‘Squaring the Triangle’: Simplifying IHT charges on relevant property trusts

HMRC’s consultation on reforming the periodic and exit charges on relevant property trusts, ended in mid-August. The reaction among professionals appears to have been somewhat chilly.

HMRC’s stated aim is to triangulate a solution that simplifies the compliance burden while being revenue neutral on the Exchequer and that complies with the overarching policy of  ‘fairness’; which combined is no small order.

triangulationThe Finance Act 2006 brought very many more trusts, particularly old-style A&M trusts, within the IHT net.

HMRC’s consultation recognises the resulting increased compliance burden that was imposed upon trustees and their advisers, many of whom lack the historical records of the settlor’s cumulative transfers at the time the trust was created necessary to accurately calculate the periodic charge.  This may not be any fault of the trustees because the trust may have been established long before such records were required and no one foresaw D-day on 22nd March 2006.

 The difficulty in sharing and compiling the necessary data may be exacerbated if the settlor, beneficiaries and trustees of related settlements having different sets of professional advisors.

 It is widely recognised that the compliance cost often far outweighs the tax charge, if any.

 HMRC’s proposals are as follows:

 1.       The settlor’s previous lifetime transfers should be ignored in determining the available nil-rate band for the purposes of calculating the hypothetical transfer on exit and periodic charges.

2.       Non-relevant property would also be ignored for the purposes of the calculation of periodic and exit charges as this relies on establishing the initial value and obtaining historical records.

3.       The nil-rate band should be split by the number of relevant property settlements which the settlor has made. This will alleviate the risk that settlors might seek to fragment ownership of property across a number of trusts to maximise the availability of reliefs or exempt amounts.

4.       That a flat rate of 6% of the chargeable transfer is used in the calculation of periodic and exit charges, rather than the lengthy calculations of the effective rate and settlement rate.

5.       That trust income (where the trustees have a power to distribute), be deemed to have been accumulated if it remains undistributed from the start of the second tax year after the end of the tax year of receipt.

6.       To align filing and payment dates for IHT with those under the Self Assessment framework.

Proposal 1: The settlor’s previous lifetime transfers should be ignored in determining the available nil-rate band for the purposes of calculating the hypothetical transfer on exit and periodic charges.

Proposal 2: Non-relevant property would also be ignored for the purposes of the calculation of periodic and exit charges as this relies on establishing the initial value and obtaining historical records.”

Proposals 1 and 2 seem to be largely welcome for the same reasons. It’s likely to be disproportionately expensive for trustees to trawl for historic documents that may not exist.  Obtaining back-dated valuations to fill in the gaps in the historical matrix can also be expensive and carries an additional degree of risk in terms of accuracy.

 The advantage of ignoring non-relevant property in the calculations, under proposal 2, would be that trustees would only need to know about exits from the trust and other related trusts in the last 10 years rather than potentially very old information.

Proposal 3: The nil-rate band should be split by the number of relevant property settlements which the settlor has made. This will alleviate the risk that settlors might seek to fragment ownership of property across a number of trusts to maximise the availability of reliefs or exempt amounts.

 Proposal 3 has raised eyebrows because it sits somewhat incongruously alongside HMRC’s stated purpose of simplifying the compliance and tax position. It is in fact about anti-avoidance.

The proposal is to split the NRB between all relevant property settlements made by the settlor and in existence at any time between the date the trust concerned was set up and the date of the first periodic charge. This would include any settlements which had been wound up before the date of charge.

For subsequent periodic charges the NRB would be split between all relevant property settlements made by the settlor and in existence at any time between the date of the previous 10 year anniversary and the date of the current charge.

 Proposal 3 is clearly designed to deter fragmentation schemes that involve the use of multiple settlements. The current position is that gifts made more than 7 years before a chargeable transfer does not affect the IHT position of that transfer, including into trust. To share the nil rate band with all other relevant property trusts made after the trust was set up or in existence (whenever created) when the trust came into being is a significant change to the basic framework of the IHT regime.

 For trustees and professional advisers to be able to calculate the tax due on exit and periodic charges in relation to their own trusts; they would need to know what new trusts had been established and what trust had been wound up. There is currently no obligation on any of the parties to share this information and some trustees may refuse on grounds of confidentiality.  In order to operate this proposal in practice would require continuous monitoring by the trustees which will be hugely burdensome and costly.

Proposal 4: That a flat rate of 6% of the chargeable transfer is used in the calculation of periodic and exit charges, rather than the lengthy calculations of the effective rate and settlement rate.

 Proposal 4 has the potential to exacerbate an existing element of double charging when calculating the first periodic charge where there has been an exit from the trust within the first 10 years.

Under the current rules an exit charge will apply where a distribution has been made before the first periodic charge and so when calculating the next periodic charge the NRB will be reduced by the amount of such distribution. In the case of the current rules its effect is softened because of the way that the reduced NRB is used to calculate the ‘estate rate’ to be applied.

Under the proposed new rules the impact of a pre-10 year exit from the trust is felt more keenly because any reduction in the NRB will feed directly into establishing a 6% tax charge on the amount by which the NRB is reduced. Effectyively charging the 6% tax rate on both the periodic charge and any exit charge.

The consensus – certainly as between the likes of ICAEW and Smith & Williamson – is to make the current formula for calculating the periodic charge the default with a mechanism for trusts to ‘opt-in’ to the flat 6% rate. Their suggestion that the flat rate should be 4% might provide a sweetener to opt-in, lest it not be forgotten that while a flat rate might be simpler, under the current periodic charge rules 6% is the ceiling that might be charged every 10 years and not the floor.

Proposal 5: That trust income (where the trustees have a power to distribute), be deemed to have been accumulated if it remains undistributed from the start of the second tax year after the end of the tax year of receipt.

 Income awaiting distribution is not treated as relevant property and is not subject to IHT. If income is accumulated and added to the trust capital, then it becomes relevant property from the date of accumulation and will subject to IHT exit and periodic charges.

HMRC’s proposal is to clarify the point at which income that remains undistributed for a long period of time should be treated as having been accumulated/capitalised.

The proposal is to deem income arising to a trust (where the trustees have a power to distribute), to be have been accumulated and added to capital if it remains undistributed from the start of the second tax year after the end of the tax year of receipt.

tax-1This seemingly innocuous proposal butts up oddly against both general trust law as well as the income tax treatment of income from trusts which has the potential to cause confusion and conflict.

 Under general trust law principles, accumulation of income is treated differently depending on the date the trust was established. The Perpetuities & Accumulations Act 2009 (PPA 2009) permits new trusts to accumulate income for the entire trust period (125 years). It’s probably too early for practitioners to have encountered many trusts that allow accumulation for this length of time.

 The position for trusts established before the enactment of PAA 2009 is to permit accumulation of income for the maximum of one of the following:

  1.  21 years;
  2. A beneficiary reaching a specified age no later than 25, but subject to the maximum 21 year period;
  3. In the case of minors living at the end of the 21 year period, on their attaining the age of 18.

 The tax treatment of trust income differs also with respect to what the terms of the trust are.

 A beneficiary with an interest in possession is treated as having a share of the undistributed income added to his share of capital in determining the quantum of his fund. For discretionary trusts the balance of undistributed income is automatically capitalised at the end of the accumulation period.

 The effect of this is that the status of a single chunk of income received in year 1, that has not been distributed, needs to be considered for the purpose of the periodic charge on a maximum of two or possibly three occasions.

 One view of the function of a trust should be a vehicle for the orderly transmission of wealth between individuals. Artificial barriers created in the tax code should not be put in the way of this. Most A&M trusts follow the pattern of the beneficiaries’ lives. During a beneficiaries’ childhood income is either usually accumulated or distributed for educational or maintenance purposes. This is dictated by need and often follows an irregular pattern. Between the ages of 18-25 it can provide an income whilst the beneficiary is studying at university, avoiding the need to take out student loans. It may also provide a regular level of income support whilst she or he is in a lower paid job. Thereafter the capital may be used in the acquisition of a home.

Income subject to the trustees’ discretion to distribute is subject to income tax at 37.5% in the case of dividend iNcome and 45% for other sources. As distributions carry a tax credit at 45% and the deemed tax suffered at source on company dividends cannot be passed on, a surcharge is payable to cover both the difference in rates and the deemed dividend tax credit.

 Because distributions are at the trustees’ discretion it would seem to be legitimate for them to avoid the deemed accumulation charge by simply resolving to distribute the income arising at the end of each tax year. Question: As a matter of policy is desirable to have a tax scheme that gives rise to that sort of distortions in a trustees’ behaviour?

It is unclear as to whether income that has been subject to IHT has changed its nature. A subsequent distribution which is liable to IHT  as an exit charge should not, as a matter of principle, also then be subject to income tax.

The stated aim of the consultation is to simplify the regime applicable to trusts, however the proposals on accumulation of income add a further level of complexity and uncertainty.

Trustees would have to maintain accurate records of when income was received and satisfy themselves as to whether or not it was relevant property. It is unclear whether distributions would be on a first-in-first-out or last-in-first-out basis. If there is undistributed income at the end of year 1 and a lump sum distribution is made at the end of year 2, which is equal to or less than the income of that year, from which year’s income is it deemed to be made?

Proposal 6: To align filing and payment dates for IHT with those under the Self Assessment framework.

IHT payment and filing dates can be confusing and illogical. The time limits for reporting a periodic or exit charge differ from the time limits for paying any IHT due.

The current time limit for reporting details of a charge is:

  • 12 months from the end of the month in which the transfer is made, or if later
  • 3 months from the date when the accountable person first becomes liable for the tax

 The current time limits for paying IHT charges are:

  • For chargeable events after 5 April and before 1 October, IHT periodic and exit charges are due on 30 April in the following year.
  • For chargeable events after 30 September and before 6 April, IHT periodic and exit charges are due six months after the end of the month in which the chargeable event took place.

Under the proposals IHT forms would be submitted by 31 October after the end of the tax year in which the charge arose and the IHT payment would be due by the following 31 January.

The proposed alignment would only apply to the periodic and exit charges arising in relevant property trusts and would not affect any IHT entry charge. Neither would it affect any other IHT charges such as charges on a person’s estate on death or on other lifetime transfers because of the ‘one off’ nature of these events.

There’s a difference between aligning IHT with self-assessment and IHT on trusts being properly integrated into the self assessment framework. HMRC’s proposals do not go that far although many of the respondents to the consultation suggested this would be highly beneficial. This may be a step on the way to achieving that result.

In principle, aligning the filing dates with those of self-assessment would fit better with the existing compliance workload for trustees and their advisors giving rise to a cost saving.

HMRC Score Card: 5/10 (Triangle not yet squared)

2 thoughts on “‘Squaring the Triangle’: Simplifying IHT charges on relevant property trusts

  1. Pingback: Next Steps in Reforming IHT Periodic Charges for Relevent Property Trusts | TrustsEstatesBarrister

  2. Pingback: Next Steps in Reforming IHT Periodic Charges for Relevent Property Trusts | TrustsEstatesBarrister

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