Principal and Exit Charges

Help your clients by understanding the Inheritance Tax (IHT) charges for relevant property trusts. These can apply on entry, at every tenth anniversary and when trustees distribute capital to beneficiaries.

Any non-exempt gifts into a trust that are subject to the relevant property regime are treated as chargeable lifetime transfers and carry with them the possibility of a number of inheritance tax charges. The relevant property regime applies to trusts such as discretionary trusts and lifetime interest in possession trusts.

At outset, if the gift (together with any other chargeable lifetime transfers in the last seven years) exceeds the available nil rate band then there is a 20% (25% if paid by the settlor) lifetime inheritance tax charge on the excess. Many advisers and clients will therefore ensure that the amount of the chargeable lifetime transfer is within their available nil rate band, meaning that the gift is taxable at 0%. However there will also be some clients who would be willing to pay the lifetime tax charge as well as other charges applicable to relevant property trusts as these would be less than if they did not carry out any inheritance tax planning and would be subject to 40% tax on their death.

During the life of the trust, there will be calculations needed on every ten-year anniversary and when assets or capital cash are distributed by the trustees to the beneficiaries.

10 year Principal charges

On every ten-year anniversary, it is the responsibility of the trustees to calculate, report and pay any principal tax charge for the trust.

When we look to calculate the 10 year principal charge there are steps that need to be taken and these can be found in the Inheritance Tax Manual.

Step 1

To look at calculating the value of the trust. This is not only the open market value of the assets in the trust in question on the date of the tenth anniversary, but also the historic value of any related settlements and same day additions should also be included here. If there have been no additions made or related settlements then this will just be the value of the assets in the trust on the tenth anniversary.

Step 2

If this value is greater than the available nil rate band on the ten-year anniversary a principal charge will arise. The available nil rate band used in the calculation is reduced by any other chargeable lifetime transfers made by the settlor in the seven years before commencement of the trust together with any distributions of capital made to the beneficiaries in the previous ten years.

Therefore, where there have been no additions, no related settlements, no distributions of capital to the beneficiaries and no previous chargeable lifetime transfers by the settlor, the calculation will look like this:

Value of trust - nil rate band = notional transfer
notional transfer x 20% = IHT on notional transfer
IHT on notional transfer / value of trust fund x 100 = effective rate of tax
effective rate of tax x 30% = actual rate of tax
Value of trust fund x actual rate of tax = principal charge

It is important to remember that the maximum rate of tax can only ever be 6% and this is usually when there is no nil rate band available.

In addition, where the settlor made potentially exempt transfer (PETs) which failed due to the death of the settlor within the seven years prior to the tenth anniversary of the trust, these will also reduce the nil rate band available at the tenth anniversary.

Exit charges

When capital is distributed to beneficiaries, an inheritance tax exit charge may arise.

Exit charges in the first ten years

If the trust was created during the settlor’s lifetime and an IHT entry charge was payable at outset, exit charges will apply in the first ten years. If there was no lifetime inheritance tax payable at outset, there should be no inheritance tax exit charges on any distributions of capital to the beneficiaries in the first ten years unless there have been additions to the trust in the same period. The position can change on death if a failed potentially exempt transfer causes a subsequent CLT to exceed the available nil rate band.

Where a discretionary trust has been set up on death through a will then exit charges can apply, even if there is no entry inheritance tax charge. This could occur, for example, where the deceased’s estate is entitled to a transferable nil rate band from a previously deceased spouse and the amount settled into trust on death exceeds a single nil rate band. A trust with a single settlor is only entitled to a single nil rate band when considering exit and principal charges.

Any exit charge due in the first ten years of a trust is based on the value of the assets settled into the trust when they were gifted.

When looking to calculate the exit charge in the first ten years, this can be complex and should be completed by a regulated tax adviser but the calculation would be:
Step 1 Work out value of trust Amount transferred in to trust - A Plus any related settlements - B = C	Step 4 Work out hypothetical notional transfer at trust creation E x 20% = F
Step 2 Work out NRB available NRB @ time of distribution less CLTs 7 years before trust was created or failed PETs due to death of settlor. = D	Step 5 Work out effective rate of tax F/C x 100 = G
Step 3 Value of trust less available NRB C-D = E	Step 6 Work out actual rate of tax G x 30% x n*/40 = H
	Step 7 Apply actual rate of tax to capital distribution Capital distribution - I I x H% = Tax due
*n is the number of complete quarters since creation of the trust.

Exit charges after the first ten years

Once the trust has passed its first ten-year anniversary, inheritance tax exit charges are always based on the effective rate of tax used for the previous ten-year anniversary charge. If this was zero, there will be no inheritance tax exit charges on any distributions of capital to the beneficiaries in the following ten years.

For the calculation, you must establish the actual rate of tax applying to the distribution, based on the effective rate for the trust at outset or at the last ten-year anniversary.

The actual rate is calculated by taking the effective rate, multiplying by 30% and then adjusting it for the number of complete quarters that have elapsed since either the commencement of the trust or the last ten year anniversary and the date of the exit charge (represented by “n”/40 - 40 being the total number of quarters in the ten period period).

Effective Rate x 30% x n/40 = Actual rate

The adjusted actual rate is then applied to the distribution itself to calculate the amount of tax due.

The calculation is therefore:

Exit charge = amount of capital distribution x actual rate

Please note: If the trustees pay the tax due on the exit charge of the distribution to the beneficiary, then the figure will need to be grossed up so the beneficiary gets the full amount of the distribution. For further details see https://www.gov.uk/hmrc-internal-manuals/inheritancetax-manual/ihtm42114

Scenario 1
Discretionary gift trust – June 2017, client makes outright gift (potentially exempt transfer or PET) of £200,000 to son – May 2019 settlor gifts £250,000 in a discretionary gift trust annual exemption used – January 2022 client dies and outright gift becomes chargeable. The trust now valued at £350,000 and trustees decided to wind up the trust and pay trust fund to beneficiaries. The tax due of the trust wind up is calculated as follows: – As PET now failed the gift to trust needs to be recalculated as gifts are calculated in order of when they were made so £200,000 of NRB taken up by failed PET and the hypothetical entry charge needs to be calculated. Step 1 Value of trust = £350,000 Step 2 and Step 3 NRB available £325,000- £200,000 failed PET = £125,000 CLT £250,000 - £125,000 = £125,000 Step 4 £125,000 x 20% = £25,000 hypothetical notional transfer Step 5 £25,000/£350,000 x 100 = 7.14% effective rate of tax Step 6 7.14% x 30% x 10/40 = 0.54% actual rate of tax Step 7 £350,000 x 0.54% = £1,890 tax due

Scenario 1

Discretionary gift trust

– June 2017, client makes outright gift (potentially exempt transfer or PET) of £200,000 to son

– May 2019 settlor gifts £250,000 in a discretionary gift trust annual exemption used

– January 2022 client dies and outright gift becomes chargeable. The trust now valued at £350,000 and trustees decided to wind up the trust and pay trust fund to beneficiaries.

The tax due of the trust wind up is calculated as follows:

– As PET now failed the gift to trust needs to be recalculated as gifts are calculated in order of when they were made so £200,000 of NRB taken up by failed PET and the hypothetical entry charge needs to be calculated.

Step 1
Value of trust = £350,000

Step 2 and Step 3
NRB available
£325,000- £200,000 failed PET = £125,000
CLT
£250,000 - £125,000 = £125,000

Step 4
£125,000 x 20% = £25,000 hypothetical notional transfer

Step 5
£25,000/£350,000 x 100 = 7.14% effective rate of tax

Step 6
7.14% x 30% x 10/40 = 0.54% actual rate of tax

Step 7
£350,000 x 0.54% = £1,890 tax due

Scenario 2
Discretionary gift trust – In May 2010, a client gifts £206,000 into a discretionary gift trust. – £6,000 is covered by 2 x annual gift allowances, therefore chargeable lifetime transfer is £200,000. – Nil rate band at the time was £325,000 and there were no other chargeable lifetime transfers by the same client in the preceding seven years. Therefore, no lifetime inheritance tax charge at outset. – There are no capital distributions to the beneficiaries in the first ten years. – On the ten-year anniversary in May 2020, the trust is valued at £400,000 ▼ 10 year principal charge – Notional transfer = £400,000 - £325,000 = £75,000 – IHT on notional transfer = £75,000 x 20% = £15,000 – Effective rate of tax = £15,000/£400,000 x 100% = 3.75% – Actual rate of tax = 3.75% x 30% = 1.125% – Principal charge = £400,000 x 1.125% = £4,500 payable by the trustees ▼ Exit charge – Two years later in 2022, the trust is valued at £500,000 and the trustees distribute the money to the beneficiaries. – The effective rate of tax for the trust is £4,500 / £400,000 = 1.125%. – The trust has completed eight quarters of the ten-year period, therefore the tax is reduced proportionately by 8/40. – Actual rate - 3.75% x 30% x 8/40= 0.225% The exit charge - £500,000 x 0.225% = £1,125

Scenario 2

Discretionary gift trust

– In May 2010, a client gifts £206,000 into a discretionary gift trust.

– £6,000 is covered by 2 x annual gift allowances, therefore chargeable lifetime transfer is £200,000.

– Nil rate band at the time was £325,000 and there were no other chargeable lifetime transfers by the same client in the preceding seven years. Therefore, no lifetime inheritance tax charge at outset.

– There are no capital distributions to the beneficiaries in the first ten years.

– On the ten-year anniversary in May 2020, the trust is valued at £400,000

▼

10 year principal charge

– Notional transfer = £400,000 - £325,000 = £75,000

– IHT on notional transfer = £75,000 x 20% = £15,000

– Effective rate of tax = £15,000/£400,000 x 100% = 3.75%

– Actual rate of tax = 3.75% x 30% = 1.125%

– Principal charge = £400,000 x 1.125% = £4,500 payable by the trustees

▼

Exit charge

– Two years later in 2022, the trust is valued at £500,000 and the trustees distribute the money to the beneficiaries.

– The effective rate of tax for the trust is £4,500 / £400,000 = 1.125%.

– The trust has completed eight quarters of the ten-year period, therefore the tax is reduced proportionately by 8/40.

– Actual rate - 3.75% x 30% x 8/40= 0.225%

The exit charge - £500,000 x 0.225% = £1,125

Scenario 3
Discretionary gift trust – In May 2010, a client gifts £206,000 into a discretionary gift trust (Trust A). – £6,000 is covered by 2 x annual gift allowances, therefore chargeable lifetime transfer is £200,000. – The inheritance tax charges for Trust A are as Scenario 2. – In May 2016, the same client gifts £131,000 into another discretionary gift trust (Trust B). – £6,000 is covered by 2 x annual gift allowances, therefore chargeable lifetime transfer is £125,000. – Nil rate band at the time was £325,000. – There was a chargeable lifetime transfer by the same client in the preceding seven years, but there is no lifetime inheritance tax charge at outset because the total (£200,000 + £125,000) does not exceed the nil rate band. – There are no capital distributions to the beneficiaries of Trust B in the first ten years. – On the ten-year anniversary in 2026, Trust B is valued at £250,000 and the nil rate band is, say, £325,000. ▼ 10 year principal charge – The available nil rate band is £125,000 (£325,000 minus £200,000 (chargeable lifetime transfer for Trust A)). – notional transfer = £250,000 - £125,000 = £125,000 – IHT on notional transfer = £125,000 x 20% = £25,000 – effective rate of tax = £25,000/£250,000 x 100% = 10% – actual rate of tax = 10% x 30% = 3% – principal charge = £250,000 x 3% = £7,500 payable by the trustees. ▼ Exit charge – Two years later in 2028, Trust B is valued at £300,000 and the trustees distribute the money to the beneficiaries. – The effective rate of tax for the trust is 10% – Trust B has completed eight quarters of the ten year period, therefore the tax is reduced proportionately by 8/40. – The actual rate for Trust B is 10% x 30% x 8/40 = 0.6% The exit charge on Trust B is £300,000 x 0.6% = £1,800

Scenario 3

Discretionary gift trust

– In May 2010, a client gifts £206,000 into a discretionary gift trust (Trust A).

– £6,000 is covered by 2 x annual gift allowances, therefore chargeable lifetime transfer is £200,000.

– The inheritance tax charges for Trust A
are as Scenario 2.

– In May 2016, the same client gifts £131,000 into another discretionary gift trust (Trust B).

– £6,000 is covered by 2 x annual gift allowances, therefore chargeable lifetime transfer is £125,000.

– Nil rate band at the time was £325,000.

– There was a chargeable lifetime transfer by the same client in the preceding seven years, but there is no
lifetime inheritance tax charge at outset because the total (£200,000 + £125,000) does not exceed the nil rate band.

– There are no capital distributions to the beneficiaries of Trust B in the first ten years.

– On the ten-year anniversary in 2026, Trust B is valued at £250,000 and the nil rate band is, say, £325,000.

▼

10 year principal charge

– The available nil rate band is £125,000 (£325,000 minus £200,000 (chargeable lifetime transfer for Trust A)).

– notional transfer = £250,000 - £125,000 = £125,000

– IHT on notional transfer = £125,000 x 20% = £25,000

– effective rate of tax = £25,000/£250,000 x 100% = 10%

– actual rate of tax = 10% x 30% = 3%

– principal charge = £250,000 x 3% = £7,500 payable by the trustees.

▼

Exit charge

– Two years later in 2028, Trust B is valued at £300,000 and the trustees distribute the money to the beneficiaries.

– The effective rate of tax for the trust is 10%

– Trust B has completed eight quarters of the ten year period, therefore the tax is reduced proportionately by 8/40.

– The actual rate for Trust B is 10% x 30% x 8/40 = 0.6%

The exit charge on Trust B is £300,000 x 0.6% = £1,800

Scenario 4
Discretionary will trust – In May 2016, a widow settles £106,000 into a discretionary trust. – £6,000 is covered by 2 x annual gift allowances. Although the remainder is a chargeable lifetime transfer, it is within her nil rate band so no entry inheritance tax charge arises. – She dies in May 2020 and settles £300,000 into a discretionary will trust. – Her executors are able to use her nil rate band and, since her husband did not use any of his nil rate band, the widow’s nil rate band can be enhanced by 100%. That means that, although the chargeable lifetime transfer plus the discretionary will trust exceeds a single nil rate band, the total is within the enhanced nil rate band of £650,000, therefore no entry inheritance tax charge arises. ▼ Exit charge – After two years in 2022, the trustees of the will trust distribute £100,000 to the beneficiaries. – Although there was no entry charge, a trust with a single settlor only has one nil rate band for the purposes of 10 year principal and exit charge calculations, so it is necessary to work out the effective rate of tax applicable to the trust. – Value of trust = £300,000 – Available NRB = (325,000- £100,000) £225,000 – £300,000 - £225,000 = £75,000 hypothetical notional transfer – £75,000 x 20% = £15,000 – £15,000/£300,000 x 100 = 5% effective rate of tax – 5% x 30% x 8/40 = 0.3% actual rate of tax – £100,000 x 0.3% = £300 tax due on distribution.

Scenario 4

Discretionary will trust

– In May 2016, a widow settles £106,000 into a discretionary trust.

– £6,000 is covered by 2 x annual gift allowances. Although the remainder is a chargeable lifetime transfer, it is within her nil rate band so no entry inheritance tax charge arises.

– She dies in May 2020 and settles £300,000 into a discretionary will trust.

– Her executors are able to use her nil rate band and, since her husband did not use any of his nil rate band, the widow’s nil rate band can be enhanced by 100%. That means that, although the chargeable
lifetime transfer plus the discretionary will trust exceeds a single nil rate band, the total is within the enhanced nil rate band of £650,000, therefore no entry inheritance tax charge arises.

▼

Exit charge

– After two years in 2022, the trustees of the will trust distribute £100,000 to the beneficiaries.

– Although there was no entry charge, a trust with a single settlor only has one nil rate band for the purposes of 10 year principal and exit charge calculations, so it is necessary to work out the effective rate of tax applicable to the trust.

– Value of trust = £300,000

– Available NRB = (325,000- £100,000) £225,000

– £300,000 - £225,000 = £75,000 hypothetical notional transfer

– £75,000 x 20% = £15,000

– £15,000/£300,000 x 100 = 5% effective rate of tax

– 5% x 30% x 8/40 = 0.3% actual rate of tax

– £100,000 x 0.3% = £300 tax due on distribution.

This information is based on Canada Life’s understanding of applicable legislation, law and current HM Revenue & Customs practice as at June 2024. It is provided solely for general consideration. The information regarding taxation is based on our understanding of current legislation, which may be altered and depends upon the individual financial circumstances of the investor. We recommend that investors take their own professional tax advice.