Relevant property trust
Written by Ray Coman
A relevant property Trust is one in which the Trustees have discretion over the payment of funds. They can be set up during the lifetime of the settlor or on death. An ‘interest in possession’ Trust can be set up on death which can work out more tax efficient, but these do not give the beneficiary automatic right to income from the Trust and are therefore less discretionary.
A transfer to a beneficiary during the lifetime of the transferor is referred to as a Potentially Exempt Transfer (PET.) Provided the benefactor survives seven years, the transfer will not form part of the estate subject to inheritance tax. A transfer into a Trust made during the lifetime of the settlor is referred to as a chargeable lifetime transfer.
The value of a chargeable transfer can be reduced by the annual allowance, plus any annual allowance brought forward. This is a total of £6,000 for current year and brought forward annual allowance.
The value of assets settled into the fund at the outset are compared to the prevailing nil rate band. There is an immediate charge to inheritance tax equal to 20% on any part the value of the transfer that exceeds the nil rate band at the time. This is referred to as lifetime inheritance tax. Provided settlements are below the nil rate band there will be no inheritance tax payable on creation of the Trust.
The chargeable lifetime transfers made in the seven years prior to death reduce the nil rate band available to reduce the taxable estate.
Let us say the settlor has made no gift for two years and then transfers £360,000 into a new Trust when the nil rate band is £300,000.
The lifetime inheritance tax is 20% x £300,000 less (£360,000 - £6,000.) There is a lifetime inheritance tax charge of £10,800 to pay on inception of the Trust.
If the settlor dies within seven years, the excess of the trust value minus the nil rate band would be liable to the inheritance tax rate, 40% at the time of writing. However, lifetime tax paid will be available as a credit to reduce any IHT payable.
The period charge should be calculated using the following three step process.
- Establish the nil rate band in force on the ten-year anniversary. This value is reduced by any chargeable transfers made by the settlor in the seven years prior to the creation of the Trust.
- Determine the worth of the Trust fund at the date of the ten-year anniversary. Add the amount of any distributions to beneficiaries in the preceding ten years.
- If the amount found in step 2 is greater than the amount found in step 1, any excess is chargeable to inheritance tax at a rate of 6%.
Continuing with our example, ten years into its life the Trust is worth £380,000 and the nil rate band has increased to £325,000
The ten-year charge is £380,000 less £325,000 x 6%. Inheritance tax payable is therefore £3,300.
If capital is distributed to any beneficiaries within ten years of Trust inception an inheritance tax ‘exit charge’ could arise. The exit charge applies if the value of the Trust when set up exceeded the nil rate band at that date.
The exit charge is calculated using the formula:
Capital distributed x (tax/value) x quarters/40
- Capital distributed is amount paid to beneficiaries; and
- Tax is (value of trust on creation – nil rate band at the date of exit) x 6%.
- Value is the value of Trust at its start date.
- Quarters is the number of complete three-month periods since trust formation.
Quarters are divided by 40 because there are 40 quarters in a ten-year period.
Continuing with the example above, let us say £50,000 of capital is distributed to a beneficiary, six years, and two months into the Trust’s life. The nil rate band is still £300,000 when the funds are appointed. The exit charge is: £50,000 x (10,800/300,000) x 24/40. Inheritance tax payable is £1,080.
After the initial ten years, the exit charge is based on the effective rate of tax used for the preceding ten-year anniversary.
Exit charge = capital distributed x (tax /value) x quarters/40.
- Capital is the amount distributed to the beneficiary
- Tax refers to 30% of the periodic charge on the first ten-year anniversary
- Value meaning value of Trust on the most recent 10-year anniversary.
- Quarters is the number of complete three-month periods since the most recent ten-year anniversary.
Following the example above, let us say that the Trust did not distribute any capital for the first 12 years and then distributes £150,000 to a beneficiary. The periodic charge is as per the example given earlier.
The exit charge is £150,000 x ((3,300 x 30%)/380,000) x 8/40. Inheritance tax payable is £78.16.
The above guidance is intended to provide a broad outline of the tax regime for Trusts. There could be complicating factors such as the number of other trusts set up by the settlor, and other chargeable lifetime transfers and potentially exempt transfers in the seven years preceding Trust creation. However, this article is intended to give a snapshot of the IHT regime for Trusts through which their basic tax implications can be noted.