Writing for Taxation magazine, BKL tax adviser Terry Jordan answers a reader’s query on calculating the inheritance tax exit charge on a discretionary trust.
‘My clients are the trustees of a discretionary trust created on the death of the settlor in 2004. The settlor/testator left half of his estate (valued at £750,000) to his spouse in an interest in possession trust and the other half for the benefit of his wider family in a discretionary trust.
A ten-year charge was calculated and paid in 2014 under the rules prevailing before 18 November 2015. That is to say, the valuation of the notional transfer, as postulated in IHTA 1984, s 66(3) and (4), includes the value of the interest in possession trust. Therefore, the value of non-relevant property contributed to the calculation of the rate of tax that applied at the last ten-year anniversary.
The trustees of the discretionary trust now wish to make a substantial capital distribution to two of the beneficiaries. We are not sure how to calculate the inheritance tax exit charge. IHTA 1984, s 69 states that the rate at which tax is charged on an occasion after a ten-year anniversary is the appropriate fraction of the rate at which it was last charged on the anniversary. Do we just use the rate that applied then? There have been no changes to the property or rates of inheritance tax.
Alternatively, do we have to re-calculate it, taking out the value of non-relevant property because that would be excluded under present rules?’
Query 19,221– Confused.
Reply by Terry ‘Lacuna’ Jordan, BKL
The property in discretionary trusts is treated as a separate trust
A settlor died in 2004 leaving half his estate in an interest in possession trust for his widow and the remainder on discretionary trusts. His date of death pre-dated Labour’s changes to the inheritance tax trust regime announced on 22 March 2006 and it was also before the introduction of transferable nil rate bands in 2007. Accordingly, using the nil rate band was conventional planning at the time. The trust for the widow is not strictly an immediate post-death interest, but the value forms part of her inheritance tax ‘estate’ under IHTA 1984, s 49.
For the purposes of the 2014 ten-year charge on the discretionary trust, regard was apparently had to the value in the widow’s trust. Confused refers to a change in the relevant legislation effective from 18 November 2015. The words ‘a qualifying interest in possession’ were substituted (three times) for the words ‘an interest in possession’ in IHTA 1984, s 80 by F(No 2)A 2015. However, Dymond’s Capital Taxes explains at 19.709 that the change was made to correct a loophole in the legislation after the 2006 changes and the ending of the period during which transitional serial interests could be created under s 49C.
HMRC’s Inheritance Tax Manual at IHTM42231 states: ‘IHTA 1984, s 80 applies:
- to trusts made after 26 March 1974,
- where the settlor or their spouse had an interest in possession (IIP) in property, which
- on their death or other termination of the IIP, forms a discretionary trust.
‘The effect is that the property now held on discretionary trusts is treated as a separate trust made by the person (whichever spouse) who was last entitled to an IIP in it. This separate trust is treated as made at the time the IIP interest came to an end, but:
the trust has the same ten-year anniversary as the original trust. IHTA 1984, s 61(2)
‘If the IIP ceases on death, any trusts created under the will of the person who had the last IIP will be related trusts.’
Accordingly, the value in the widow’s trust should not have been reflected in the 2014 ten-year charge calculation and a repayment should be claimed under IHTA 1984, s 241 on the assumption that the trustees are within the four-year time limit to make such a claim. The proportionate or exit charge now should reflect the revised rate in 2014.
For more information, please get in touch with your usual BKL contact or use our enquiry form.
Terry will be speaking about inheritance tax planning at our seminar on 13 September. Find out more here.