfer can be made. If the amount that is finally brought into the UK is less than the IHT, any balance will be waived (see ESC F6). [35.64]-[35.80]

V FOREIGN SETTLEMENTS, REVERSIONARY INTERESTS AND EXCLUDED PROPERTY

I Foreign settlements

As a general rule, settled property which is situated abroad is excluded property if the settlor was domiciled outside the UK when the settlement was made (IHTA 1984 s 48(3) and see Tax Bulletin, February 1997). Therefore, the domicile of the individual beneficiaries in such cases is irrelevant, so that even if the beneficiary is domiciled in the UK, there will be no charge to IHT on the termination of his interest in possession nor on any payment made to him from a discretionary trust. [35.81] [*852]

EXAMPLE 35.4

Generous, domiciled in the USA, settles shares in US companies on his nephew, Tom, for life. Tom is domiciled and resident in the UK The property is excluded property, being property situated abroad settled by a senior domiciled at that time outside the UK, so that there will be no charge to IHT on the ending of Tom's life interest.

If, however, those shares were exchanged for shares in UK companies, the property would no longer be excluded and there would be a charge to IHT on the termination of Tom's life interest.

If Generous had settled those same US shares on discretionary trusts for his nephews, all of whom were UK domiciled, the property would be, for the same reason, excluded property, so that the normal discretionary trust charges would not apply'. (Note the CGT treatment of IHT excluded property settlements as a result of FA 1998 changes: see [27.111].)

2 Reversionary interests

a) Definition

For HIT purposes any future interest in settled property is classified as a reversionary interest (IHTA 1984 s 47). The term, therefore, includes an interest dependent on the termination of an interest in possession, whether that interest is vested or contingent. A contingent interest where the settlement does not have a interest in possession is also a reversionary interest for IHT purposes.

EXAMPLE 35.5

Property is settled on the following trusts:

(1) A for life, remainder to B for life, remainder to C. B and C both have reversionary interests for IHT purposes.

(2) A for life, remainder to B for life, remainder to C if he survives B. C's contingent remainder is a reversionary interest for IHT purposes.

(3) To A absolutely contingent upon his attaining the age of 21. A is currently aged six and has a reversionary interest for IHT purposes.

The interest of a discretionary beneficiary is not, however, a 'reversionary interest', being in no sense a future interest. Such a beneficiary has certain present rights, particularly the right to be considered by the trustees when they exercise their discretion and the right to compel due administration of the fund. The value of such an interest is likely to he nil, however, since the beneficiary has no right to any of the income or capital of the settlement. He has merely a hope (spes). [35.82]

b) 'Situs' of a reversionary interest

A reversionary interest under a trust for sale is a chose in action rather than an interest in the specific settled assets be they land or personalty (Re Smyth, Leach v Leach (1898)). In other cases the position is unclear; but by analogy with estate duty principles it will be a chose in action if the settled assets are personally; but an interest in the settled assets themselves if they are land. [*853] Since a chose in action is normally situated in the country in which i1 is recoverable (New York Life Insurance Co v Public Trustee (1924)), in some cases the reversionary interest will not be situated in the same place as the settled assets. [35.83]

c) Reversionary interests--the general rule

A reversionary interest is excluded property for IHT (IHTA 1984 s 48(1); see [33.61]) with three exceptions designed to counter tax avoidance:

(1) Where it was purchased for money or money's worth.

EXAMPLE 35.6

There is a settlement on A for life, remainder to B. B sells his interest to who gives it to his brother Y. X has made a transfer of value (a PET) of a reversionary interest (which can be valued by taking into account the value of the settled fund and the life expectancy of A).

(2) Where it is an interest to which the settlor or his spouse is beneficially entitled.

(3) Where a lease for life or lives is granted for no or partial consideration, there is a settlement for IHT (IHTA 1984 s 43(3)) and the lessor's interest is a reversionary interest (IHTA 1984 s 47). Such a reversionary interest is only excluded property to the extent that the lessor did Not receive full consideration on the grant (see IHTA 1984 s 48(1)(c)for valuation of the lessee's interest in possession and IHTA 1984 s 170 for the valuation of the lessor's interest). [35.84]

EXAMPLE 35.7

L grants a lease of property worth £30,000 to T for £10,000 for T's life. T is treated for IHT purposes, as having an interest in possession and, therefore, as absolute owner of two-thirds of the property (£30,000 - £10,000). L is treated as the owner of one-third of the property (because he received £10,000). Therefore, one-third of his reversionary interest is not excluded property.

d) Reversionary interests--the foreign element

Under IHTA 198,1 s 48(1) a reversionary interest (with the three exceptions above) is excluded property regardless of the domicile of the settlor or reversioner or the situs of the interest. Where the settled property is in the UK, but the reversionary interest is situated abroad (see [34.83]) and beneficially owned by a foreign domiciliary the interest probably is excluded property in all eases under the general rule of IHTA 1984 s 6(1).

However, the status of a reversionary interest in settled property situated Outside the UK is cast into some doubt by virtue of IHTA 1984 s 48(3) to which s 6(1) is expressly made subject (IHTA 1984 s 48(3)(b)). Section 48 (3) States:

'where property comprised in a settlement is situated outside the UK

(a) the property (but not a reversionary interest in the property) is excluded property unless the settlor was domiciled in the UK at the time the settlement was made; and [*854]

(b) section 6(1) above applies to a reversionary interest in the property, but does not otherwise apply in relation to the property'

This provision appears 10 exclude the operation of s 48(11) by saying that a reversionary interest in settled property situated abroad is only excluded property (under the general rule in s 6(1)) if it is itself situated abroad and owned by a foreign domiciliary.

However, it is thought that s 48(3) only prevails over s 48(1) in eases of conflict and that there is no conflict here since the words 'but not a reversionary interest' in s 48(3)(a) mean that whether a reversionary interest is excluded property depends not on the situs of the settled property nor on the settlor's domicile, but on the general rule in s 48(1).

In summary, therefore, a reversionary interest is always excluded property regardless of situs or domicile with three exceptions (see [33.61]). Even if the interest falls within one of the exceptions, it will still be excluded property if the interest (regardless of the whereabouts of the settled property) is situated outside the UK and beneficially owned by a foreign domiciliary (IHTA 1984 s 6(1)); or if the reversionary interest is itself settled property, is situated abroad and was settled by a foreign domiciliary (IHTA 1984 s 6(1) and s 48(3). [35.85] [*855]

36 Relief against double charges to IHT

Updated by Aparna Nathan, LLB Hons, LLM, Barrister Gray's Inn Tax Chambers and Natalie Lee, Barrister Senior Lecturer in Law, University of Southampton

I Case 1--PETs and death [36.2]

II Case 2--Gifts with a reservation and subsequent death [36.3]

III Case 3--Artificial debts and death [36.41

IV Case 4--Chargeable transfers and death 36.5]

The risk of a double charge to IHT arises in a number of situations and FA 1986 s 104 enabled the Board to make regulations to give relief to taxpayers in certain cases. The Regulations were made on 30 June 1987 and carne into force on 22 July 1987, although the relief is given for transfers of value made, and other events occurring on or after 18 March 1986 (Inheritance Tax (Double Charges Relief) Regulations 1987, SI 1987/1130). [36.1]

I CASE 1-PETS AND DEATH

The first case is concerned with the area of mutual transfers, ie where property is transferred (by a PET which becomes chargeable) but at the death of the donor he has received back property from his donee (either the original property or property which represents it) which is included in the donor's death estate. The position is illustrated in the following example: all the examples in this Appendix are based on illustrations given in the Regulations themselves. It is assumed that current IHT rates apply throughout; grossing-up does not apply to lifetime transfers; and that no exemptions or reliefs are available.

EXAMPLE 36.1

July 2000 -- A makes a gift of a Matthew Smith oil painting (value £100,000) to B (a PET)

July 2001 -- A makes a gift into a discretionary trust of £335,000 -- IHT paid £10,000 Jan 2002 A makes a further gift into the same trust of £30,000 IHT paid £6,000

Jan 2003 -- B dies and the Smith picture returns to A Apr 2004 A dies. His death estate of £400,000 includes the picture returned to him in 2003 which is still worth £100,000 [*856] If no relief were available, A in Example 36.1 would be subject to IHT on the value of the picture twice: once when it was given away in 2000 (the chargeable PET) and a second time on its value in 2004 (as part of his death estate). In addition A's cumulative total would be increased by the 2000 PET, thereby necessitating a recalculation of the tax charged on the 2001 and 2002 transfers and resulting in a higher charge on his death estate.

Regulation 4 affords relief in this situation and provides for two alternative IHT calculations to be made and for the higher amount of tax produced by those calculations to be payable. The alternative calculations may be illustrated as follows:

EXAMPLE 36.1 CONTINUED

First calculation:

Charge the picture as part of A's death estate and ignore the 2000 PET:

July 2000 -- PET £100,000 ignored -- Tax nil

July 2001 -- Gift £335,000: tax £20,000 -- Tax payable = £10.000

Less: £10,000 already paid

Jan 2002 -- Gift £30,000: tax £12,000

Tax payable = £6,000

Less: £6,000 already paid

Apr 2004 -- Death estate £400,000 -- Tax payable = £160,000

Total tax due as result of A's death £176,000

(Note because the 2000 PET is ignored A's cumulative total is unaltered and a recalculation of tax on the 2001 and 2002 transfers is unnecessary.)

Second calculation:

Charge the 2000 PET and ignore the value of the picture on A's death

July 2000 -- PET £100,000: tax £nil July 2001 Gift £335,000: tax £60,000 £50,000

Less: £10,000 already paid

Jan 2001 -- Gift £30,000: tax £12,000 £6,000

Less: £6,000 already paid

Apr 2003 -- Death estate £300,000 £120,000

Total tax due as result of A's death £176,000

Tax payable: The tax payable is equal in amount tinder the two calculations: see Example 36.3 below.

It may be that reg 4 is capable of being exploited to the benefit of the taxpayer as can be seen from the following illustration. Assume that Adam gives property worth £100,000 to his daughter Berta in 2002 and buys the property hack for £75,000 (which represents less than full consideration) in 2003. He then dies in 2004. Under reg 4 the value of the property (flOO,000) will remain subject to IHT but Adam's estate has been reduced by the £75,000 paid for the property (see especially reg 4(3)(a)). [36.2]

II CASE 2--GIFTS WITH A RESERVATION AND SUBSEQUENT DEATH

This case covers the situation where a gift with a reservation (either immediately chargeable or a chargeable PET) is followed by the death of the donor at a time when he still enjoys a reserved benefit or within seven years of that benefit ceasing (ie within seven years of the deemed PET). The situation is illustrated in Example 36.2.

EXAMPLE 36.2

Jan 2000 -- A makes a PET of £150,000 to B

Mar 2004 -- A makes a gift of a house worth £335,000 into a IHT paid discretionary trust but continues to live in the £10,000 property. The gift is of property subject to a reservation

Feb 2007 -- A dies still living in the house. His death estate is valued at £485,000 including the house which is then worth £340,000

Regulation 5 prevents double taxation of the house in this example by

providing for two separate IHT calculations to be made as follows: [36.3]

EXAMPLE 36.2 CONTINUED

First calculation:

Charge the house as part of A's death estate and ignore the gift with reservation:

. Tax

Jan 2000 -- PET Nil

Mar 2004 -- Gift with reservation ignored Nil

Feb 2007 -- Death estate £485,000: tax £80,000

. Less £10,000 already paid £70,000

. -------

. Total tax due as a result of A's death £70,000

(Note: credit for tax already paid on the gift with reservation cannot exceed the amount of death tax attributable to that property. In this example the tax so attributable is £56,082 (ie £80,000 x £340,000/£485,000) -- hence credit is given for the full amount of £10,000.)

Second calculation:

The gift with reservation is charged arid the value of the gifted property is ignored in taxing the death estate:

. Tax

Jan 2000 -- PET Nil

Mar 2004 -- Gift of house £335,000: tax £20,000 £10,000

. Less: £10,000 already paid

Feb 2007 -- Death state £145,000 (ignoring house) £58,000

. -------

Total tax due as result of A's death: £68,000

[*858]

Tax payable: the first calculation yields a higher amount of tax. Therefore the gift of the house in 2004 is ignored and tax on death is charged as in the first calculation giving credit for IHT already paid.

III CASE 3--ARTIFICIAL DEBTS AND DEATH

Relief is afforded under reg 6 when a chargeable transfer (or chargeable PET) is followed by the transferor incurring a liability to his transferee which falls within FA 1986 s 103 (the artificial debt rules).

EXAMPLE 36.3

Nov 1998 -- X makes a PET of cash (£95,000) to Y

Dec 1998 -- Y makes a loan to X of £95,000

May 1999 -- X makes a gift into a discretionary trust of £20,000

Apr 2004 -- X dies. His death estate is worth £305,000 but the loan from Y remains outstanding

Under s 103 the deduction of £95,000 would be disallowed so that the 1997 PET and the disallowed debt would both attract an IHT charge. Relief is provided, however, under reg 6 on the basis of the following alternative calculations: [36.4]

EXAMPLE 36.3 CONTINUED

First calculation:

Ignore the 1998 gift but do not allow the debt to he deducted in the death estate:

. Tax

Nov 1998 -- PET ignored Nil

May 1999 -- £20,000 Nil

Apr 2004 -- Death estate £295,000 £16,000

Total tax due as result of X's death £16,000

Second calculation:

Charge the 1998 gift but allow the debt to he deducted from the estate at death.

. Tax

Nov 1998 -- PET £95,000 Nil

May 1999 -- Gift £20,000 Nil

Apr 2004 -- Death estate (£305,000 - loan of £95,000) £16,000

Total tax due as result of X's death £16,000

Tax payable: The total tax chargeable is equal in amount under the two calculations and reg 8 provides that in such cases the first calculation shall be treated as producing a higher amount: accordingly the debt is disallowed against the death estate and the PET of £95,000 is not charged.

IV CASE 4--CHARGEABLE TRANSFERS AND DEATH

Under FA 1986 s 104(1)(d) regulations can be made to prevent a double charge to IHT in circumstances 'similar' to those dealt with in the first three cases above.

Regulation 7, made in pursuance of this power, applies when an individual makes a chargeable transfer of value to a person after 17 March 1986, arid dies within seven years of that transfer, at a time when lie was beneficially entitled to property which either directly or indirectly represented the property which had been transferred by the original chargeable transfer.

For relief to be given under this regulation it is important to realise that the lifetime transfer must have been chargeable when made. Prior to the changes made by FA 2006, the majority of transfers to individuals would not have fallen within its ambit since they would have been PETs. Since that is no longer the case, the regulation may now be of increased significance and will be of importance in the following cases:

(1) When the chargeable transfer is to a discretionary trust which subsequently returns all or part of the property to settlor.

(2) When the chargeable transfer creates a beneficial interest in favour of the settlor.

(3) When the chargeable transfer is to a company with, again, that property being returned to the transferor.

As with the other cases, relief under reg 7 is given on the basis of two alternative calculations. The first includes the returned property in the death estate but ignores the original chargeable transfer (although there is no question of any refund of tax paid at that time). The second calculation taxes the original chargeable transfer (ie it may be subject to a supplementary charge on death and remains in the taxpayer's cumulative total) but ignores the returned property in taxing the transferor's death estate. [36.5]

Return to Chapters 28-32