WHAT IS A TRUST?

A trust is an arrangement under which someone, who is called a trustee, holds or manages assets (the trust fund), of which he is considered to be the legal owner, under a legal obligation to use them for the benefit of a person, purpose or organisation (the beneficiary) or people, purposes or organisations (the beneficiaries), of whom the trustee may be one. The person who sets up the trust is called the settlor and the trust may be created by an express statement of the settlor (an express trust) or by implication from his conduct or presumed intention (an implied or resulting trust) or imposed by the law to achieve fairness in a particular situation (a constructive trust). This book is concerned mainly with express trusts. Although express trusts of assets can be created orally, they are usually created by a document such as a deed or will and the document which creates them is called the trust deed. The trust deed sets out the rules by which the trust is to be managed and defines the trust fund and the powers and the duties of the trustees. Each trust may have up to four trustees and they must be aged 18 or over and mentally capable. The trust deed also states who the beneficiaries are to be or defines them as being the members of a particular class, e.g. ‘my grandchildren who are living at the date of my death’.

A trust has its own independent existence and is a separate legal entity, separate from the settlor, the trustees and the beneficiary.

THE ESSENTIALS OF A VALID TRUST

To be valid a trust must comply with what are known as the ‘three certainties’:

• certainty of words
• certainty of subject matter
• certainty of objects.

Certainty of words means that the words or conduct which are used to create the trust must show that it is intended to impose upon the trustees a legal obligation to use the trust fund for the beneficiaries; the words must be imperative and not merely an expression of wishes or hope.

Certainty of subject matter means that the property that is to be the subject of the trust and the extent of the benefit which each beneficiary shall have in it must be clearly defined or ascertainable. A trust of ‘some of my paintings’ is therefore void.

Certainty of objects means that the identity of the possible beneficiaries must be clear at the latest when the time comes to distribute the trust funds. A disposition for the benefit of ‘my friends’ will be ineffective.

INTEREST IN POSSESSION TRUSTS AND THEIR USES

The nature of an interest in possession trust

Limited interest in possession trusts (which for the sake of brevity are, in the following pages, referred to simply as interest in possession trusts) are trusts in which someone (technically known as the life tenant or tenant for life), has a present or immediate legal entitlement to benefit from the trust fund for his life or any other limited time (the interest in possession), after which the benefit will pass to another person.

The interest or right to benefit that will exist after the life tenant’s interest ceases is known as the remainder or reversionary interest and the person to whom it will pass is known as the remainderman. There can be more than one tenant for life and more than one remainderman in a given trust at any one time.

Uses for interest in possession trusts

Interest in possession trusts are particularly useful in the case of second or subsequent marriages if a taxpayer wishes his assets to benefit his spouse after his death but to ensure that they are inherited by his children and no one else after her death. Thus a taxpayer might leave his house to trustees upon trust to provide a home for his widow (the tenant for life) during the remainder of her life and to be inherited by his children (the remaindermen) after her death. In this way he is able to provide for his widow but at the same time to extend the period during which he can control the destiny of his asset.

Interest in possession trusts are also useful to provide for the maintenance of individual children in a family until they are capable of providing for themselves. They are expensive from an income tax point of view if the income exceeds £100 per annum and the trust funds have been provided by a parent, as opposed to, say, by a grandparent, because in the former event (for income tax purposes) the income will be considered to be that of the settlor parent and the child will not be able to set his tax free and reduced rate income tax allowances against the income.

RELEVANT PROPERTY OR DISCRETIONARY TRUSTS, THEIR ADVANTAGES AND USES

The nature of a relevant property trust

A relevant property trust is a trust in respect of which no individual beneficiary has a present or immediate right to a defined part of the trust assets or of the income of the trust: the trustees have a discretion to divide them as the trustees think fit between any one or more beneficiaries (or class or classes of beneficiaries) specified in the trust deed. For this reason relevant property trusts are sometimes referred to as discretionary trusts. Until the trustees have made a decision and exercised their discretion, all the individual potential beneficiaries have is a hope or expectation of benefiting from the trust even though, in accordance with the general principles of trust law, if the potential beneficiaries all have full legal capacity they can collectively put an end to the trust.

A provision should be included in the trust deed of a discretionary trust to the effect that if, at the date the trust is to terminate, the trustees have not been given and used a power to allocate the trust fund to beneficiaries, a specified beneficiary or beneficiaries shall inherit the undistributed trust fund. If this is not done in the case of a trust created by the settlor during his lifetime, at the end of the trust period the trust fund will revert to the settlor and he will be considered for inheritance tax purposes to have reserved a benefit from the gift of the trust assets to the trust when he created it.

Some trust deeds give the trustees wide powers to decide who shall benefit from the trust funds at any given time but identify specific people or causes to benefit from the funds unless and until the trustees exercise those powers. The trusts created by such deeds are sometimes referred to as hybrid trusts and in truth may be interest in possession trusts or discretionary trusts at different times during their existence and taxed accordingly. The test at any moment of time is ‘has a particular person or group of people or cause, an immediate right to income from the trust fund for a limited period?’ If the answer is yes, an interest in possession trust is in existence; if no, a discretionary trust.

Letters of wishes

It is the usual practice for the settlor of assets on a discretionary trust to leave a letter of wishes stating the principles the settlor wishes the trustees to use when deciding how to exercise the discretion they are given concerning the allocation of the trust fund and the income it produces. If the settlor leaves a letter of wishes great care must be taken in the drafting of the letter to ensure that the trustees’ discretion remains legally unfettered and that they are free to ignore the settlor’s wishes, otherwise the trust will be classed as an interest in possession trust and not as a discretionary trust.

Advantages and uses of discretionary trusts

The principal advantage of a discretionary trust is that no inheritance tax is charged upon the death of a potential beneficiary because no beneficiary has a right to any defined interest in the trust assets or the income they produce until the trustees have exercised their discretion in his favour.

A further major benefit of discretionary trusts is flexibility. Within the wide boundaries set out in the trust deed a discretionary trust permits the trustees to use the trust fund in the way they consider to be most appropriate having regard to the circumstances which exist at the times they make their decisions. The circumstances at these times might be very different from those that existed at the time the settlor set up the trust and considered his objectives.

Discretionary trusts are frequently used to provide for people whose financial needs are likely to vary at different times in the future or to protect the trust fund from creditors if one of the potential beneficiaries is a spendthrift or engaged in hazardous business ventures and likely to become bankrupt.

THE TWO-YEAR DISCRETIONARY WILL TRUST

A particularly useful provision is contained in section 144 of the Inheritance Tax Act 1984. This section in effect provides that if a discretionary trust is created by a will, transfers made not less than three months and not more than two years after the death of a testator out of the trust can be treated as being dispositions made by the will and made directly by the testator. It should be noted that if trustees of a two-year discretionary will trust use their discretion to allocate capital and choose that the allocation shall be considered as having been made by the testator in his will, the recipient will be considered to acquire the allocated assets for the purposes of capital gains tax at the base value which exists at the date of the allocation and not that which existed at the date of the testator’s death. Any gain or loss in the value of the relevant trust asset between the date of the death and the date of the allocation will be considered to be that of the trust for capital gains tax purposes.

TAXATION OF TRUSTS IN GENERAL

For UK taxation purposes, a trust is a separate legal entity and the trustees of a trust are considered as a continuing body distinct from the individuals who compose it. A change of trustee does not have any tax implications. Generally speaking the trust has its own taxation rates, limits and exemptions. However, if the settlor or the settlor’s spouse or registered civil partner might benefit from the trust, income and the capital gains of the trust are considered to be those of the settlor although taxed in the hands of the trustees at the rate applicable to trusts, unless the income is distributed income which is taxed at the dividend trust rate.

Taxation of a trust must be considered in respect of inheritance tax, capital gains tax and income tax and at three stages: when assets are transferred into the trust, during the continuance of the trust, and when assets are transferred out of the trust including when it finally terminates. Different types of trust are taxed differently and it is therefore important to know to which class of trusts a particular trust belongs and which trust taxation system applies to it.

The law has traditionally applied one of two different systems or regimes of taxation to trusts. The first system is that which applied to ‘relevant property’ trusts and the other system is that which applied to ‘limited interest in possession trusts’.

THE TAXATION OF TRUSTS BEFORE 22 MARCH 2006

An outline of the taxation of relevant property trusts

In summary the relevant property trust tax regime consists of:

• an immediate charge to tax at the lifetime inheritance tax rate (at the time of writing 20%) upon any funds that exceed the inheritance tax threshold which are transferred into the trust during the settlor’s life – this is known as the ‘entry charge’
• a ‘periodic charge’, levied on every tenth anniversary of the creation of the trust, of a maximum of 6% of the sum by which the value of the trust fund exceeds the inheritance tax threshold
• an ‘exit charge’, which is levied when assets are taken out of the trust between the ten-year anniversaries and which is proportionate to the periodic charge, the proportion depending upon the time that has elapsed since the last ten-year anniversary.

Tax on the creation of relevant property trusts – the entry charge

The transfer of assets into a new or existing relevant property trust is a transfer of value for inheritance tax purposes.

Unless the transfer is one of the statutory exempt transfers or the assets are excluded property, a lifetime transfer of assets into a discretionary trust which causes the settlor’s nil-rate band to be exceeded will be immediately chargeable with tax at one-half of the rate applicable to transfers on death. Transfers into relevant property trusts are not PETs.

If the discretionary trust is created by the taxpayer’s will on his death, the assets which become part of the trust are treated as part of the taxpayer’s estate and the normal inheritance tax rules apply.

Capital gains tax is charged in accordance with the normal capital gains tax rules when an asset is put into a discretionary trust by a settlor during his lifetime, but because there is no capital gains tax on death, no capital gains tax is charged when a discretionary trust is created by the testator’s will.

The ten-year periodic charge to inheritance tax

Every ten years during the life of a discretionary trust there is a periodic charge to inheritance tax on the value of the ‘relevant property’ immediately before the tenth anniversary of the commencement of the trust that falls after 31 March 1983. Subject to very minor and infrequent exceptions, ‘relevant property’ is the settled property, i.e. the trust funds of the discretionary trust (other than property held only for charitable purposes and excluded property) in which there is no interest in possession subsisting.

The rate at which the periodic charge to tax is charged is three-tenths of the rate at which tax would be charged on a lifetime transfer of:

• the assets of the trust fund
• any other settlement made by the same settlor which began on the same date

made by a person who had a cumulative total of transfers equal to the total of those made by the settlor in the seven years prior to the commencement of the trust and any capital which has been transferred out of the trust in the previous ten years.

The maximum ten-year charge at current rates on assets which have been in the trust fund for a full ten years is 6% of the value of the asset i.e. three tenths of the current lifetime inheritance tax rate of 20%.

TAX TIP

If possible it is better to make lifetime gifts after and not before transferring assets to a discretionary trust because if made after, the gifts would count as PETs and the transferor might survive long enough to enable them to become exempt transfers. If the gifts are made before the transfer to a discretionary trust, the gifts will be counted in the settlor’s cumulative total of transfers made in the seven years prior to the commencement of the trust when calculating the ten-year charge.

The periodic charge is intended to produce an amount of tax equivalent to that which would normally be produced in respect of the trust fund in other circumstances over a generation.

The discretionary trust inheritance tax exit charge

The exit charge to inheritance tax applies when the trust fund or a part of the trust fund ceases to be subject to discretion, for example when a capital payment is made from the trust fund to a beneficiary. A payment from the trust which is paid to someone and is income of that person for the purpose of UK income tax, or which leaves a discretionary trust because it is used to pay expenses relating to relevant property, is exempt from an exit charge.

The inheritance tax exit charge differs depending upon whether the trust fund or part of the fund (as the case may be) ceases to be subject to discretion before the first ten-year anniversary or after the first ten-year anniversary of the creation of the trust.

Exit charges before the first ten-year periodic charge

If assets are transferred out of the trust before the first ten-year anniversary, the charge is made upon the value of the assets transferred out and ceasing to be subject to the trustees’ discretion. If the tax is to be paid by the trustees as opposed to being paid by the recipient, that value must be grossed up at the effective rate of the tax. The effective rate of tax is calculated on the basis of a hypothetical transfer of the value of the funds in the trust and in any other settlement made by the same settlor which began on the same date, immediately after the trust was created and by a settlor and with a cumulative total of transfers equal to those of the creator of the trust in the seven years before it was created. The tax is charged at three-tenths of the effective rate and according to the number of completed quarters which have elapsed between the date the assets entered the trust and the date they left, proportionate to ten years, i.e. at one-fortieth of three-tenths of the effective rate for each complete quarter.

Exit charges after the first ten-year periodic charge

If the trust fund or part of the fund is transferred out of the trust by the trustees exercising their discretion or ceases to be subject to discretion after the first ten-year periodic charge, tax is charged at the rate of one-fortieth of the previous periodic charge rate for each complete quarter that has elapsed between the previous anniversary charge and the date of the present exit charge.

The tax is charged upon the difference between the value of the fund before the disposition and its value after the disposition. If the tax is to be paid by the trustees out of the trust assets, as opposed to being paid by the recipient, the value must be grossed up at the effective rate of tax.

Because no individual potential beneficiary of a discretionary trust is considered to own a defined share of the trust fund or the income it produces, no inheritance tax charge arises on the death of a potential beneficiary of the trust.

The taxation of interest in possession trusts created before 22 March 2006

The creation of an interest in possession trust before 22 March 2006 by a settlor during his life was treated as a PET, but after that date a lifetime transfer of assets into a trust incurs an immediate charge to tax at the rate applicable to lifetime transfers if it causes the settlor’s cumulative total of chargeable transfers to exceed the nil rate band, unless it is a transfer to a trust for the disabled. If an interest in possession trust was created by the taxpayer’s will or by an intestacy on his death, the assets which became part of the trust were treated for inheritance tax purposes as part of the taxpayer’s estate and the normal inheritance tax rules applied. When an asset was put into an interest in possession trust by a settlor during his lifetime, capital gains tax was charged in accordance with the normal capital gains tax rules, but because there was no capital gains tax on death, no capital gains tax was charged when an interest in possession trust was created by the testator’s will or upon his intestacy.

For inheritance tax purposes the tenant for life of an interest in possession trust was treated as the owner of the trust fund during his lifetime. Consequently on the death of the life tenant, unless the trust fund consisted of excluded property, the value of the trust fund was added to the value of his estate and inheritance tax charged on the total sum, subject to the usual exceptions and with the benefit of the usual reliefs. There was an exception to this rule in the case of reverter to the settlor trusts. In the case of reverter to the settlor trusts the value of the trust fund was not added to the tenant for life’s estate if the trust fund reverted to the settlor, to the settlor’s UK-domiciled spouse or if the settlor had died, to his UK-domiciled widow within two years of the settlor’s death.

If more than one person were entitled to the income of the trust at a given time they were treated as owning the trust fund in the same proportions as their respective entitlement to the income of the trust. Thus if three people were entitled to share the income of the trust equally, on the death of one of them his estate was taxed as if it included one-third of the value of the trust fund.

If the life tenant disposed of his interest during his lifetime he made a transfer of value and inheritance tax was charged on the same proportion of the value of the fund as his income bore to the total income of the fund. The usual inheritance tax exceptions and reliefs applied and the disposition was a PET unless the disposition was to a discretionary trust, in which case it was immediately chargeable at the rate applicable to lifetime gifts (one-half of the death rate) to the extent that the taxpayer’s nil-rate band had been fully used. The disposal might give rise to a capital gains tax charge being made upon the tenant for life depending upon what other disposals he had made during the relevant tax year.

A transfer of a reversionary interest did not cause inheritance tax to be charged because reversionary interests are usually excluded property. Nor was there any capital gains tax on a transfer of a reversionary interest unless the remainderman had purchased it. It was therefore a good idea, from an inheritance tax and capital gains tax planning point of view, for a remainderman who was comfortably off and satisfied that he would not require his reversionary interest to pass it on during his lifetime.

If an interest in possession trust itself disposed of trust assets, the capital gains tax regime applied and the trust was taxed on any gains made by the trust that exceeded its annual tax-free limit. This also applied if a beneficiary of a trust (other than a bare trust) became entitled to assets from the trust and it applied whether the trust was an interest in possession trust or a discretionary trust. However, there was an exception in that capital gains were treated as the settlor’s in the case of trusts for the benefit of the settlor’s children who were under age, unmarried and did not have a civil partner. The tax-free limit for trusts other than bare trusts (which do not have a tax-free allowance) in any given tax year is one-half of that which applies to an individual. If the trust disposed of a residential property occupied by the tenant for life as his sole or principal residence, capital gains tax private residence relief applied.

The income of an interest in possession trust was considered to be the income of the tenant for life and taxed accordingly unless the income from the asset exceeded £100.00 and had been settled by a parent upon a child who was under age, unmarried and did not have a civil partner, in which case all income from the asset was taxed as the income of the parent.

THE TAXATION OF TRUSTS AFTER 22 MARCH 2006

The rules relating to inheritance tax and trusts were radically changed in 2006, making trusts in many ways much less attractive as tax-planning vehicles.

The taxation of interest in possession trusts which existed on 22 March 2006

The rules for the taxation of interest in possession trusts which existed on 22 March 2006 continue to apply to such trusts after 22 March 2006 until the life tenancy which existed at that date comes to an end. Therefore if the life tenancy comes to an end because of the death of the life tenant, the value of the trust fund is added to the value of his free estate and inheritance tax charged accordingly. If the life tenancy comes to an end while he is still living, e.g. because he surrenders it to the beneficiary next entitled under the terms of the trust deed, the termination of the life interest will count as a PET by the life tenant if the trust funds pass to an individual or to a trust for the disabled, but if they continue to be held on any other type of trust the termination counts as an immediately chargeable transfer by the life tenant into a new relevant property trust.

Additionally, if after 22 March 2006 a life tenancy which existed at 22 March 2006 terminates before 22 March 2008 and is immediately followed by another life tenancy; or a life tenancy which existed at 22 March 2006 ends after 22 March 2008 and is immediately followed by a life tenancy in favour of the deceased life tenant’s spouse or civil partner, then the rules for the taxation of interest in possession trusts which existed before 22 March 2006 continue to apply to such trusts until the termination of the second life tenancy.

In all other circumstances, if the trust continues after the termination of the life interest that existed on 22 March 2006, the termination of the life tenancy is considered to create a new trust to be taxed as a relevant property trust unless it is a charitable trust or a trust for the disabled. For example, if the terms of the trust were that the trust fund was to be held for A during his life and then for A’s son B during B’s life and then for C, A’s death after 22 March 2008 is considered as creating a new post-21 March 2006 trust.

The taxation of trusts created on or after 22 March 2006

Unless legislation provides otherwise, all trusts created on or after 22 March 2006 are subject to the relevant property regime which before that date applied only to discretionary trusts.

Trusts created on or after 22 March 2006 by a settlor in his lifetime

The only trusts created on or after 22 March 2006 by a settlor in his lifetime which are exempt from the relevant property taxation regime are trusts which are totally for charitable purposes as defined by the law, and trusts which qualify as trusts for the disabled. To qualify as disabled under section 89 of the Inheritance Tax Act 1984 a beneficiary must either be:

• unable to administer his or her property or manage his or her affairs because of mental disorder within the meaning of the Mental Health Act, or
• in receipt of either attendance allowance or in receipt of disability living allowance by virtue of entitlement to the care component at the highest or middle rate

and not less than half of the settled property which is distributed during his life must be applied for his benefit.

A trust for the disabled includes a trust made by someone in his own favour in the expectation of future disability.

Trusts for the disabled are usually written as discretionary trusts. The discretion given to the trustees enables them to adjust payments within limits according to the beneficiary’s needs and the financial limits for any local authority or social security benefits the beneficiary might be receiving. While the trust fund is held on discretionary trusts for the disabled person, it is treated for inheritance tax purposes as if he owned it and any distribution of capital to him is not considered to be a transfer of value and is not subject to an inheritance tax charge. Neither does the ten-year periodic charge to inheritance tax apply. When property ceases to be subject to the trustees’ discretion or when the disabled person dies there is a charge to inheritance tax as if the trust were an interest in possession trust.

Placing money in a trust for the disabled for a person unable to administer his property or manage his affairs because of mental disorder avoids the cumbersome and expensive involvement of the Office of the Public Guardian in his affairs in relation to the money.

Taxation of trusts which come into existence on death on or after 22 March 2006

Trusts which come into existence on death, i.e. upon an intestacy or under the settlor’s will, on or after 22 March 2006 are subject to the relevant property trust taxation system unless they fall into one of the following categories.

• Trusts for the disabled.
• Trusts for bereaved minors, i.e. trusts for the benefit of an under-age child who has lost at least one of his parents and who will become fully entitled to the trust funds at an age which is not greater than 18. While the bereaved minor is under the age of 18 any capital used for the benefit of a beneficiary must be used for the benefit of the bereaved minor and no income of the trust can be used for the benefit of any other person. The trusts must be created by the settlor’s will or on his intestacy, by a parent, step-parent or other person who has parental responsibility for the child or created under the Criminal Injuries Compensation Scheme. After any inheritance tax due on the parent’s death has been paid there is no further inheritance tax payable.
• 18–25 trusts. These are trusts which do not qualify as trusts for bereaved minors solely by reason of the fact that the beneficiary does not become entitled to the trust funds at the age of 18 or under. However, the beneficiary must become entitled to the trust funds at an age not greater than 25. While the beneficiary is under the age of 18 there is no liability for periodic ten-year anniversary charges and no exit charge upon payments made to a beneficiary who is under the age of 18 or on attaining that age. Payments to a beneficiary who is over the age of 18, or on the beneficiary’s death between the ages of 18 and 25, incur an exit charge which is calculated in the usual way from the date at which the beneficiary became 18.
• Immediate post-death interest trusts, i.e. trusts created on death for a life tenant whose interest begins immediately on the death. These trusts are taxed as pre-March 2006 interest in possession trusts and on the death of the life tenant the trust funds are aggregated with the life tenant’s free estate for inheritance tax purposes. If the life tenant is the settlor’s surviving spouse or civil partner, the surviving spouse exemption applies. If the life tenant terminates his interest, e.g. by surrendering it, the termination will be an immediately chargeable lifetime transfer if the trust continues, unless the continuing trust is a trust for charitable purposes or for the disabled or a bereaved minor’s trust, in which cases the termination of the life interest will operate as a PET by the life tenant. If the termination of the life interest puts an end to the trust, the termination is a PET by the life tenant.

BARE TRUSTS, CHARITABLE TRUSTS AND LIFE POLICY TRUSTS

Before leaving the discussion of different types of trust there are three kinds of trusts which deserve special mention: bare trusts, trusts for charitable purposes and life policy trusts.

Bare trusts

What are bare trusts?

A bare trust is a trust which exists when an asset is in the name of one or more people but is not to benefit them but is for the benefit of others – nothing more and nothing less. Its main use is to hold property when it would not be practical for legal or other reasons for the beneficiary to have the property in his own name; for example, if the beneficiary is under age or mentally incapable of managing it himself or where it is desired to hide the identity of the beneficiary.

The taxation of bare trusts

When property is placed in the trust for the benefit of someone other than the settlor there is a transfer of value from the settlor/ transferor’s estate for inheritance tax purposes and whether and if so how the transfer will be taxable depends upon the rules previously discussed.

In the case of a bare trust, while the asset is in the trust, any income it produces and any income paid out is ultimately taxed as that of the beneficiary, unless:

• the asset was provided for the trust by a parent and the trust is for the benefit of an unmarried child who has not entered into a civil partnership and is under the age of 18 and
• the income produced by the asset is in excess of £100.00 per annum, in which case the whole of the income from the asset is taxed as that of the parent.

While the income is accumulating within the trust it is taxed as the trust’s income at the rate applicable to trusts.

For capital gains tax purposes a bare trust is not considered to exist independently of the settlor or the beneficiary. Any capital gains made by the trust are considered to be those of the beneficiary, who is considered for capital gains tax purposes as the owner of the trust fund, unless a parent provided the trust asset and the beneficiary is an unmarried under-age child who has not registered a civil partnership, in which case the gain is treated as a gain by the parent. Because the beneficiary of a bare trust is considered to be the owner of the property for the purposes of capital gains tax, the capital gains tax exemption allowance to be applied is the full one for an individual and not the half-rate allowance given to other trusts.

When the asset leaves the trust, because the asset is considered to be that of the beneficiary, there is no transfer of value for inheritance tax or capital gains tax purposes if it is transferred out to the beneficiary. If it is transferred to some other person, e.g. on the beneficiary’s death or upon his instructions during his lifetime, there will be a transfer of value to be taxed in accordance with the usual inheritance tax rules and unless the transfer is a transfer on death, a disposal for capital gains tax purposes. Holdover relief for capital gains tax is not available when transferring assets into or out of a bare trust.

Trusts for charitable purposes

What are charitable purposes?

Charitable purposes as defined by the law are purposes for:

• the relief of poverty, or
• the advancement of education or religion, or
• other purposes beneficial to the community.

There must be a substantial public element even in the first two classes to make a purpose or cause charitable in the eyes of the law; a trust to preserve the settlor’s children from poverty or to educate them is not a charitable trust. The definition is due to be considerably widened when the remainder of the Charities Act 2006 comes into force (anticipated early 2008) but there will still be a requirement of public benefit which will not be presumed.

Taxation of trusts for charitable purposes

Gifts for the purposes of charity as defined by the law are exempt from inheritance tax if made in favour of a charity or charitable trust established within the United Kingdom, whether given during the taxpayer’s lifetime or by his will. Inheritance tax is not payable while trust assets are held exclusively for charitable purposes, but if the trust deed provides that the trust assets are to be held by the trustees for the charitable purpose for only a limited period, an inheritance tax exit charge (albeit at a reduced rate depending upon how long the trust fund has been held for charitable purposes) will be payable when the assets cease to be held for charitable purposes. There is no inheritance tax exit charge levied when a discretionary trust makes a distribution to a charity.

Similarly, a donor does not incur a liability to capital gains tax in respect of any increase in the value of an asset over the price he paid for it if he gives the asset directly to a charitable trust, but if he sells the asset and makes a gain and then donates the proceeds of the sale to the trust, the gain will be taxable in his hands. A donor making a gift of an asset directly to a charitable trust cannot claim any capital gains tax loss; to do so he must first sell the asset and then donate the proceeds to the trust.

Charitable trusts do not incur any capital gains tax upon any gains they make in the course of their charitable activities or liability to income tax in relation to their non-business activities. Charities can reclaim any tax deducted at source from income of their non-business activities, but they can no longer claim the tax credit attached to dividend income received from their investments. The taxation of any trading income of a charity is complex and if a charity wishes to carry on a business-for-profit activity it will usually carry on the activity through a wholly owned subsidiary company which will covenant to donate its profits to the charity.

Life policy trusts

Life interest in possession trusts of life policies in existence at 22 March 2006 continue to be treated under the rules for taxation of interest in possession trusts which were in force before that date and the same applies to life interests which come into force on the death of a preceding life tenant of such trusts as long as there is no break in the chain. Premiums paid by an individual to such trusts continue to be PETs. Life policy trusts created after 22 March 2006 are taxed under the relevant property trust regime but because of their value, most premiums paid to new life policy trusts on their creation or during their existence may well be exempt under the annual gifts allowance, the £250 individual gifts exemption or as regular gifts made out of income which do not reduce the donor’s standard of living.

TRUSTS: CAPITAL GAINS TAX AND INHERITANCE TAX

When considering effecting a transaction in the context of inheritance tax planning it is always necessary to bear in mind the cost of the transaction including the possibility that it will give rise to a capital gains tax liability at that time or in the future which will render the transaction inefficient from a taxation point of view.

The subject of capital gains tax deserves a book on its own and has indeed had several books devoted solely to it. No passing reference can do the subject justice or be thoroughly accurate and although detailed treatment of the subject is not possible in the context of this book, when considering inheritance tax and especially tax planning, it cannot be ignored. I make no pretence that what follows or what has been written above is a comprehensive summary of capital gains tax, but I trust that it will act as a signpost to any reader who has no previous knowledge of the subject.

How capital gains tax works

Capital gains tax is charged when an asset that is not exempt from the tax is disposed of, and is charged upon any increase in the value of the asset (the gain) between the date of its acquisition and its disposal. From the gain it is permissible to deduct the cost of acquiring the asset, increasing its value, defending one’s title to and disposing of the asset, and taper relief is usually claimable to reduce a gain dependent upon the length of time that the asset has been owned. It is proposed that taper relief will be abolished at the end of the current tax year 2007/8. There is a minimum annual total of gains (currently £9,200 per individual or per trust for the disabled or £4,600 for other trusts) below which the tax is not charged.

Assets which are exempt from the tax include:

• UK government stock
• Savings Certificates
• Premium Bonds
• assets held in PEPs
• assets held in ISAs
• cash held in sterling
• foreign currency held for personal use
• chattels valued at £6,000 or less
• private motor cars
• the taxpayer’s principal private residence with land in total not exceeding one half a hectare.

The payment of capital transfer tax due can be postponed by claiming holdover relief in certain circumstances.

Capital gains tax on a death

No capital gains tax is payable by a deceased person’s personal representatives at the time of the death on the assets of the estate and for the purposes of capital gains tax the personal representatives are deemed to acquire the assets at their probate valuation. The transfer of assets from the deceased to his personal representatives which occurs on the death of a taxpayer is not considered to be a disposal of the assets for the purposes of capital gains tax and neither is the transfer of the assets from the personal representatives to the beneficiaries who again are deemed to acquire them at the probate valuation. If the personal representatives dispose of assets to anyone other than the legatees during the course of the administration of the estate (for example, if they sell assets to raise funds to pay debts), there is a disposal and a potential liability to capital gains tax, but the estate can claim the individual’s annual exemption allowance for the tax year in which the death occurs and the two subsequent tax years.

Capital gains tax and trusts

Trusts (other than bare trusts and settlor interested trusts) are treated as separate entities for the purpose of capital gains tax and transfers into and out of trusts are treated as disposals. In the case of a bare trust the assets of the trust are considered to be those of the beneficiary. In the case of a settlor interested trust any capital gains tax liability of the trust is considered to be that of the settlor. A UK settlor interested trust for capital gains tax purposes is one from which the settlor or his spouse, civil partner or unmarried, under-age children who are not or have not been in a civil partnership can benefit.

The rate of capital gains tax charged in the case of a bare trust is that of the beneficiary unless the beneficiary is the settlor’s child who is under age and has not married or entered into a civil partnership, in which case the gain is taxed as though it were the settlor’s. Because the beneficiary of a bare trust is considered to be the owner of the property for the purposes of capital gains tax, the capital gains tax exemption allowance to be applied is the full one for an individual and not the half-rate allowance usually given to other trusts.

In the case of an interest in possession trust or relevant property trust, capital gains are assessed as those of the settlor if the settlor or his spouse or civil partner retains an interest in the trust or the settlor’s under-age child who has not married or entered into a civil partnership is a beneficiary; otherwise they are taxed at the rate applicable to trusts. The rate of capital gains tax applicable to trusts is currently 40%.

Hold-over relief can be claimed when transferring assets into interest in possession trusts and relevant property trusts, provided that they are not bare trusts or settlor interested trusts. Hold-over relief means that the payment of any capital gains tax on the transfer is postponed until the assets transferred are disposed of by the trust and at that time taper relief is calculated by reference to the original cost to the settlor and the time that has elapsed since the date the settlor acquired them although it is proposed to abolish taper relief for capital gains tax on 5 April 2008.