Trusts are not much trusted by the general public. To many, they are associated with deliberately muddying the waters over people’s wealth, created to keep assets hidden from the taxman. And, fair to say, many schemes marketed in the early 2000s did use trusts as a way to avoid or evade tax. Offshore trusts were employed in very aggressive tax planning, while onshore structures were seen as a legitimate way of avoiding inheritance tax. Attitudes to what constitutes acceptable tax planning have changed and so has the law.
The 2006 Finance Act put a stop to much of the abuse of onshore trusts by imposing higher tax rates on most new ones. However, there’s a sense among practitioners that the current tax rules are creating disincentives for trusts to be created for the people who really need them. Earlier this year the government issued a consultation on the taxation of trusts and is currently analysing feedback. Sue Moore, technical manager – private clients in ICAEW’s Tax Faculty, would like to see the government turn the focus back to the good that trusts can do. “Don’t start from the principle that trusts are only a negative thing and used for fraud. Stop looking at them as tax avoidance and evasion vehicles and start looking at them for the genuine reasons for which many of them are set up.”
Tax rules on trusts
Trusts are deeply embedded in the English legal system as a way of protecting assets and individuals. Some are used to preserve family assets and businesses, including family companies and farms, or for intergenerational family planning. But another use is to protect vulnerable people, such as minors or those who lack the mental capacity to manage their own finances. Up until 2006 individuals could set up accumulation and maintenance trusts, usually for their children or grandchildren. The gift made to the trust was treated as a potentially exempt transfer, so inheritance tax (IHT) might only be payable if the donor died within seven years of making the gift. Life interest trusts were also popular. Again, the gift into the trust was a potentially exempt transfer while the beneficiaries had an immediate interest in the income generated within the trust. Discretionary trusts, in which the trustees choose when and to which of a defined range of beneficiaries they distribute trust assets to, are a different matter. IHT is charged at 20% on amounts over the nil-rate band on property as soon as it is settled into a discretionary trust.
A periodic charge of up to 6% is made on the value of the trust assets every 10 years, and there is an exit charge whenever property leaves the trust. Income tax rates on discretionary trusts are high: 38.1% on dividends and 45% on other income exceeding a maximum of £1,000. And the highest rates of capital gains tax (28% on residential property and 20% on other gains) automatically apply to sales of discretionary trust assets. The changes in 2006 brought nearly all trusts into the same regime as discretionary trusts under the relevant property regime, with the exception of trusts created in a will coming into effect immediately on the death of the testator such as a life interest trust for a surviving spouse or a trust for bereaved minors. Grant Thornton tax director Andrew Cockman, who chaired the Tax Faculty Working Committee on Capital Taxes and Trusts, says the changes marked a retrograde step.
“Before 2006 you could have had interest in possession settlements for vulnerable people. That’s no longer the case because of the tax charges that apply to relevant property trusts.” He points out that most of the trusts created to provide for people who need protection are relatively small in value. “Yes, there are larger trusts, for example where there is landed property involved or which hold shares in family companies. But a great many are there to protect people who are vulnerable,” Cockman says.
Vulnerable beneficiary trusts are odd structures as the definition of “vulnerable” is narrow and has to do with what state benefits the beneficiary receives. There’s a strong case for extending the definition, says Moore, as this currently excludes many people who need protection. “Not every vulnerable person receives the specified benefits. Another problem is that while someone who doesn’t have the capacity to deal with their own affairs can be seen as vulnerable, a lot of people have intermittent capacity, such as someone who has mental health issues and who goes in and out of capacity. They do not qualify for a vulnerable person trust.” She points out there are other ways in which a vulnerable beneficiary trust could be used. “For instance, if a couple is divorcing, the spouse paying the money should be able to put it into a trust in which the former spouse has a life interest before it passes to the children without creating an onerous tax situation.” Cockman sees a problem looming, given the nature of our ageing population.
“There are many people who will suffer from dementia or similar conditions. Enduring and lasting powers of attorney don’t always deal adequately with the needs of these people and sometimes it would be better for their assets to be held in a trust. But the trust would have to be tax neutral: it wouldn’t give any tax advantages but would provide a suitable framework for holding their assets.” Tax neutrality is a problem for vulnerable people, says Moore. “Creating a vulnerable beneficiary trust still leads to IHT issues. Even if you are creating it with your own wealth as you know you are going to be vulnerable, it will still attract IHT. We think these trusts should be tax neutral: they should exist purely to protect the assets and the tax should operate as though the settlor still owned it personally, with no entry charges and no changes to the income and capital gains tax.” There is precedence for tax-neutral trusts, says Cockman. “The US has grantor trusts, which are transparent entities for tax purposes but still impart important legal safeguards.”
Potential for change
The taxation of trusts is a highly complex field. Moore would like to see the 10-year charge simplified: “The amount of money HMRC collects from this is quite low and they should look at making this easier. One option we’ve considered is having two routes for calculating this charge. One would be very simple and apply to small trusts that do not have professional advisers. The other route, which could follow the current regime, would operate for larger trusts that do.” Cockman agrees that the current trust taxation system is only really relevant for trusts holding large amounts of money. “There are an awful lot of trusts, such as those that have come into existence because of intestacy, where the beneficiaries are not rich, the people looking after them don’t deal with trusts on a regular basis, and it becomes disproportionately expensive to deal with the IHT. You could have property being appointed out to a beneficiary under a relatively small trust, but the cost in professional time of reporting might exceed the value of the property that’s being given away. “That seems totally wrong. You could take a certain population of trusts, say below a certain value, out of the charge to tax. That would be a radical solution but would make commercial sense.”
The Office for Tax Simplification’s recent review into IHT covered a number of overlapping areas. One was changes to the various gift allowances. ICAEW’s Sue Moore, who sat on the consultative committee, says the current number and type of gift exemptions can be confusing. “The OTS suggested replacing the annual gift exemption and the exemption for gifts in consideration of marriage or civil partnership with an overall personal gifts allowance, and at the same time reforming or doing away with the regular gifts out of income. The new allowance should be increased, as should the regular small gifts allowance.” With taxation of lifetime gifts, any tax crystallising on gifts is currently paid by the donee unless the donor has specified in their will that the estate should bear the tax. “This leads to anomalous results,” says the OTS. Tax is potentially chargeable if the donor dies within seven years. Moore says this should be shortened to five as it’s hard for executors to get information that’s more than six years old from banks. “At the same time, taper relief should be abolished. Many people misunderstand this and think the taper applies to the gift where it in fact applies to the tax.”