How are capital additions included in a trust’s second ten-year inheritance tax charge? Writing for Taxation magazine’s Readers’ Forum, BKL tax consultant Terry Jordan responds to this query.
‘A settlement was created 20 years ago with a capital sum of about £150,000. The settlor had no other trusts so this was a nil-rate band trust. Matters were fairly straightforward for the first ten years. There were some capital additions, but the total value after ten years was still below the nil-rate band. We are now at the second ten-year anniversary and in the past decade there has been another single capital addition of about £150,000. There have also been some smaller additions as well as annual trust expenses of about £5,000, which the settlor pays from his own pocket.
The net result is that the total value of the settlement is now about £400,000.
How will the above affect completion of the second ten-year return and, more importantly, the calculation of the ten-year inheritance tax charge? Also, how should the additions to the trust be taken into account? Finally, can payment of the annual trust expenses be regarded as habitual gifts out of income?’ Query 19,571 – Trustee.
Terry Jordan’s reply: The tax rate will be adjusted to reflect the more recent additions
‘Trustee asks how the second ten-year charge for a settlement should be accounted for. It is implicit in his query that he is dealing with a discretionary trust since it was created in 2000. In those days, an interest in possession trust would not have been subject to ten-year charges; the value would, for inheritance tax purposes, have formed part of the life tenant’s estate. Significant changes were announced on 22 March 2006 with some taking effect on that day. Nowadays, most lifetime transfers to trust are immediately chargeable rather than being potentially exempt and the value goes into the ‘relevant property’ regime. In general, as long as the reservation of benefit rules are not in point, relevant property trusts keep the value outside the estates of individuals and the periodic charges at a current maximum rate of 6% (being 30% of the lifetime rate of 20%) are designed roughly to equate to a 40% charge each generation.
In 2010, the value was below the £325,000 nil-rate band and an account may not have been required to be delivered under the 2008 regulations. The value now is in excess of the nil-rate band and an account will be required. The charge arises under IHTA 1984, s 64 and the rate is determined in accordance with s 66 and s 67. The additions have not been relevant property for the full ten years up to the ten-year anniversary and the tax charged will be reduced to reflect that fact. It should be borne in mind that income that arose more than five years before the anniversary will also be taxed in view of amendments to s 64 effective from 6 April 2014.
Dymond’s Capital Taxes at 19.303B gives an example of when it may be appropriate for trustees to accumulate income to capital just in advance of a ten-year charge to reduce the tax payable as although then capital for inheritance tax purposes it will benefit from the reduction in s 66(2).
Trustee asks whether the payments by the settlor of the trust’s annual expenses may be covered by the exemption in s 21 for ‘normal expenditure out of income’. Such gifts do not have to be made to individuals to benefit from the exemption. The transfers are clearly regular and there is a demonstrable pattern of giving. So the key question is whether the settlor has sufficient surplus income after meeting his expenses including tax, taking one year with another, to make them.’
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