As many practitioners will know, the government is considering major reform of the taxation of trusts. In November 2018, it launched a consultation inviting views on the principles that it believes should underpin the taxation of trusts: transparency, fairness and simplicity. Following the submission of stakeholders’ responses to the consultation, practitioners and clients with any involvement with trusts now await the government’s proposals. It is therefore an apposite moment to consider the current tax treatment of trusts, and ways in which this might be reformed. The focus of the government’s consultation is primarily the tax treatment (and in particular, Inheritance Tax (‘IHT’)) of private trusts for individuals. This article therefore focuses on the tax treatment of life interest trusts, discretionary trusts, non-resident trusts and vulnerable beneficiary trusts.
The government’s approach
The consultation document suggests that the government believes that some trusts – particularly non-resident trusts – may still be used for tax avoidance / evasion. In reality, the primary motivation for setting up a trust is rarely one of tax-saving. An individual may wish set up a trust to retain a degree of control over assets; to protect family assets (for example, to avoid assets being at risk in divorce financial proceedings); to preserve major assets such as farmland and heritage property; or to provide for a vulnerable beneficiary.
Transparency, fairness, and simplicity constitute a reasonable approach to ensure an effective trust taxation system. In the consultation document, fairness (also referred to as neutrality) is taken to mean ensuring that tax considerations neither incentivise nor disincentivise the use of trusts. The taxation of trusts has, however, become so unduly onerous and complex in some areas that it can in fact disincentivise the use of trusts.
The current taxation regime
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, are two particularly common forms of trust. Lifetime IIP trusts can be a useful way of providing for family members, vulnerable people, or settlors themselves. Discretionary trusts are useful where it is desirable for the trustees to use their judgment as to who should benefit and to what extent (if at all) from a trust, depending on the beneficiaries’ circumstances. Discretionary trusts can be particularly useful when used in a Will, protecting against the risk of profligate beneficiaries squandering cash and enabling family members most in need of financial assistance to receive it.
Lifetime IIP trusts (created post-22nd March 2006) and discretionary trusts are subject to the ‘relevant property regime’ for IHT purposes. This regime charges IHT at 20% 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). Thereafter, an IHT charge arises every ten years up to a maximum of 6% 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 equalise, so far as possible, 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. The comparison with the tax payable at 30-year intervals on the death of an individual is misleading, however, since individuals have lifetime tax planning opportunities which do not exist for trusts – for example, the ability to make potentially exempt transfers (PETs) for IHT purposes. There are also other disadvantages to be borne in mind.
Relevant property trusts suffer IHT at a maximum of 38% during the first 30 years of their existence – just under the 40% death rate of IHT for individuals. However, they 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). 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.
Further, relevant property trusts are treated more harshly when it comes to the valuation of, for example, unquoted shares, since even where there are a number of different trust funds for different beneficiaries, shares within such funds are amalgamated for valuation purposes. Differences between tax law and trust law mean that the same monetary value can be taxed twice – for example, scrip dividends paid on a trust holding within a relevant property regime are deemed to be income and are therefore subject to income tax at the higher rate at the time of receipt, but are also subsequently liable to IHT at the time of the periodic charge on the basis that they are treated as capital of the fund. These are obvious examples of where the tax treatment of relevant property trusts is disadvantageous.
In the case of discretionary trusts, although these factors are evidently negative, they can 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 this context.
However, the consultation seems to hint at a possibility that the IHT periodic charge rate for relevant property trusts may increase. Any proposal to increase the rate, even by a small amount, should be considered very carefully, as it could cause significant problems for a number of trusts, including long-running family trusts. Any increase would effectively have a retroactive effect, such that trusts previously entered into with sensible and legitimate planning objectives might immediately become unviable. The end result could well be that family estates and structures designed for asset protection and preservation may be broken up. It is difficult to see how this would be a fair outcome, or indeed for the public benefit.
In the context of lifetime IIP trusts, fairness and neutrality are arguably lacking in their tax treatment. Before the Finance Act 2006, settling property into a lifetime IIP trust would have been a PET for IHT purposes. Such a transfer did not trigger an immediate 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% IHT entry charge, and periodic and exit charges referred to above.
Without wishing to go over old ground, the 2006 changes seemed to indicate a perception that trusts were per se used for tax avoidance. But an IIP trust is not generally considered to be a mechanism for tax avoidance, particularly when seen together with the anti-avoidance provisions of the Finance Act 1986 and the Inheritance Tax Act 1984. When combined with the General Anti-Abuse Rule (GAAR) and the current disclosure requirements for trusts, there is vanishingly little scope for tax avoidance. The most neutral approach would be to liken a transfer into a lifetime IIP trust to an outright gift to an individual, given that the intention – to remove assets from one’s estate to benefit a third party – is the same. Applying the consultation principles of fairness and neutrality should result in transfers to lifetime IIP trusts being treated as PETs for IHT purposes. The current tax treatment of post-2006 lifetime IIP trusts is therefore neither fair nor neutral, as it discourages their use in comparison with making an outright gift.
The consultation also focuses on non-resident trusts, and asks why a UK resident / domiciled person would choose to set up a non-UK-resident trust (the implication being that such trusts may be used for tax avoidance).
It is very difficult to use non-resident trusts for the purposes of tax avoidance following the legislative changes of recent years. There are several legitimate reasons why a settlor may wish to create a non-resident trust. Such trusts were historically set up for reasons as simple as asset diversification where it was economical to do so. If a beneficiary lives outside of the UK or assets are located outside of the UK, it may well be more practical and straightforward for a settlor to settle assets into a non-resident trust than into a UK-resident trust. It may indeed be a requirement of the jurisdiction in which the assets are located for the asset holding structure (i.e. the trust) to be outside the UK. There may in addition be a lack of a double-tax treaty as between the UK and another country, which mean that it may be tax-inefficient for a person with dual UK and another residency to set up a UK-resident trust. Setting up a UK-resident trust in such circumstances could lead to deleterious tax consequences in the individual’s other country of residence. There are therefore a number of legitimate reasons to set up non-resident trusts.
Vulnerable beneficiary trusts and voluntary settlements
Although Vulnerable Beneficiary Trusts carry some advantageous tax treatments, the statutory definition of ‘vulnerable person’ is so narrow that it prevents many clearly vulnerable people, often with some form of disability, from qualifying. In addition, there is considerable work involved to ensure that such a trust benefits from positive tax treatment, often resulting in higher accountancy / legal fees than for, say, a discretionary trust. This has in certain cases been considered disproportionate and too onerous to justify such a structure being put in place. A simplified and broader definition of ‘vulnerable person’ might promote greater fairness.
In a similar vein, voluntary settlements should be allowed to qualify for the same beneficial tax treatment as vulnerable beneficiary trusts. Someone may wish to self-settle in order to provide for future, anticipated vulnerability, or indeed a vulnerability which would not qualify under the test for vulnerable beneficiary trusts. This could occur where a beneficiary is in the early stages of a degenerative illness, such as dementia or multiple sclerosis. Likewise, people who suffer from a recurring vulnerability – such as recurring acute mental illness – should receive favourable tax treatment. Some vulnerabilities are significant, but may not qualify for favourable treatment under the current legislation. Why an individual who settles property on himself should be taxed any differently to the same individual retaining such property in his absolute ownership is unclear. This is neither a neutral nor fair outcome.
Further simplification and reform
In addition to a simplification of the definition of ‘vulnerable beneficiary’, there are other areas of trust taxation which would benefit from simplification. Simplification is highly desirable in the context of periodic charges, particularly for smaller trusts. The payment of a flat fee in lieu of the submission of an IHT100 with the complicated periodic charge calculations would mean that smaller trusts would become financially viable. This would give greater access to trusts to the ordinary tax payer / family, who may wish to make long-term provision, or provide protection, for their family members. This would achieve greater fairness.
The decision to set up a trust will involve consideration of the advantages and disadvantages. In the context of discretionary trusts, the concomitant costs of flexibility, protection and control are periodic charges, administration, management and compliance / transparency costs, a considerable compliance burden, and an often disadvantageous regime in terms of both CGT and income tax. This seems to be a fair compromise in view of the utility of discretionary trusts. But the lack of fairness and neutrality in the tax treatment of lifetime IIP trusts and vulnerable beneficiary trusts / voluntary settlements are two areas in which reform may be needed in order to bring their tax treatment in line with the consultation principles of fairness and neutrality. The use of lifetime IIP trusts is clearly disincentivised by the existing tax regime, and the aims of fairness and neutrality are not met in the context of vulnerable beneficiary trusts and voluntary settlements. A reconsideration of the current regime might go some way to meeting the aims of fairness and neutrality in respect of such trusts.
This article was published in Taxation and can be accessed here.