Outline

IHT is a direct tax on gifts by individuals and Trustees of property (including cash). It previously existed as CTT, which underwent some fundamental reforms in the Finance Act 1986. ED was the forerunner of CTT. The IHT treatment of trusts has, more recently, been dramatically changed by the Finance Act 2006 ("FA2006"), along with various other trust modernisations. The Finance Act 2008 ("FA2008") has also modified the treatment of certain successive life interest following FA2006.

IHT applies to the world-wide estate of an individual who is domiciled in the UK (or deemed domiciled under the special rules which apply for IHT purposes). In the case of a non-UK domiciliary the tax only applies to his assets in the UK - see Domicile and Residency.

When is the Tax Chargeable?

IHT is charged whenever there is a chargeable transfer. Broadly, this is a disposition which reduces the value of the transferor's estate and which is not an exempted or relieved transfer (see 3 below) or is under the nil rate band (£312,000 for 2008/09) being the value that may be given without IHT becoming chargeable in any seven year period.

In addition, IHT is charged in certain other situations specified by statute in which there is deemed to be a transfer of value, for example, where a person has an interest in possession in settled property and that interest comes to an end. However, following the FA2006, this only applies in limited circumstances, see a) below. The effect of the FA2006 is that most new trusts and eventually many existing trusts will be charged to IHT under the discretionary trust regime, please see b) for more details.

It is important to consider whether the action you are taking attracts IHT.

IHT is immediately chargeable in a number of situations including the following:

1. Death

   On a person's death he is deemed to make a transfer of all the property including cash within his estate at that time.

   The value transferred on death is cumulated with the value of the chargeable lifetime transfers made within 7 years before the death and the potentially exempt transfers (PETS - see below) that lose their potentially exempt status because of the death. This total value is the basis of determining the rate of tax payable on death.

   A person's estate includes not only the property that he owns outright but also the property in trust in which he has a life interest, provided it was created: before 22nd March 2006; out of such a trust before 4th October 2008; or under a Will or Intestacy such as an Immediate Post Death Interest ("IPDI") - see b) below. A death estate would include the value of the property underlying the life interest trust (not just the value of his interest in the settled property). For example, if a person has a life interest in a picture (which is worth £100,000 at his death) he is treated as making a transfer of value of £100,000 on death.

   However, once a life interest created before 22nd March 2006, or a successive life interest created before 4th October 2008 or an IPDI, comes to an end, any other successive life interest will be taxed under the discretionary trust regime and the underlying trust property will not be added to the life tenants estate on his death.

   In addition to an IPDI mentioned above, two further trusts were created by the FA2006 known as a Bereaved Minor Trust ("BMT") and under an 18 to 25 Trust - see b) below for more on these new trusts. If a beneficiary under either trust dies under the age of 18, the value of that interest is also added to their death estate.

   Before 22nd March 2006, if a beneficiary under an Accumulation & Maintenance ("A&M") trust died before taking an absolute or life interest under the trust there was no IHT consequence then. If the beneficiary died with a life interest in that trust, the value of that interest would be added to their free estate and taxed as described above.

   The FA2006 changed the rules on A&M trusts. Provided, by 6th April 2008, beneficiaries of a pre-22nd March 2006 A&M trust take absolutely at 18 that trust will continue to be taxed in the same way before the beneficiary takes at 18. After 18, his share would be taxed as part of his estate. If the beneficiaries of a pre-22nd March 2006 A&M trust take absolutely at 25, shares in that trust will not be taxed under the discretionary trust regime until a beneficiary reaches 18. If a beneficiary then dies, receives capital or the trust interest vests absolutely at or before 25 there will be an exit charge in the same way as an 18-25 Trust - see b) below. If a beneficiary dies between 18-25, the value of his share will not be aggregated with his free estate on his death.

   The death of a beneficiary of a trust taxed under the discretionary trust regime has no IHT consequence.

2. Lifetime

   If an interest in possession, A&M or a discretionary trust were created after 22nd March 2006, it would be taxed under the discretionary trust regime. The value of the transfer in excess of the nil rate band would be charged to IHT at 20% unless the transfer of value is relieved or exempted - see 3 below. It is the view of HMRC that any property added, after 22nd March 2006, to a life interest or A&M trust in existence before 22nd March 2006 will also suffer an immediate charge to IHT and would then be subject to the discretionary trust regime. In effect there would be two settlements.

   As well as the immediate charge to tax, the discretionary trust regime imposes a charge known as 'the periodic charge', which is levied every ten years at a maximum rate of 6% on the value over the nil rate band in relation to that trust. There is also an exit charge (which at present will be at a rate lower than 6%) if the property stops being subject to the trust. There are special rules to establish when the ten-year anniversaries occur, as it is not necessarily ten years from when the trust is first established.

   Transfers to an individual, a qualifying disabled trust under the FA2006 or a bare trust will continue to be treated as a PET, see 4) below, and these two trusts will be taxed under their own regime, as they were before the FA2006. These transfers are not subject to the 20% IHT charge.

   A pre-22nd March 2006 A&M trust where the beneficiaries do not take an absolute interest in the trust property by 25 will be taxed under the discretionary trust regime from 6th April 2008. When the first ten-year charge applies will depend on whether or not the ten-year anniversary is after the 6th April 2008. A settlement date of 22nd December 1999 would make the first ten-year charge as 22nd December 2009. If, however, the A&M trust were created on 20th June 1997 then the first ten-year charge would be 20th June 2017.

   A life interest trust created before 22nd March 2006 or a successive life interest created out of it before 4th October 2008 will continue to be taxed under their original tax regime and therefore will not be subject to an immediate charge to tax, ten-year or exit charges. When these life interests come to an end, any successive life interest will then be subject to ten-year charges on the trust capital over the nil rate band and exit charges on any capital leaving the trust as well as the periodic charge. Where the initial life interest trust was not in favour of the settlor or his spouse, the first ten-year anniversary after the death of the life tenant will be based on the date of the settlement's creation. If the settlor or spouse had an interest then the first ten-year anniversary will be based on the date of death of the life tenant.

   The FA2006 also created three new trusts referred to above in a), which may only arise under a Will or by Intestacy and which escape the discretionary trust regime. The first is an IPDI, which is a life interest trust and continues to be taxed as such. An IPDI may benefit anyone, including a spouse, but the income interest must take effect immediately on death.

   A parent may create the second new type of trust, a BMT, so that trust capital would be taken at 18. The child's share may not be varied after the death of the parent. There is no IHT charge when the child attains 18 and no exit or periodic charge before hand. When the child takes at 18 there is a CGT disposal, any gains may be heldover - see CGT below. If the child dies before 18 with an interest in possession then that value is taxed to IHT and there is the usual CGT uplift to death market value - see CGT below. However if a beneficiary dies before 18 and without an interest in the trust, there is no IHT payable and there is no disposal for CGT purposes.

   The last new trust is the "18 to 25 trust", which may only be set up by a parent and under his/her Will. This trust allows the parent greater control and it also avoids any exit or periodic charges until a child reaches 18. There is no IHT charge on reaching 18 and if the child dies before then there is no IHT consequence. If a child receives capital between reaching 18 and attaining 25 or if he dies before 25 there will be an exit charge at a rate that increases each quarter up to 25 when the maximum rate is 4.2%. This exit is a disposal for CGT but holdover relief is available - please see CGT below.

Exempt & Relieved Transfers

The available exemptions include the following:

1. Lifetime transfers of property between spouses and civil partners ("spouses") are exempt, (unless the donor spouse is domiciled in the UK but the donee spouse is not, in which case a £55,000 limit applies to the exemption), as was a lifetime transfer before 4th October 2008 to a spouse of a life interest in existence before 22nd March 2006 or a successive interest created out of that interest before 4th October 2008. This life interest will then continue to be taxed as a life interest trust.

   Death transfers are subject to the same domicile restrictions as mentioned above. An absolute transfer to a spouse is exempt to IHT as is a life interest that takes immediate effect. If the life tenant spouse of a pre-22nd March 2006 life interest trust dies and leaves his/her interest to the spouse this exemption will apply, even if the life tenant died after 4th October 2008. This life interest will not be taxed under the discretionary trust regime but under the old regime for life interest trusts and will therefore aggregate with the death estate of the surviving spouse.

2. Transfers to charities, to political parties, for the public benefit and for national and similar purposes are exempt. These concepts are defined in the legislation. The latter category covers transfers to the bodies listed in IHTA 1984 Schedule 3 (see Appendix A), which includes the National Gallery and the British Museum as well as any local authority or university college.

3. Conditional exemption can be applied for in respect of property, which qualifies on grounds of national, historic, artistic, scientific, scenic or architectural interest, depending on the type of property involved and by historical association with a heritage building. Please see - Conditional Exemption for Works of Art below.

4. Property subject to surviving spouse relief in relation to ED regime. When ED applied, if property were left by one spouse to the other, and the other only had a life interest in the property, the property was exempt from ED on the death of the surviving spouse. If the first death took place before 13th November 1974, such property would be exempt from IHT on the death of the surviving spouse or if the interest of the surviving spouse ends during his or her lifetime.

5. Provided a business asset has been owned for at least two years, Business Property Relief ("BPR") reduces the value of a transfer by:

   100% if the asset is an unincorporated business or a share in it, or unquoted shares in a business; or

   50% if the assets are quoted shares in a business giving control or land machinery or plant used wholly or mainly in a company in which the transferor had control or a partnership in which he was a partner, and any trust property used for the purpose of a business carried on by the life tenant.

   Business assets must be wholly or mainly used in the trade. BPR is not available to a business whose activities are mainly or wholly specifically excluded such as dealing in land and securities and making and holding investments. Business assets that are wholly or mainly used for private use will not qualify for BPR.

   BPR relieves IHT rather than exempts it. On a lifetime transfer of a business interest the donee must continue to hold the interest for seven years in order that BPR would apply fully although the position is different on a death.

   Agricultural Property Relief may apply to agricultural property but it is unlikely to apply for our purposes.

   Note that the above exemptions are capable of applying to lifetime transfers as well as the transfers on death.

6. Each year a person may make gifts up to the value of £3,000 without incurring IHT. Any unused part of the exemption can be carried forward for one year only.

7. A transfer in consideration of marriage of no more than £5,000 by each parent of a party to the marriage is exempt. The exemption is £2,500 for gifts by any remoter ancestor of either party to the marriage. Anyone else can give £1,000 in consideration of the marriage.

Potentially Exempt Transfers (PET)

Since 18th March 1986, IHT could be avoided by transferring property to anyone other than to a discretionary trust or a company provided the donor survived the gift by seven years. No IHT would be charged when this gift is made. This is known as a PET.

If a parent gave a work of art to a child, which was then taken to the child's house, that would be an example of a PET. However, a similar gift between spouses would not usually be a PET, as such a transaction mould normally be exempt already (see 3a above).

If the transferor dies within 7 years however, then the transfer has its potentially exempt status removed retroactively and tax if appropriate, becomes payable on the value at the date of transfer unless a GWR arises - see 5) below.

Since the FA2006, a lifetime transfer to an individual, a bare trust, or a qualifying disabled trust will continue to be treated as a PET. The termination of a life interest created before 22nd March 2006 or a successive life interest created out of such a trust before 4th October 2008 will also be treated as a PET as the trusts will be taxed under their original tax regimes. It appears that only a termination of the whole life interest will be treated as a PET.

The termination of an IPDI so that trust property vests absolutely in an individual or a disabled trust will both be treated as a PET, as will a successive life interest to a qualifying disabled trust under the FA2006. Also qualifying as a PET is the replacement by a BMT of a parent's IPDI. If an IPDI is terminated in any other way there will be an immediate IHT charge of 20% if over the nil rate band and the successive trust interest will be subject to the discretionary trust regime.

When a PET becomes chargeable, the transfer is for most purposes treated as having taken place when it actually occurred and so it is the value of the property at the time of the transfer, not at the time of death, that is brought into account. If the tax rates have been reduced since the date of transfer, the reduced rates will apply. Otherwise, the amount of tax is determined by the death rates prevailing at the time of death.

When a PET becomes chargeable, because the transfer is treated as chargeable at the date of the transfer, tax on chargeable transfers or later PETs made within the last seven years of death may need to be paid or adjusted.

Where the donor dies more than 3 years after the transfer, the rate of tax (not the amount of value transferred) is reduced by 20% for each completed year survived after the first 3 years. That is, the tax is reduced by 20% after 3 years, 40% after 4 years, 60% after 5 years, 80% after 6 years, and there is no tax if 7 years elapse.

Usually, the tax is due from the donee.

Gifts with a Reservation of Benefit ("GWR")

Special rules apply if a person makes a gift while reserving some benefit for himself in the property transferred. Although the gift may effectively transfer legal title in the property, the donor will still be treated as beneficially entitled to the property for IHT purposes unless, in the case of land or chattels, the reservation is for full value. If the gift was intended to be a PET, the 7-year period will not start to run unless and until the enjoyment of the benefit ceases, at which point there will be a deemed PET. A gift with a reservation of benefit can only be made on or after 18th March 1986. Before that date, the reservation of benefit rules did not apply to CTT or ED.

What constitutes a benefit is not always easy to determine. If a person makes a gift of his pictures but keeps them on the walls of the house where he lives, there would be a GWR and, unless a full market rental was negotiated and paid for the enjoyment of the pictures, the gift would not be effective for IHT purposes.

The FA2006 has extended the ambit of the GWR regime. If an ex- life tenant benefits from previous trust property, a GWR will arise. Previously, trustees could terminate a life interest and no GWR would have arisen if the life tenant later took benefit. The following life interests will also now be caught: life interest trusts created before 22nd March 2006 or a successive interest created before 4th October 2008; an IPDI created after 22nd March 2006; and a disabled persons interest in an a pre-6th April 2008 successive interest created out of an pre-22nd March 2006 trust. If original property were swapped into new property, tracing provisions allow the GWR regime to apply to the replacement property.

The GWR regime will also apply where a spouses' life interest, created under a Will, were terminated by trustees in favour of a discretionary trust of which that spouse may benefit. Interestingly, it appears where a settlor created a life interest for himself after 22nd March 2006 a GWR will not arise as the trust property is no longer deemed to be part of his IHT estate.

Licences for the Use of Chattels

Owners of works of art, as with any other assets, may wish to transfer them to the next generation to ensure continuity of ownership. However, the donor may not wish to part with them even though ownership has transferred.

The normal result of making a gift and surviving the requisite seven years under the PET regime is that the value of the PET would then fall out of the donor's IHT estate.

Following the introduction of the GWR regime, any benefit derived by the donor from a donated asset would invalidate the IHT effect of making the PET and the value of the chattels would remain within the donor's IHT estate. In order to avoid this, the usual course of action is for the donor and the new owner to enter into an agreement for the use of the chattels whereby the donor pays for the continued use.

The relevant legislation makes it clear that provided a full consideration is paid "in money or money's worth" for the use of the assets in which a benefit is retained, the value of gift will fall out of the donor's IHT estate in the normal way. The consideration is made up in part by a rental fee which should be agreed by independent negotiators on behalf of both parties within the parameters of existing practice and which would have to be reviewed on a regular basis. The donor may also agree to accept various obligations and these expenses may be factored into the overall consideration.

Pre-Owned Assets Tax (POT)

The POT regime imposes an annual income tax, starting on 6th April 2005, on the value of assets previously given but which the owner still takes benefit. This tax applies to gifts or sales under market value that took place after 17th March 1986 although the tax will not be charged until the tax year 2005/06 and so the tax has what the government describes as a retroactive rather than a retrospective effect. This tax carries a tracing provision; cash given to buy an asset, which is later enjoyed could still be subject to POT.

The POT charge applies to UK domiciled individuals on their worldwide assets whereas POT is only applicable to UK assets for a non UK domiciliary.

Chattels caught by this tax are subject to income tax on a statutory 5% of their value. If you are a 40% taxpayer and the chattels are valued at £500,000 the benefit would be £25,000 with an annual income tax charge of £10,000. Chattels must be re-valued every five years.

However, there is no income tax charge where the benefit is under £5000, the assets are within the taxpayers IHT estate or special GWR rules are complied with.

If a taxpayer has successfully avoided the GWR rules but is now caught by the POT regime, he/she may have elected by 31st January 2007 to opt back into the IHT regime. However, HMRC may consider a late election.

A pre-22nd March 2006 life interest benefiting the settlor was not subject to a POT charge as the interest was part of the settleors IHT estate. However, the same trust created after 22nd March 2006 would be subject to POT and an income tax charge could arise.

Trusts on Divorce

Before decree absolute is declared the spouse exemption continues. Following the budget announced on 22nd March 2006, this exemption still applies after decree absolute on a transfer of assets pursuant to a court order and where the assets were not intended to confer any gratuitous benefit or the transfer was for the maintenance of the ex-spouse.

On or before 22nd March 2006, trusts could secure the children’s interests, while giving the former spouse a life interest, and there would be no exit or periodic charges and the initial transfer was either exempt or a PET. After 22nd March 2006, following the 2006 Budget, trusts created as a result of a divorce will be treated for IHT purposes as any other trust.