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Settlor-interested trusts without the gift with reservation provisions

This month we continue the thread of settlor-interested trusts but we explore one area which is frequently overlooked.

Whilst, generally speaking, if a settlor is included as one of the beneficiaries under the trust, this would amount to a gift with reservation of benefit (GWR) and so be ineffective for IHT purposes, there are some trusts where the settlor is a beneficiary but which are not subject to the GWR provisions. 

Non-domiciled settlors

It is generally well known that individuals who are not domiciled in the UK can create trusts of property which is classified as "excluded property" (generally speaking assets held offshore, as well as UK authorised unit trusts and OEICs) and, as long as the property in the trust remains excluded property, such a trust (referred to as an excluded property trust, or EPT) will be outside of the IHT net even if the settlor is included as one of the beneficiaries (which typically will be the case under such trusts) as  the GWR provisions will not apply.  This will remain so even if the settlor subsequently becomes UK domiciled or deemed UK domiciled for IHT purposes.  The only exception to this rule currently proposed is for cases where an individual had a UK domicile of origin, then acquired a non-UK domicile of choice and settled an EPT, which is then followed by the reacquisition of UK domicile.  In such cases the excluded property protection will not apply.  However, for all other EPTs the existing rules should continue to apply. 

What about UK domiciled settlors?

Prior to 22 March 2006 there was a category of trust called "probate trust" which, typically, would be a trust settled by an individual granting a life interest to himself, followed by a flexible trust or discretionary trust provisions after his death.  If the settlor was entitled to a life interest under the trust he had created, the transfer of assets to the trust would have been neutral for IHT purposes as the property would simply continue to be included in the estate of the settlor by virtue of his interest in possession and no transfer of value had taken place.
 
Following the changes to the taxation of UK trusts introduced in 2006, creation of such a trust during lifetime would now be a chargeable lifetime transfer (CLT) as well as a GWR, as the tax-favoured treatment for most lifetime interest in possession (IIP) trusts ended on 22 March 2006 (if a pre-2006 trust was created under which another person had an IIP, the transfer to such a trust would have been a PET).  This is the general rule.  There is, however, a very important exemption from this rule and this is in respect of settlors who are disabled or "prospectively disabled".  This was another rule introduced in the 2006 reform of the IHT treatment of trusts but one which is often overlooked.  Basically, there are special IHT reliefs for a settlor who is either actually disabled (in the tax sense) or is prospectively disabled, that is they have a condition under which they reasonably expect to become disabled, for example an early stage of dementia.  In both cases such a settlor can create a trust under which they can either have an immediate interest in possession or they can have what is referred to as a "deemed interest in possession" provided that the trust satisfies the conditions to be a trust for the disabled. The rules on this changed in 2013. The current rules are that, for the tax-favoured treatment to apply, the individual concerned must be a disabled person, as defined in the legislation, and either the person has an interest in possession or the trust satisfies the following requirements:

  • if any of the settled property is applied during the disabled person's lifetime it is applied for their benefit, and
  • on termination of the trust during the disabled person's lifetime either the disabled person or another person will become absolutely entitled.

In addition to the above, for trusts created on or after 17 July 2013, there is a requirement that all trust income must be applied for the benefit of the disabled person, subject to a de minimis limit of the lower of £3,000 and 3% of the maximum trust fund which can be applied to other beneficiaries.  In such cases, even if no interest in possession actually exists under the trust, the disabled beneficiary will be treated as being entitled to a "deemed interest in possession" which means that the gift to such a trust will be a PET (unless the gift is in favour of a disabled or prospectively disabled settlor when there will be no IHT implications at all, as was the case with pre-2006 probate trusts) and the value of the trust assets will be in the estate of the disabled beneficiary, in the same way as if an actual interest in possession existed.  So the periodic charges and exit charges will not apply.

Who qualifies as a disabled person for tax purposes?

disabled person is someone who qualifies under one or more of the following criteria:

  • He/she is incapable of administering his/her property or managing his/her affairs because of mental disorder within the meaning of the Mental Health Act 1983 as amended by the Mental Health Act 2007.
  • He/she is receiving any of:
    • attendance allowance;
    • disability living allowance (DLA) based on entitlement to the care component at the highest or middle rate;
    • personal independence payment (PIP) based on entitlement to the daily living component;
    • an increased disablement pension (for a person with an industrial injury who needs constant attendance);
    • constant attendance allowance (for a person receiving industrial injuries disablement benefit or a war disablement pension); or
    • armed forces independence payment.
  • He/she is receiving attendance allowance or disability living allowance (DLA) based on entitlement to the care component at the highest or middle rate.
  • He/she would be entitled to receive one of the allowances mentioned in the previous bullet points if not for the fact that he/she is:
    • resident outside the UK ;
    • provided with certain accommodation (such as hospital accommodation); or
    • (in the case of attendance allowance) receiving treatment for renal failure in a hospital.

 The relevant condition applies at the time when assets are transferred to a trust.

CGT implications of settlements for the disabled

Whilst we have considered the IHT implications of trusts for the disabled, it is important to also consider the capital gains tax (CGT) implications. These apply regardless of whether the beneficiary is the settlor himself or another disabled person. One of the important points about CGT is that, where an individual has a qualifying life interest under a trust, termination of such an interest on the death of the life tenant will result in a tax free uplift for CGT purposes in the same way as if the individual owned the assets outright. 

Until 2013, this only applied to actual interest in possession trusts, not to deemed IIPs.  Fortunately, the changes introduced in 2014 for deaths after 4 December 2013 extended the CGT revaluation on death to deemed IIP trusts for the disabled. This has made such deemed IIP trusts more attractive as, until then, there was little advantage in creating a  disabled interest trust if there was no benefit of the CGT uplift on death, bearing in mind that the trust assets were already included in the estate of the disabled beneficiary for IHT purposes, which potentially meant a  double tax charge.


COMMENT

Creating a trust for a disabled beneficiary, provided that the trust satisfies the relevant conditions, will mean that the trust is not subject to the IHT relevant property regime even if the trust is discretionary.  However, in practice, it may not always be the best option that the value of the trust fund is included in the estate of the beneficiary, which is the price to pay for being outside of the IHT relevant property provisions. 

The choice of the appropriate trust, or whether to have a trust at all, will, of course, depend on a variety of circumstances, not least of which is the sum involved.  If the sum involved is within the nil rate band (or twice the nil rate band if a husband and wife are jointly making the gift) then a fully discretionary trust is probably more useful as it will be outside of the beneficiary's estate for IHT purposes whilst still avoiding the relevant property charges. 

On the other hand, when planning for a disabled settlor or prospectively disabled settlor, a lifetime trust will not make the position any worse from a tax standpoint (compared to doing nothing) but is likely to offer practical benefits, not least the certainty that the intentions of the settlor are dealt with under the trust even after he loses capacity as well as after his death, without having to go through probate.

It is surprising how often advisers come across the subject of trusts for disabled persons and provision for disabled beneficiaries generally.  It is therefore important to be familiar with the relevant provisions.

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