Discretionary trust taxation

The Finance Act 2006 made radical changes to the inheritance tax treatment of interest in possession (IIP) trusts and accumulation and maintenance (A&M) trusts.

Transfers into IIP or A&M trusts created on or after 22 March 2006 would be subject to the the relevant property regime. i.e. the same inheritance tax (IHT) treatment as a discretionary trust.

The following document details the initial, exit and 10 yearly periodic charge including examples.

Transfers into these trusts are chargeable lifetime transfers (to the extent that they are not otherwise exempt). Tax is payable at one half of the death rate (20%). Where the settlor pays the tax, the transfer of value is grossed-up (divided by 80% if over nil-rate band) to reflect the overall loss to the settlor's estate.

For example, if a client created a discretionary trust in 2010/11 for £342,000 and no exemptions were available, tax of (£342,000 - £325,000) x 20% = £3,400 would be payable by the trustees. If the settlor paid the tax, the transfer of value would be grossed-up to £4,250 (tax at 20% = £4,250).

The table below shows the tax payable if the settlor were to die within seven years. The tax is recalculated at 40% using the nil-rate band (NRB) applicable at death (in these examples, the NRB assumed is £325,000). Tax already paid by the trustees is credited (up to the extent of the liability) and taper relief may reduce the liability after three years.

Where a discretionary trust is created by two settlors, for IHT purposes each settlor is treated as making a settlement and will be separately assessed for initial, periodic and exit charges. For example Mr and Mrs Jones created a discretionary trust for £676,000, each contributing £325,000, therefore initial charges if paid by trustees £338,000 - £325,000 (NRB) x 20% = £2,600 for each settlor.

Where a discretionary trust is created by two settlors, for IHT purposes each settlor is treated as making a settlement and will be separately assessed for initial, periodic and exit charges. For example Mr and Mrs Jones created a discretionary trust for £676,000, each contributing £325,000, therefore initial charges if paid by trustees £338,000 - £325,000 (NRB) x 20% = £2,600 for each settlor.

Assets and cash (property) which are held in an IIP trust created on or after 21 March 2006 or are held in a discretionary trust are defined as relevant property. Where any property ceases to be relevant property (the property is distributed to beneficiaries), it will be subject to an exit charge based on the time that has elapsed since the commencement of the settlement or from the date of the last 10-year anniversary, if later.

The rate of tax chargeable before the first 10-year anniversary will be an appropriate fraction of the 'effective rate'. For this purpose, the appropriate fraction will be 3/10ths multiplied by 1/40th for each successive quarter since the commencement of the settlement. Any quarter expiring before the day on which property became comprised in the settlement will be ignored. Please note: the 'effective rate' is the average rate that would be charged if an individual had made a chargeable lifetime transfer (CLT) equal to:

i. the value of property comprised in the settlement or related settlements (ie created on the same day by the same settlor) immediately after it commenced, and
ii. the value of property subsequently added to the settlement immediately after its addition.

In determining the rate of tax applicable to the above mentioned transfers, any chargeable transfers made by the individual during the seven years immediately before the transfers will be taken into account – but not potentially exempt transfers (PETs) unless they later become chargeable by reason of death within seven years.

In many cases, particularly where the settlor had made no chargeable transfers in the seven years preceding the settlement, there would be very little, if any, tax payable on property ceasing to be relevant before the first 10-year anniversary. Indeed, a settlor, having made no previous CLT, may deliberately settle assets within his NRB knowing that there would be no exit charge before the first 10-year anniversary.

Initial charge

Exit Charge

The trustees distribute £10,000 to Miss Green and £15,000 to Master Green on 1 May 2013.

Hypothetical CLT

Where a distribution is made in the first 10 years, the IHT payable is calculated by taking into account the settlor's chargeable transfers in the seven years before he settled the discretionary trust plus the initial value of the Trust Fund.

10-year Periodic Charge

Each 10th anniversary from commencement of the settlement, the trust fund is valued and assessed for IHT based on its current value on the anniversary date together with the greater of:
i. any previous chargeable transfers in the seven years prior to creating the settlement; or
ii. any previous chargeable transfers in the seven years prior to the date of any additional property being made to the settlement plus any distributions that gave rise to an exit charge in the past ten years.

The current NRB is deducted from this sum and 20% of any excess will represent the taxable portion of the trust fund to calculate the effective rate. 30% of the effective rate is then applied to the trust fund as the 10-year periodic charge.

10-year Periodic Charge example

At the 10th anniversary on 1 May 2020 of the discretionary trust created by Mr Green, the trust fund is worth, say, £500,000 and the NRB then is, say, £400,000. Mr Green has made no other chargeable transfers since creating this trust and we know that the trustees have made previous distributions totalling £25,000 in the previous ten years.

The rate of tax chargeable between 10-year anniversaries for Exit Charges will be the appropriate fraction (30% x 1/40th for each successive quarter since the last 10-year anniversary) of the rate at which it was charged at the last 10-year anniversary.

The effective rate is recalculated every 10 years using the Trust value at the anniversary (plus any distributions) to use for the 10-year periodic and exit charges in the subsequent 10 years.

Initial charge

Mr Hill settles £425,000 into a discretionary trust on 15 May 2010, having made no previous gifts (other than his annual exemptions which have been used elsewhere).

Exit Charge
The trustees distribute £50,000 to Miss Hill on 15 May 2013 (assuming tax was payable out of the £50,000 so that no grossing up was necessary).

Hypothetical CLTs
Where a distribution is made in the first 10 years, the IHT payable is calculated by taking into account the settlor's chargeable transfers before he settled the discretionary trust plus the initial value of the trust fund.

Hypothetical CLT Tax @ 20%    £ 27,000

Initial Charge
Mrs White made a CLT of £325,000 to a discretionary trust in January 2010. She is creating a further discretionary trust for £50,000 in February 2010 by transferring a further £50,000 to the trustees of this trust.

Since her cumulative total of previous transfers has used up Mrs White’s NRB, the transfer into the second trust will be immediately chargeable at 20% (one half of death rate).

Assuming the settlor pays the tax, it is necessary to gross up the value of the gift by 20% to reflect the total loss to Mrs White's estate.
Thus her gift becomes:

Exit Charge
If the trustees distributed £15,000 from the additional discretionary trust in February 2013 (assuming the tax payable is out of £15,000 so no grossing up was necessary).

Hypothetical CLT calculation
Where a distribution is made in the first 10 years, the IHT payable is calculated by taking into account the settlor's chargeable transfers in the seven years before she settled this second discretionary trust in February 2010 plus the initial value of the trust fund.

This article is not designed to be exhaustive.

It does not, for example, include additional property transferred into a discretionary trust or the consequences of having related settlements and assumes current tax rates and reliefs remain unchanged.