Pilot trusts are a well-established and popular method of Inheritance Tax (IHT) planning, but their usefulness in the future may be curtailed by HMRC’s recent proposals to change the way IHT is applied to trusts.

In general terms, assets are removed from the settlor's estate for IHT purposes when settled into a discretionary trust. Most trusts are subject to certain IHT rules known as the Relevant Property Regime. Those rules impose a charge to IHT when assets leave the trust (exit charges) and on each ten-year anniversary from the date of its creation (periodic charges). The rate of tax applied is between 0% and 6% of the value in/leaving the trust. The calculation can be complicated and will take into account, among other things, the opening value of any other trusts made by the same person that were created on the same day.  These are called 'related settlements'.

The rationale behind these rules is to tax trusts in a way that will result in HMRC collecting similar revenues to those which would have been received had the settlor kept the settled funds in his own estate and, therefore, subject to the IHT rules on his death.

As with individuals, each trust has the benefit of a nil rate band (currently £325,000) which is, generally speaking, the amount that can leave the trust (for exit charges) or be held in the trust (for periodic charges) before IHT becomes due. Related settlements are created on the same day and so have to share one nil rate band between them.

Under existing rules, a person can create multiple trusts and divide his or her assets between them, ensuring that no individual trust contains a fund worth over the nil rate band, and so keep all the trust funds under the IHT threshold (provided that those trusts are created on different days). It has therefore become popular practice for a settlor to create separate trusts, each containing a minimal amount (usually £10) on different days during his lifetime, which are designed to receive a share of his estate on his death. The trusts will each have their own nil rate band, whereas any trusts created in the settlor’s will would be deemed to begin on the same day (his death) and therefore only have one nil rate band available between them.

The use of pilot trusts in this way was unsuccessfully challenged by HMRC in the 2003 case of Rysaffe Trustee v IRC. HMRC also recently commented in its guidance published in April this year for the new General Anti-Abuse Rule (GAAR) that, as HMRC had lost the Rysaffe case and had not (at that stage) chosen to change the tax legislation for trusts, it “must be taken to have accepted the practice”. Such arrangements would be considered acceptable tax planning and not ‘abusive’ for tax purposes under the new GAAR.  For more information on this see 'The Budget 2013 - the key issues' our May 2013 update.

In a U-turn from its approach in the GAAR guidance, HMRC has now published a consultation that recommends new tax rules that remove the IHT advantages of setting up multiple trusts. In its consultation entitled ‘Inheritance Tax: Simplifying Charges on Trusts – the next stage’ HMRC notes that, by using pilot trusts, the IHT exit and periodic charges 'can be easily side-stepped'. It therefore proposes that all the trusts set up by a single settlor during his life will have to share a single nil rate band. The rate of tax on exit and periodic charges will always be 6%.

The consultation proposes that these amended rules will apply not only to new settlements but also to all existing settlements from a given date. There is no indication currently of the date from which the new rules will apply. There is also no indication of whether the nil rate band is to be shared equally between all lifetime trusts or on a pro-rata basis in accordance with the respective values of their trust funds.

A simplification of the IHT rules for trusts is welcome (indeed, it is not uncommon for the costs of the IHT calculation to exceed the amount of tax payable). However, the changes proposed would remove the IHT advantages of creating multiple pilot trusts during one’s life - IHT planning that many people have put in place on the basis that such an arrangement constituted legitimate tax mitigation - which now may lead to unexpected tax charges.

We will produce more detailed guidance on this issue when the HMRC consultation is more advanced and it may be that settlors will in due course need to look at consolidating existing pilot trusts, appointing out their funds or equalising the values of their funds, in anticipation of a single shared nil rate band. Whatever HMRC’s final recommendations are, it is clear that the use of multiple trusts will carry less tax advantages in the future, placing more emphasis on people making use of lifetime gifts and exploring available IHT reliefs.

Despite the future removal of the IHT advantages, pilot trusts can be beneficial for other purposes and will remain an important aspect of estate planning. For example, trusts established to receive death in service benefits or the benefit of a life assurance policy need to be created during the settlor’s lifetime in order to be nominated as the recipient of funds.