Will planning and pilot trusts

Pilot trusts have been in the news recently in the context of the extension of the trust registration service (TRS) to include certain trusts even if they do not suffer any liability to tax.

While, currently, trusts need to be registered only if the trustees incur certain tax liabilities, under the new rules enacted in the Money Laundering and Terrorist Financing (Amendment) (EU Exit) Regulations 2020 (SI 2020/991), which came into effect on 6 October 2020, even if there is no tax liability almost all trusts set up during lifetime before 9 February 2022 (with some exceptions), as well as certain will trusts, will have to be registered not later than on 10 March 2022.

Broadly, all UK resident trusts and some non-UK resident trusts will have to be registered on the TRS unless they are included in the list of "excluded trusts". For the purpose of this article, the list of excluded trusts includes "pilot’ trusts but only those created before 6 October 2020 and where the value of the property held by the trust does not exceed £100 (if further funds are added to the trust so that the trust fund exceeds £100 the trust will have to be registered at that point). So there was in effect a "sell by" date although what exactly will be the benefit to HMRC of insisting that pilot trusts (many of which will never receive any substantial funds) set up after 5 October 2020 must be notified to them (over the cost of this extra bureaucratic burden)  is unclear. Sometimes you wonder if there is a gremlin somewhere there introducing these odd provisions, likely to be the same character who, in the name of tax simplification, came up with a tax rate of 38.1% for taxing trust dividend income.

Returning to the subject of pilot trusts...

 

What is a pilot trust and why create it?

The term 'pilot trust' is generally used to describe a lifetime settlement created with a nominal sum, (usually with just a £10 note pinned to the trust document). Typical planning would involve an individual creating a number of pilot trusts, with the intention that substantial amounts are added to them at some later stage, usually following the individual’s death. The individual would then make a will which provided for legacies to be added to those pilot trusts created during lifetime. 

The main reason for the creation of pilot trusts used to be that, as long as the trusts were created on different days, they would not be related settlements for IHT purposes (following the decision in the Rysaffe case - see below for further consideration).

Each trust would have its own nil rate band for the 10-year periodic charge calculations and only the initial value of any related settlements (i.e. those created on the same day) would be included when calculating future IHT charges and not the property which was subsequently added to those trusts. Unsurprisingly perhaps the Government decided to take steps to counter this type of planning.

 

Same-Day Additions (SDAs) - the rules explained

Finance (No 2) Act 2015 introduced a TAAR to counter IHT planning involving multiple trusts created on or after 10 December 2014 or additions made after that date to trusts created before. Therefore, if no property is added to a settlement created before 10 December 2014 the SDA rules do not apply.

There was a period of grace if the testator died before 6 April 2017.

Under these rules where property (valued at more than £5,000) is added to two or more settlements on the same day and, after the commencement of those settlements, the value of the property added to the other trusts will be brought into account in calculating the rate of tax for the purposes of periodic charges and exit charges under a particular trust. Those other trusts will also be regarded as related settlements and so the property put into them at outset will also be brought to account when calculating IHT on a particular trust.

The important point to remember is that the rules refer to “same-day additions”. This is therefore mostly relevant to additions following the death of a person as regardless of when property from the estate is distributed, the addition will be deemed to take place immediately after death.

In practice, this means that if someone has created a number of pilot trusts and has made a will under which legacies are to be added to those trusts (with the idea that each trust would continue to benefit from its own and separate IHT rates) then, if the testator is still alive, the planning will not work as intended and so, ideally, they should review and update their will.

It has been suggested that, following the introduction of the rules on SDAs, there is no longer room for pilot trusts in estate planning. Is this really the case? 

 

Is Rysaffe planning still viable?

The Rysaffe principle (so named after the case CIR v Rysaffe Trustee Company (CI) Ltd [2003] STC 536 is usually concerned with the creation of a number of pilot trusts on different days and the decision in Rysaffe confirmed that such trusts will not be related settlements for IHT purposes. However, the SDAs rules have clearly upset this type of planning

As explained above, in practice, the SDAs usually take place on the death of a person. So, if a person has created a number of these pilot trusts with the intention that substantial assets are added after their death, under the new rules all such trusts will have to be aggregated for the purpose of the IHT periodic and exit charges, with only one nil rate band available.

However, the SDA rules do not apply if there are no Same-Day Additions. The keyword is the "addition". An increase in the value of an asset held in a trust will not constitute an addition. Furthermore, even if there is an addition, to count for the purpose of the SDA rules it must take place as a result of a transfer of value for IHT.

 

So when do pilot trusts and the Rysaffe principle still work?

The Rysaffe principle can still be useful when dealing with life assurance policies effected for large sums assured. If the sum assured under a policy is more than the nil rate band (currently £325,000) and is paid to the trustees in the event of a claim, there will be potential periodic charges and exit charges if 10 years or more have elapsed since the creation of the trust. If, instead of one policy, the settlor effects several smaller policies, each on a different day and each subject to its own trust, each such trust will then have its own nil rate band and so the periodic and exit charges can be avoided, or at least reduced. The new rules do not affect such arrangements as no SDAs are involved.

As explained above, generally speaking, SDAs take place on the death of the settlor. When a number of life assurance policies are effected by an individual on different days subject to different trusts, each trust is separate and the asset of each trust is the individual life assurance policy. Although clearly the value of the asset in the trust will increase following the death of the life assured and the payment of the sum assured, this is not an addition to the trust but merely an increase in value of the asset by virtue of the individual’s death. It is for this reason that the Rysaffe principle works very well with life assurance policies in trust.

In addition, as far as premium payments are concerned, Finance Act 2015 provided specific exemption from the SDA rules for such payments

It is important to remember that for the Rysaffe principle to work, there must be a separate trust created with a separate policy on different days. What is therefore essential is that the paperwork is completed properly on different days and that each of the policies can be dealt with independently of the others.

Similar considerations should apply to relevant life policies (RLPs) so, in principle, subject always to the "reasonableness" test, there is no reason why a series of RLPs could not be effected, with smaller sums assured, in place of one large policy for one employee.

 

Examples of pilot trusts used in estate planning 

Although the use of pilot trusts with the intention that assets are added from the settlor's estate after his death has lost its attraction in estate planning, there are other reasons to create a pilot trust. In particular, there are two types of pilot trust that are well-known to financial advisers. These are also known as 'spousal by-pass trusts' or just ‘by-pass trusts’. The main purpose of this type of arrangement is to ensure that the surviving spouse has access to the funds after the death of the settlor but without the funds being in the estate of the spouse for IHT purposes.

One type of spousal by-pass trust is usually created when it is intended that lump sum death benefits from a pension fund are to be paid to a discretionary trust under which the spouse of the scheme member is one of the beneficiaries.

Another type of spousal by-pass trust is a trust created by a business owner who has entered into an option agreement with their co-owners for the sale and purchase of their business interest following their death. Here the use of a spousal by-pass trust will ensure that the proceeds of sale of a business interest are transferred to a trust under which the surviving spouse is one of the beneficiaries but, again, the funds are not aggregated with the spouse's estate on his or her subsequent death. Provided the option agreement is set up correctly the business assets would qualify for IHT business property relief on death, meaning that sums in excess of the nil-rate band can be transferred, in effect tax-free, to a discretionary trust. Such a trust can, of course, be created in a will, but if it is desired to create certainty of the trust provisions, then it is preferable to create a lifetime pilot trust. Of course, post 9 December 2014, if any other trusts are created in the will or there are any other pilot trusts created by the same settlor to which additions are made on death, the SDA rules will apply.

There are also a couple of important points to remember when carrying out the type of planning described above.

First, as already indicated, the pilot trust must be established with a real asset. This will usually be a nominal sum although a covenant to pay a sum on demand may also be acceptable. If the gift is expressed as a nominal amount, usually a sum of £10, it is essential that it is actually transferred to the trustees as without a transfer of actual property to the trustees there will be no valid trust created.  The £10 note is usually pinned to the trust document.

Second, there are certain rules under succession law which mean that it is essential to follow a certain order of events to ensure that the executors of the will, following the death of the settlor, can in fact transfer the relevant assets to the said pilot trust. These rules depend on whether the by-pass trust is to receive pension death benefits or the proceeds of the sale of shares.

 

By-pass trusts for shares - will legacy to a pilot trust

Key points to remember here are as follows:

First, a gift by will to trustees of an existing trust can only be made if that trust has been made before the will is executed. It is not possible to make a gift by will to trustees of a trust made after the will has been made. So the pilot trust must be set up before the will or a codicil is executed.

Second, in addition to the above, a gift made by will must be to trustees to hold on trust on terms as declared before the will is executed. This means that there should be no appointments made by the trustees of the pilot trust after the execution of the will and before the settlor's death. In effect, the legacy in a will should be that the relevant assets are to be held on trusts set out in an existing document (executed before the will is executed) and there must be no power to substitute other trusts.

 

By-pass trusts for pension death benefits  

Clearly, it would be up to an individual to consider all their circumstances to decide whether any lump sum on their death should be paid to trustees or via, say, a flexi-access drawdown pension for the beneficiaries.

For the purpose of this article what is important to note is that a payment from a pension scheme to a pilot trust, such as a by-pass trust, will not invoke the SDA rules because, whilst there will be an "addition", the payment is not as a result of a transfer of value for IHT purposes. So the tax advantages of a pilot trust will be retained. Of course, simply having a pilot trust does not necessarily mean that it will actually receive any funds following the death of the scheme member but it will be there if needed. It should always be recommended that there is a review of any letters of wishes/nominations ahead of the member reaching age 75 so a decision can be made based on the then current objectives.

As for other tax implications of a by-pass trust then, while the creation of a by-pass trust to potentially receive the pension death benefit will not by itself have any adverse tax implications, two points should be remembered: first, that the settlor would have created another trust that may affect the size of the CGT annual exemption for other trusts created by them and, secondly, any such trust created since 6 October 2020 will have to be registered with HMRC using the online TRS.

 

Comment

Where someone has made a will which includes legacies to one or more existing trusts, these should be reviewed and updated as necessary to avoid unintended subsequent IHT charges in relation to the trusts as well as the potential for dispute.

It is, however, important to remember that the SDA rules do not apply to all additions to pilot trusts, the pension by-pass trust being one notable exception and, as explained above, as far as life assurance policies are concerned, the Rysaffe principle still works.

It is essential that advisers are familiar with these rules and do not overlook the tax planning possibilities still available.