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How to calculate the charges on a trust

Is there a 10-year charge on my trust?

It is over 10 years since, the then Chancellor, Gordon Brown changed the inheritance tax (IHT) treatment of trusts so that most trusts effected on or after 21 March 2006 fall under the relevant property regime. From 21 March 2006, as flexible trusts (also known as interest in possession) were treated as relevant property, many providers moved away from flexible trusts to discretionary trusts.

When settling money into a relevant property trust the taxation implications need to be considered. An entry IHT charge applies where the total chargeable lifetime transfers made in a rolling seven-year period exceed the IHT nil rate band (NRB), currently £325,000. This amounts to 20% of the excess over the available NRB and falls on the trustees to pay from the trust property. For this reason many settlors will try to avoid exceeding the available NRB and keep gifts into such trusts within this limit and use the exemptions available.

Whilst the asset is within the trust there is also the possibility of ongoing IHT charges. On each 10-year anniversary of the start date of the trust, the trustees have a responsibility to calculate if a charge applies and whether the trust needs to be reported to HMRC. This charge is known as a periodic charge.

As more and more trusts are reaching their 10-year anniversary, trustees are looking for help and guidance from their advisers to understand their reporting obligations and how to calculate if any tax is due and the potential tax liability.

At each 10-year anniversary, if the value of the trust fund, plus any distributions to beneficiaries in the previous 10 years, exceeds the trust’s available nil rate band, a 6% periodic charge will apply to the excess.

As well as determining whether the trust has a tax liability, the trustees also need to decide whether the trust needs to be reported to HMRC. Reporting requirements apply where the value of the trust is over 80% of the available NRB (currently £260,000). The trustees may therefore still have an obligation to report the trust to HMRC even if no tax charge arises.

In order to calculate whether a periodic charge is due, the trustees will need to understand:

  • how the trust value is calculated
  • what is included as a distribution and
  • how to calculate the trust’s available nil rate band.

Calculating the value of a trust is relatively straightforward if you are dealing with a discretionary gift trust, however it is a little more complicated for gift and loan trusts, discounted gift trusts and flexible reversionary trusts.

Under a gift and loan trust, any outstanding loan due back to the settlor needs to be deducted from the value of the trust. The loan is not a transfer of value and is therefore not an asset of the trust. In fact it is a liability that the trustees need to take into account when calculating the net value of the trust.

For a discounted gift trust, if the settlor is still alive, then the trustees have an obligation to provide the regular fixed payments to them and the actuarial value of this commitment should be deducted from the value of the trust. HMRC have agreed that, when calculating the discount, the age of the settlor used to calculate the discount at outset can be increased by the number of years to the relevant 10-year anniversary.

For example, if the settlor was 65 years of age, but after medical underwriting they were rated and treated as a 69-year-old, on the 10th anniversary the recalculated discount (if required) would be based on a 79-year-old, and on the 20th anniversary, an 89-year-old and so on.

But remember this discount can only be deducted if the trustees still have an obligation to provide those regular fixed payments. So, if the settlor had died and the trust continued to a 10-yearly anniversary, as there would be no need to calculate a discount, the full value of the trust would need to be used instead.

When looking at distributions that need to be factored into the periodic charge calculation, these are only capital distributions to discretionary beneficiaries.

If the trust allows reversions back to the settlor and these are correctly carved-out at outset and held under an absolute trust for the settlor, they will not be treated as distributions from the relevant property trust. This would apply to the fixed regular payments to a settlor under a discounted gift trust as well as maturities under a flexible reversionary trust provided both have been held under an absolute carve out.

Likewise, neither will any loan repayments made to a settlor under a gift and loan trust be treated as a distribution, as the loan repayments arise to the settlor from the loan agreement and the trustees’ liability to repay that loan, not as a distribution from the trust.

So, next the trustees need to consider the NRB available to the trust. The amount available will be the NRB at the 10th anniversary less any chargeable transfers made by the settlor in the seven years before this trust was created. From this you can see that the trustees will need to be aware of previous transfers made by the settlor and the impact that these gifts can have for the lifetime of the trust.

Let’s consider an example:

In January 2015, Lisa made an outright gift of £500,000 to her daughter. As this is a potentially exempt transfer (PET), no tax is payable.

In January 2019, Lisa sets up a discretionary trust with a gift of £200,000. Lisa regularly used her £3,000 annual gift exemption.

As the gift is below the available NRB no tax is payable.

Lisa, sadly, dies in January 2021.

In January 2029, the trustees must calculate whether a periodic charge is due. The trust value has grown to £250,000 and the NRB has increased to £400,000.

As Lisa died within seven years of the PET, the PET failed and became chargeable. As the failed PET was £500,000, the available NRB at the 10-yearly anniversary (2029) is zero.

Therefore a periodic charge will be payable in 2029 on the trust of 6% x £250,000 = £15,000.

Summary

The possibility of IHT charges on trusts is not unlikely and adviser firms will come across these more now that we have seen 10 years pass since the changes made in 2006.

Many advisers have helped clients with estate planning, but the trustees of these arrangements will need help and guidance to understand their reporting obligations, how to calculate if any tax is due, and how much this tax is.


Kim Jarvis

Kim Jarvis is a Technical Manager at Canada Life. She has worked in the life industry arena for over 20 years, with experience in trusts and their taxation, product development, the impact of new legislation on the industry and delivering training. She is an affiliate of the Society of Trusts and Estate Practitioners and a Chartered Insurer.

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