Pilot trusts: GAAR and IHT Simplification

By | 1 October 2013

A ‘pilot trust’ is a term often used to describe a discretionary trust set up during a person’s lifetime. Pilot trusts can be useful for inheritance tax (IHT) planning purposes, due to the way in which IHT charges are calculated on chargeable events in respect of ‘relevant property’ trusts, e.g. on every ten year anniversary of the trust, or when assets cease to be held by the trust as relevant property, such as on a transfer to a beneficiary (commonly known as an ‘exit charge’).

Related settlements

In the case of ten year anniversary charges for trusts, the rate of IHT applied depends on a number of factors, one of which is whether the settlor created any related settlements. Two (or more) settlements are ‘related settlements’ for IHT purposes broadly if they were created by the same settlor and commenced on the same day (IHTA 1984, s 62).

The related settlements rule can be avoided by the settlor arranging for settlements to commence on successive dates. A settlement ‘commences’ for these purposes when it is first made, notwithstanding 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, perhaps on consecutive days) a succession of small pilot settlements, for example with £10 each. The settlor can then leave additional property to each of the settlements on the same day, such as in his or her will. Each settlement falls to be treated as a separate settlement for IHT purposes (see Rysaffe Trustees (CI) Ltd v IRC [2003] STC 536)), with the benefit of its own nil rate band.

Pilot trusts and GAAR

The introduction of a general anti-abuse rule (GAAR) in Finance Act 2013 raised the question whether pilot trusts might be affected by the new legislation. However, HMRC’s GAAR guidance (www.hmrc.gov.uk/avoidance/gaar.htm) includes examples to illustrate when various arrangements might or might not be treated as abusive for the purposes of the GAAR (although 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”.

HMRC example

‘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 taxpayer’s position in the above 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.’

IHT ‘simplification’ 

In May 2013, HMRC published a consultation document ‘Inheritance Tax: Simplifying Charges on Trusts – the next stage’. The document discusses a number of areas for simplification or possible reform.

One proposal put forward in the consultation document is to split the IHT nil rate band between the number of settlements created by the settlor, and using an IHT rate of 6% for ten year (and exit) charges. HMRC explains the rationale for this change as follows:

‘Splitting the nil-rate band is integral to the proposals to simplify the calculations. Without this provision, the scope for any changes to simplify the calculations would be limited due to the risk that it would lead to greater avoidance and the adverse impact to the Exchequer. Dividing the nil-rate band equally or apportioning it between the number of trusts in existence would ensure fairness in the system and protect IHT revenues.’

HMRC also seek to justify the change on the basis that it would ‘replace the burdensome requirement for historical information when calculating the IHT charges.’ However, the need to ascertain the number of settlements created by the settlor may be seen as a ‘burdensome requirement’ for some.

Applying this proposal to the example in HMRC’s GAAR guidance suppose that, on the ten-year anniversary of the trusts the assets in each of them have 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 7 settlements will have a reduced nil rate band of £46,428 rounded down (i.e. £325,000 divided by 7);
  • The chargeable value of each settlement on which the 10 year charge is £278,572 (i.e. £325,000 less £46,428);
  • The IHT rate is 6%, resulting in an IHT charge for each settlement of £16,714.

Simplification or anti-avoidance? 

Having accepted that pilot trust arrangements are not abusive, HMRC considers that splitting the nil rate band between related settlements is necessary to ‘ensure fairness in the system and protect tax revenues’, notwithstanding that this apparent anti-avoidance measure has been proposed under the umbrella of tax simplification.

The proposals in the consultation document also appear to have possible repercussions beyond dispensing with the need for the related property rule in IHTA 1984, s 62. For example, under current law, an individual may set up a new nil rate band discretionary trust every 7 years, each with its own nil rate band. However, the consultation document indicates that (say) in relation to the first 10 year charge, the nil rate band is split between all relevant property settlements made by the settlor and in existence at any time between the date when the trust concerned was set up and the time of the charge (a similar restriction in the nil rate band is proposed for subsequent 10 year charges). This would appear to frustrate the above arrangements whereby the settlor creates settlements at 7 yearly intervals.

HMRC’s consultation period ended on 23 August 2013. Any legislation considered to be necessary is likely to be introduced in Finance Bill 2014.

The consultation demonstrates that although an arrangement may not be caught by the GAAR, this does not necessarily mean that the government and HMRC will not seek to block the arrangement from a tax perspective, by changes in the law.