Last Opportunity For Life Interest Trusts To Avoid UK Tax Hit, Advisor Warns

by Robert Lee, Tax-News.com, London

11 September 2008

There are less than four weeks left to reorganise existing life interest trusts without triggering a tax charge in the UK under the new Inheritance Tax (IHT) rules, reminds Deloitte, the advisory firm.

The new rules were introduced in the Finance Act 2006 with a two-year transitional period, originally due to expire on April 5 this year. Under the Finance Act 2008 this deadline was extended to October 5, 2008.

Paula Higgleton, head of UK private client services for Deloitte, comments: “There is now a very limited window of opportunity for individuals receiving income from a trust to give all or part of it away without triggering a tax charge under the new IHT rules.”

A Life Interest trust is a trust where the income is paid to one or more named individuals (sometimes called the life tenant(s)), but the capital will ultimately go to someone else. The old IHT rules treated the person with the income entitlement as if they owned the underlying capital.

The Finance Act 2006 introduced major changes to the way that the inheritance tax rules apply to many trusts, including life interest trusts. The new rules treat a trust as if it was a separate entity; inheritance tax is charged when the trust is established at 20% (or up to 40% if the donor dies within 7 years), and when property leaves the trust, as well as on the tenth anniversary when the trust is treated as having being established.

Paula Higgleton adds: “Provided the individual terminating all or part of their interest in favour of another life tenant survives for at least seven years, no inheritance tax liabilities will arise on the transfer. If the donor doesn’t survive, the effect could be to accelerate the IHT charge. The real advantage here is that it postpones the time when a Life Interest trust enters the discretionary trust regime.”

HM Revenue & Customs (HMRC) has confirmed this relief can apply where only part of an interest is terminated in favour of a life interest in favour of another beneficiary. Paula Higgleton explains: “This makes the idea attractive to individuals who previously felt that the gift of their entire interest was a step too far as they might need the income for their living costs, for instance in old age.”

However, if no further action is taken, continuing trusts will be liable to 10-year and exit charges. Significantly, the spouse exemption would not be available on the death of the life tenant. She adds: “With careful additional planning the surviving spouse of a beneficiary of the transitional relief may also be able to benefit from the spouse exemption when the beneficiary dies.”

Paula Higgleton continues: “This planning will be useful for trusts where an individual had a life interest prior to March 22, 2006. It will be particularly relevant for those offshore trusts that were established during the 1980s and have substantial pools of trust gains which can make it uneconomic to consider the outright termination of trusts. But tax can be saved equally where the trust is UK resident, and where the aim is simply to postpone the date when the beneficiary will inherit the trust capital.”

After October 5, a termination of a pre March 22, 2006 life interest in favour of another interest in possession, whether partial or otherwise, will be a chargeable lifetime transfer and therefore subject to tax.

Therefore, says Deloitte, the extension of the transitional period is an important planning opportunity which trustees of interests in possession settlements must consider.

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