Pre-March 2006 flexible trusts

Before 22 March 2006, interest in possession (IIP) trusts were very popular, particularly those that gave the trustees, or sometimes the settlor, the flexibility to be able to change the person or persons who had the interest in possession. Such a change would usually have been a potentially exempt transfer (PET) from the person who had held the IIP but, since 22 March 2006, exercising the flexibility could create consequences that were not contemplated when these trusts were created. The following case study illustrates the issues.

In the late 1980s, Andrew, a wealthy businessman, effected an investment bond for £500,000 under a flexible interest in possession trust. This was a potentially exempt transfer and, since Andrew survived for more than seven years, it is now wholly exempt. The trust had potential beneficiaries including Andrew’s children and grandchildren. Until the trustees appointed any of these, the trust named Andrew’s two young children, Brian and Caroline, as default beneficiaries, giving them the initial interest in possession.

Brian and Caroline eventually left home and are now very secure financially. The value of the bond has grown to more than £1m and Andrew is considering whether the trustees should exercise their power to appoint the IIP to his grandchildren, David, Ellie, Fiona and George.

For inheritance tax (IHT) purposes, one half of the value of the bond is currently included in the estate of each of Brian and Caroline. This would mean that, if the trustees made an appointment in favour of the grandchildren, this would create a chargeable lifetime transfer (CLT) from each of Brian and Caroline, rather than a PET. Given the size of the bond, this will result in an immediate IHT liability.

Secondly, such an appointment would result in the trust being brought into the relevant property tax regime. Thus, there would be a periodic charge at the next ten-yearly anniversary, as well as an exit charge when benefits are eventually paid to the beneficiaries.

Finally, if the appointment were revocable, the benefit could return to Brian or Caroline or both of them as they remain potential beneficiaries. This means that they will have made a gift with reservation. Even if they were to die, say, twenty years from now with the trust still in existence for the benefit of the grandchildren, 50% of the value of the trust fund at the date of their death would have to be included in their estate for IHT purposes.

So, if the trustees did make this proposed revocable appointment in favour of the grandchildren, what was once a very IHT-efficient arrangement has turned into a nightmare:

  • Brian and Caroline would have involuntarily made CLTs which would trigger an immediate IHT liability for the trustees;
  • the trust would potentially be subject to periodic and exit charges; and
  • whenever Brian and Caroline died, whatever their previous share of the trust fund has grown to would have to be included in their estate for IHT purposes.

One way to avoid this disaster would be for the trustees to make an appointment in favour of the grandchildren irrevocably. This would convert the trust into a bare trust, with the following result:

  • Brian and Caroline would be making PETs, not CLTs;
  • there would be no IHT periodic or exit charges in the future; and
  • Brian and Caroline would not be making gifts with reservation.

However, Andrew is reluctant for the trustees to take this course. The grandchildren are very young at present; Andrew would not wish them to have access to a share of a large sum of money at age 18.

It would be possible to make a revocable appointment and exclude Brian and Caroline as beneficiaries, removing the gift with reservation problem. However, Andrew doesn’t wish to do this either, as he wants to be able to protect them if their businesses fail. He therefore needs another way to retain the flexibility of the trust without losing the IHT efficiency. Fortunately, there is one.

Rather than the trustees changing the IIP now, Andrew could give them an expression of wish. Although not legally binding, this would state that, although he wants the current IIP to remain with Brian and Caroline, he would like the trustees to make an irrevocable appointment in favour of the grandchildren after his death, just before the trustees distribute the trust fund.

This would give continued flexibility, since Andrew could replace the expression of wishes at any time during his lifetime if required, but there would be no CLTs (although there would still be PETs when the appointments take place), no gifts with reservation and no periodic or exit charges.

In conclusion, therefore, if a client has a pre-March 2006 flexible IIP trust, changing who has the IIP can now have major taxation consequences. Clients in this situation should therefore always be encouraged to obtain professional advice before taking any action.

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