Inheritance tax (IHT) changes are not perhaps as frequent as other taxes, although there have been major changes over the past ten years or so, such as in relation to the IHT treatment of trusts and also the transferable nil rate band facility.
Further changes, albeit less radical ones, were announced in Budget 2014 and included in Finance Bill 2014, some of which are outlined below (Note: Finance Bill 2014 has not received Royal Assent at the time of writing, and is therefore subject to change).
1. IHT nil rate band
The IHT nil rate band has remained at £325,000 since 2009/10. In Finance Act 2010, the nil rate band was frozen at £325,000 for the tax years 2010/11 to 2014/15 inclusive. Legislation in the Finance Bill 2014 extends the freezing of the nil rate band at £325,000 for the tax years 2015/16 to 2017/18 inclusive.
In doing so, the government has effectively switched off the legislation in IHTA 1984, s 8, which otherwise allows the nil rate band to be increased by indexation for each tax year.
2. Liabilities and foreign currency bank accounts
The government introduced legislation in Finance Bill 2014 to close a perceived ‘loophole’ in the IHT provisions introduced in Finance Act 2013 restricting deductions for liabilities in certain circumstances. This change relates to liabilities incurred to fund foreign currency bank accounts.
The new provision applies where the balance on a qualifying foreign currency account is to be left out of account (under IHTA 1984, s 157 ‘Non-residents’ bank accounts’) in determining the value of a deceased person’s estate, if the person had borrowed money which was held in that account, or had a liability which indirectly financed the funds held in it. A foreign currency bank account balance (within s 157) is left out of account on the death of a person who is not domiciled and not resident in the UK. It is not ‘excluded property’ as such for IHT purposes, but is treated in a similar way on death.
The effect of this provision is broadly that the liability is disallowed for IHT purposes if the borrowed money financed the foreign currency account balance. If the liability exceeds the relevant balance, the excess may be allowed, provided that it has not arisen for the purpose of securing a tax advantage or an increase in the amount of the liability (new IHTA 1984, s 162AA).
There are also provisions dealing with the partial repayment of liabilities used to acquire relevant account balances and other assets before an IHT charge arises, which provide an order of priority for the deduction of such repayments. The changes apply to transfers of value made (or treated as made) from the date that Finance Bill 2014 receives Royal Assent.
3. Trust filing and IHT payment dates
A simplification measure for ‘relevant property’ (e.g. discretionary) trusts provides for the filing date for IHT returns, and the deadline for IHT payments, to be aligned in respect of trust IHT charges, such as ten year anniversary or exit charges.
For trust IHT charges prior to the changes in Finance Bill 2014, the time limit for filing an IHT account is the later of twelve months from the end of the month in which the transfer is made, or three months from the date when the trustees first become liable for the IHT, if later (IHTA 1984, s 216(6)(c)). With regard to IHT payments, the deadline for a payment depends on when the chargeable event occurred. If the chargeable event occurred between 6 April and 30 September inclusive, the IHT generally becomes payable no later than 30 April in the following tax year. If the chargeable event occurred between 1 October and 5 April inclusive, the IHT is due six months after the end of the month in which the chargeable event takes place (IHTA 1984, s 226(1)).
However, for IHT charges in respect of relevant property trusts on or after 6 April 2014, the filing and payment dates are generally aligned. The IHT return must be filed, and the related IHT payment must be made, no later than six months after the end of the month in which the chargeable transfer or event occurs (new ss 216(6)(ad), 226(3C)).
The following example compares the filing and payment dates under the ‘old’ and ‘new’ rules.
Example 1 – Ten year anniversary
The Lee discretionary trust had its first ten-yearly anniversary on 10 April 2013. The IHT filing and payment dates are based on the ‘old’ (pre-Finance Bill 2014) rules.
Assuming that the trustees are obliged to file an IHT return, they must do so no later than 30 April 2014 (i.e. 12 months from the end of the month in which the chargeable event occurred). The deadline for paying the ten year IHT charge is also 30 April 2014.
A year later (on 10 April 2014), the Lee discretionary trust appointed an asset to a beneficiary. This is a chargeable event, and an IHT return needs to be filed. Following Finance Bill 2014, the IHT return and payment must both be submitted to HMRC no later than 30 October 2014.
In the above example, the filing and payment dates are much shorter under the ‘new’ rules than the ‘old’ ones. Trustees and their advisers should note and prepare for these changes accordingly, to avoid potential penalties and interest charges in the future.
4. Trusts: Ten Year Anniversary Charge
The ten-yearly IHT change also relates to relevant property trusts, such as discretionary trusts. It concerns the IHT treatment of trust capital. Broadly speaking, if a trust receives income and the trustees distribute it to beneficiaries shortly afterwards, the income generally retains its identity as income as opposed to capital for IHT purposes. However, suppose that the income is not immediately distributed to beneficiaries, but remains held within the trust.
Trust income which is not distributed to beneficiaries is often accumulated by the trustees and treated as additional capital. For example, some trust deeds state that if the trustees do not distribute trust income within a certain period (say, two years), the income must be treated as capital. Alternatively, the trust deed may allow the trustees discretion to accumulate trust income as capital.
However, in some cases the trust deed may not stipulate when income must be accumulated and treated as capital. This can cause difficulty when calculating the IHT position on a ten year anniversary of a relevant property trust, particularly when trust income remains undistributed for long periods.
Previously, there was no rule in the IHT legislation about when undistributed income became capital. However, Finance Bill 2014 broadly provides that for ten year IHT charges (under IHTA 1984, s 64) from 6 April 2014, trust income which remains undistributed for more than five years up to the ten year anniversary will generally be treated as part of the trust capital for the purposes of the IHT calculation (new s 64(1A)-(1C)).
Thus, when calculating the ten year anniversary charge for IHT purposes, it will generally be necessary to look at the trust fund and identify whether any of the income arose more than five years previously. That might sound like a straightforward exercise. However, suppose that a discretionary trust has received income every year for the last ten years. Some income is paid to beneficiaries, and some income remains undistributed. Which income should be treated as having been distributed first – the income which arose more than five years ago, or the income which arose less than five years ago?
HMRC published a document ‘Inheritance tax: simplification of trust charges – the next stage’ in December 2013, which suggested a potential solution. It states (at para 3.56):
“We realise that trust accounts may not necessarily show how the income in hand figure at the ten year anniversary is made up, but the…rule ought to encourage trustees to ensure that they have distributed the earliest net (after trustee expenses) income first. In such cases, HMRC would accept a ‘first in, first out’ approach, giving the taxpayer the greatest benefit at the ten year anniversary.”
So at least that’s some good news for trustees. However, there is some bad news as well. When calculating the IHT rate for the ten year anniversary charge, a reduction is generally made in respect of assets which were not relevant property (or were not owned by the trust) throughout the whole of the ten year period (IHTA 1984, s 66(2)). However, following the change in Finance Bill 2014, IHT will be charged at the full rate on any trust income treated as capital under the ‘five-year rule’ mentioned earlier, without any proportionate reduction to reflect the period during which the income was retained.
The reason given by HMRC for this rule is that it would avoid the need for trustees to keep very detailed records. Unfortunately, it seems that this ‘simplification’ will come at a cost in IHT terms.
5. IHT simplification of trust charges
This IHT measure was originally going to be introduced in Finance Act 2014, but has now been postponed, probably until Finance Act 2015. As mentioned above, HMRC published a document on the IHT simplification of trust charges in December 2013. This was in response to a consultation document published in May 2013, which outlined a number of possible areas for simplification or reform.
One of the proposals put forward in the May 2013 consultation document potentially affects IHT planning arrangements involving pilot trusts. A ‘pilot trust’ is broadly a discretionary trust set up during a person’s lifetime. As mentioned, IHT is calculated on chargeable events in respect of ‘relevant property’ trusts, such as on the ten year anniversary of a discretionary trust, or on a capital appointment to a beneficiary of the trust (commonly known as an ‘exit charge’).
For example, in the case of ten year anniversary charges for trusts, the IHT rate depends on a number of factors, one of which is whether the settlor created any ‘related settlements’. The ‘related settlements’ legislation is an anti-avoidance provision. Two or more settlements are ‘related settlements’ broadly if they were created by the same settlor and commenced on the same day (IHTA 1984, s 62). The application of this anti-avoidance rule can be prevented if the settlor arranges for separate settlements to commence on successive dates. A settlement ‘commences’ for these purposes when it is first made, notwithstanding any later additions (IHTA 1984, s 60).
It may therefore be possible for a settlor (who has not made any chargeable transfers) to set up on different dates a succession of small pilot settlements (e.g. with £10 each). The settlor can then leave additional assets to each of the settlements on the same day, perhaps in his or her will. Each settlement falls to be treated as a separate settlement for IHT purposes (following the case Rysaffe Trustees (CI) Ltd v IRC  STC 536)), with the benefit that each trust has its own nil rate band in the IHT calculation of the ten year charge.
One proposal put forward in HMRC’s consultation document in May 2013 was to split the IHT nil rate band between the number of settlements created by the same settlor, and to apply an IHT rate of 6% in the calculation of ten year charges, and for exit charges as well.
Interestingly, when the general anti-abuse rule (GAAR) was introduced in Finance Act 2013, HMRC published guidance on the GAAR (www.hmrc.gov.uk/avoidance/gaar.htm), which includes examples to illustrate when various arrangements might, or might not, be treated as abusive for the purposes of the GAAR (albeit that they may still be challenged by HMRC on other grounds). One of the examples specifically deals with pilot trusts, which HMRC’s guidance describes as “a long-established practice approved by the courts”:
Example 2 – Pilot Trusts
‘C wishes to leave his estate in trust for his 7 grandchildren. He wants to ensure that these settlements are not subject to IHT after his death. C establishes one settlement per day over a period of 7 days, settling £100 on each. He revises his Will so that he leaves a specific legacy of £250,000 free of tax to each settlement. Following his death, his executors pay the legacies to each of the trustees.’
HMRC’s analysis of the IHT position in this example is as follows:
‘On C’s death, his estate will be subject to IHT and the tax will be borne by the residuary estate. But going forward, each settlement will benefit from its own nil-rate band and the funds added to each of the other settlements will not be taken into account in arriving at the rate of tax as the settlements are not related settlements. Provided that the value of the settled property remains below the IHT nil-rate band, the trusts will not pay any tax.’
HMRC’s conclusion was that ‘The arrangements accord with established practice accepted by HMRC and are accordingly not regarded as abusive.’
Continuing the above example, but this time adopting HMRC’s proposal to split the IHT nil rate band between the number of settlements created by the same settlor, and using a flat IHT rate of 6%, suppose that, on the ten-year anniversary of the trusts the value of assets in each of them has increased to the current nil rate band of £325,000. Assuming in this example that there is no increase in the nil rate band:
- Each of the seven settlements will have a reduced nil rate band of £46,428 (rounded down; i.e. £325,000 divided by seven);
- The chargeable value of each settlement on which the 10 year charge is calculated is £278,572 (i.e. the value of the trust assets of £325,000, less the reduced nil rate band of £46,428);
- The IHT rate is 6%, resulting in an IHT charge for each settlement of £16,714 (i.e. £278,572 x 6%).
So the total IHT under HMRC’s proposal is £116,998 (i.e. £16,714 for each of the seven settlements), compared with no IHT in HMRC’s example under the present regime.
Some of the responses to HMRC’s consultation document in May 2013 suggested that this proposed change was not so much tax simplification as an anti-avoidance measure. There were also concerns that one set of complex rules was being replaced by another complex and potentially more onerous set of rules, and also that it would be unfair to apply retrospective legislation to existing trusts.
HMRC responded to those concerns in its December 2013 document by stating that it would consider alternative ways in which the IHT calculations can be simplified fairly, “without loss to the Exchequer and without the risk of fragmentation of settlements” and that HMRC would be consulting further on this.
It does seem strange that an individual can make gifts up to their IHT nil rate band every seven years, and yet under the proposal to split the nil rate band between trusts created by the same settlor, if that individual transferred assets up to the nil rate band to a new trust every seven years, there would be a single nil rate band divided between the trusts which he or she has created during his or her lifetime. However, it would seem that HMRC is opposed to trusts renewing the IHT nil rate band every seven years, in the same way that an individual can.
HMRC states in the December 2013 document: “we believe that the tax system should be neutral in its treatment of trusts, neither penalising nor encouraging their use”. But HMRC’s current view does not seem to be neutral to someone wishing to set up more than one relevant property trust. It would appear that IHT planning using ‘pilot trusts’ will be affected.
HMRC will be consulting further on its ‘simplification’ proposals with a view to introducing legislation in Finance Act 2015, so we will need to wait a little longer before finding out exactly what the new rules will look like.
Note – Finance Bill 2014 has not received Royal Assent at the time of writing, and is therefore subject to change.