The U.K. government launched a public consultation on the taxation of trusts, requesting views on the principles that should (in its view) form the basis of the taxation of trusts: transparency, fairness/neutrality, and simplicity.
The consultation document noted examples of where the government felt the current system fell short of these principles and sought views for and against reform.
Transparency, fairness and neutrality, and simplicity are reasonable principles for ensuring an effective trust taxation system. Neutrality is taken to mean ensuring that tax considerations neither incentivize nor disincentivize the use of trusts. There are many examples where the use of trusts is clearly disincentivized by the existing tax regime, where the aims of fairness and neutrality are not met, and where reform could be desirable.
Why Use a Trust?
The consultation document suggests that the government believes that some trusts may still be used for tax avoidance/evasion. In fact, the taxation of trusts in the U.K. has in some areas become so complex that it can disincentivize the use of trusts.
Most clients create trusts for a range of legitimate reasons: asset-protection; preserving major assets such as farmland and heritage property; providing for inter-generational family planning or to ensure a long-term family legacy; or providing for vulnerable people. Tax avoidance is no longer an enticement.
Two common types of trust are:
- lifetime interest-in-possession (IIP) trusts—trusts created during a settlor’s lifetime which give the beneficiary the right to benefit from the trust income/property during their life, but no right to the underlying capital; and
- discretionary trusts.
Lifetime IIP trusts can be a particularly useful way of providing for family members, vulnerable people, or indeed settlors themselves. Discretionary trusts are valuable where it is advisable for the trustees to use their discretion as to who should benefit and to what extent (if at all) from a trust, depending on the beneficiaries’ circumstances. This can protect against the risk of profligate beneficiaries squandering cash, and enable assets to pass to family members most in need of financial assistance. Discretionary trusts therefore offer flexibility, protection, and control.
How are Trusts Taxed?
The “relevant property regime” applies to lifetime IIP trusts (created post-March 22, 2006) and discretionary trusts for inheritance tax (IHT) purposes.
This regime charges IHT at 20 percent of the value of property settled into the trust after any exemptions and reliefs, and deduction of the IHT nil-rate band (currently 325,000 pounds ($425,321)). Thereafter, an IHT charge arises every 10 years up to a maximum of 6 percent of the value of the trust assets (the “periodic charge”), as well as a proportion of the periodic charge every time property leaves the trust (the “exit charge”).
The aim of the relevant property regime is to equalize the IHT which would be payable were property to be passed on to the next generation every 30 years (an approximation for the length of a generation) on death, as compared with leaving assets in trust. However, the equivalence with the tax payable at 30-year intervals on the death of an individual is potentially misleading, since trusts are subject to disadvantageous treatment as compared with the taxation of assets remaining in the outright ownership of individuals.
Trusts do not benefit from a capital gains tax (CGT) uplift on the death of a beneficiary (contrary to assets which are retained in outright ownership).
In the context of the relevant property regime, the need to raise cash to fund periodic charges and exit charges, and the administrative costs associated with reporting the liability, carry a significant opportunity cost and can be disproportionate to the size of the trust. For trusts that hold only or mainly illiquid assets, the periodic charge can mean that there are insufficient funds available to settle the charge. Non-trust assets may often need to be added or loaned to the trust to pay for periodic charges, which leads to further complexity.
In the case of discretionary trusts, although these factors are evidently negative, they can fairly be seen as the price to be paid for the benefit of the flexibility, protection and control which they offer. The aims of fairness and neutrality are therefore arguably met in respect of the taxation of discretionary trusts, despite the various costs to which they are subject in the current regime.
In the tax treatment of lifetime IIP trusts, fairness and neutrality are arguably lacking. Prior to the Finance Act 2006, settling property into a lifetime IIP trust would have been a potentially exempt transfer (PET) for IHT purposes.
Such transfers did not trigger a charge to IHT provided the settlor survived the transfer by seven years (in line with the treatment of outright lifetime gifts to individuals, which today continue to be treated as PETs). Following the 2006 changes, transfers into lifetime IIP trusts fell within the relevant property regime, giving rise to the immediate 20 percent IHT entry charge, and periodic and exit charges referred to above.
The 2006 changes seemed to be based on an assessment that all trusts were used for tax avoidance and that their use should be discouraged. But a straightforward IIP trust is not generally considered to be a mechanism for tax avoidance, particularly when seen in conjunction with the anti-avoidance provisions of the Finance Act 1986 and the Inheritance Tax Act 1984.
When combined with the General Anti-Abuse Rule and the current disclosure requirements for trusts, it is difficult to see what scope there is for tax avoidance in the context of lifetime IIP trusts.
A transfer into a lifetime IIP trust ought perhaps to be comparable to an outright gift to an individual, given that the intention to benefit a third party, and to remove assets from the settlor’s estate, is the same.
The current regime could be reconsidered in this regard, in line with the principles of the consultation. Applying the principles of fairness and neutrality should result in transfers to lifetime IIP trusts being treated as PETs for IHT purposes, which would remove the 20 percent entry charges. The current tax treatment of post-2006 lifetime IIP trusts is therefore neither fair nor neutral, as it can discourage their use when compared with making an outright gift.
Vulnerable Beneficiary Trusts
Although vulnerable beneficiary trusts (i.e. trusts for disabled persons and bereaved minors) carry some advantageous income tax and CGT treatment, the statutory definition of “vulnerable person” is so narrow that it prevents many clearly vulnerable people—often with a significant form of vulnerability which falls outside the scope of the legislation—from qualifying for positive tax treatment.
There is often also considerable work involved in ensuring that such trusts benefit from positive tax treatment, often resulting in higher accountancy and legal fees than for other trusts. A simplification and expansion of the definition of “vulnerable person” might ensure a fairer outcome.
Similarly, voluntary settlements (trusts where settlors settle assets on themselves) should arguably be permitted to qualify for the same tax treatment as vulnerable beneficiary trusts. Someone may wish to self-settle in order to provide for an anticipated vulnerability, for example when someone is in the early stages of a degenerative illness like dementia or multiple sclerosis.
It is not clear why an individual who settles property on himself should be taxed any differently to the same individual retaining such property in his absolute ownership. This outcome is neither neutral nor fair.
Lifetime IIP trusts and vulnerable beneficiary trusts/voluntary settlements are subject to tax treatment which is arguably neither neutral nor fair.
Reform may therefore be needed in order to bring their tax treatment in line with the consultation principles of fairness and neutrality. There can be clear fiscal disadvantages in using lifetime IIP trusts, and the tax treatment of vulnerable beneficiary trusts and voluntary settlements is not neutral or fair. A reconsideration of the current tax treatment of such trusts could go some way to attaining the aims of fairness and neutrality in these cases.
Daniel Watson is an Associate at Hunters, U.K.