New rules on the taxation of trusts were contained in draft legislation published on 10 December 2014 and were scheduled to be brought into effect on 6 April 2015. As reported in our January update (Taxation of trusts), one of the key aims was to prevent the use of multiple pilot trusts to receive benefits from a deceased person’s residuary estate so that the value of each trust could be kept below the threshold of the nil rate band for inheritance tax purposes. This would save inheritance tax during the life of the trust – potentially lasting for 125 years without the funds ever becoming liable for inheritance tax.
The Budget on Wednesday 18 March saw two surprising developments in the progress of these new rules. First, the new rules will no longer become law on 6 April 2015 but instead will, potentially, be legislated in a future Finance Bill. Second, the proposed rules have been slightly altered; we have drawn your attention to these alterations in the penultimate paragraph below. It is unclear whether, if re-elected, the Government intends to publish amended legislation.
Despite the delay in legislation, the likely impact of the new rules on an individual’s estate planning remains significant where this planning makes use of multiple pilot trusts set up to received funds from the will, and it is important proper consideration is given to the impact the changes may have on your affairs.
As explained in our January update, pilot trusts are sleeping discretionary trusts drafted on flexible terms, usually set up with a small sum, that lie inactive waiting for further funds to be added. The familiar tax advantage utilised under the old rules centred on the concept of the pilot trust.
There are three occasions of charge to inheritance tax in the life of such a trust; an entry charge when the trust is set up, an exit charge when trust property leaves the trust, and otherwise 10 year anniversary charges. Traditional planning involves maximising the available nil rate tax amount (currently £325,000) by creating the pilot trust when the settlor has a full or nearly full nil rate amount available, and to avoid setting up the pilot trusts on the same day because the value of those other pilot trusts are included when calculating the tax. This is also the reason the trusts are usually set up with a nominal amount, say £10.
If prepared correctly, each pilot trust will have a full or nearly full nil rate amount of its own for inheritance tax, and when funds are directed to the pilot trust on death, with each pilot trust receiving an amount below the nil rate amount, the trusts should be capable of operating for many years without inheritance tax liabilities arising.
Proposed new rules
The crucial change is the concept of a ‘same-day addition’ included in the tax calculation of a trust. Whereas before, only the value of trusts set up on the same day were included in the calculation, now the value of other trusts to which value is added on the same day by the settlor, is included in the calculation, as well as the initial value of those other trusts irrespective of when they were set up.
Take the example of an individual directing his residuary estate to three pilot trusts, each receiving £250,000 on death, and each trust having its own full nil rate amount (£325,000). Applying the old rules the relevant value for inclusion in the tax calculation for each trust is well below the current nil rate threshold and no tax would be due at the time of a taxable event. Applying the new rules, the relevant value includes the value of all three pilot trusts because funds were added to the trusts on the same day. The relevant value is now £750,000 and thus well in excess of the nil rate threshold, which means the previous tax benefits of the pilot trust arrangement are lost, and each pilot trust will be liable to tax at the time of a taxable event. In numerical terms, a tax charge of 6% every ten years compared with the previous expectation of 0% every ten years plus exit charges may be the result.
Existing pilot trusts created under old rules – limited scope for continued enjoyment
If you have set up pilot trusts before 10 December 2014 and not made same-day additions to those trusts after that date, then these still fall under the old rules and retain their tax advantage, subject to transitional rules. This only applies so long as no further same-day additions are made. You must be careful that you do not make same-day additions to more than one trust or the tax advantage will be lost.
Transitional rules exist to allow property to be added to an existing pilot trust after 10 December 2014 without the new rules applying, but only if the addition is made by will and the provisions of the will are ‘in substance the same as they were immediately before 10 December 2014’, and the individual dies before 6 April 2016.
18 March 2015 Budget – alterations to draft legislation
In the March 2015 Budget, the Government has softened some of its proposals contained in the draft legislation of 10 December 2014. There was concern that small same day additions to a number of trusts (eg amounts paid by the settlor into the trust to cover trustee fees) would result in the property in those trusts being caught by the same-day addition rules. However, there will now be no same-day addition where the value of an addition is £5,000 or less.
The transitional rules for distributions from an estate have been extended so that the old rules will apply in cases where death takes place before 6 April 2017.
Although the Budget announcement has delayed the pressing need to consider these issues, the reality is that you should revisit your planning in the context of the proposed changes, and seek advice when considering making additions to existing trusts.