Periodic charges

This article looks at the areas you need to consider when advising your trust clients about the periodic charge.

The UK Finance Act 2006 saw radical changes to the inheritance tax (IHT) treatment of interest in possession (IIP) trusts created on or after 21 March 2006. It led to many insurers moving their default flexible trusts from power of appointment trusts to discretionary trusts. Discretionary trusts fall under the relevant property regime and are referred to as ‘relevant property trusts’. Relevant property trusts are all subject to entry, exit and periodic charges – though there are some exceptions, such as trusts for vulnerable beneficiaries.

Other trust types also fall under the relevant property regime; such as IIP Trusts created on or after 21 March 2006 (unless part of a Will). The rules can be complex and the trustees may need to seek further advice on the nature of the trust.

The periodic charge offers a significant advice opportunity as the trustees will need to calculate any periodic charges and understand the future impacts for distributions to beneficiaries.

So, what should you consider when meeting with your affected trustee clients?

Pertinent questions for review

• How many relevant property trusts has your client, as settlor, created?
• When were the trusts created and what amounts were initially paid into them?
• Were there any Chargeable Lifetime Transfers made in the seven years prior to the date the trust was created?
• Have there been any premiums paid to the trust since it was created? If so, when?
• If there were premiums paid / gifts made into the trust since it was created, were there any Chargeable Lifetime Transfers made in the seven years prior to the date of the most recent premium paid / gift made?
• If there were premiums paid / gifts made into the trust since it was created, were there any other Chargeable Lifetime Transfers made on the same day to a different settlement?
• What is the current value of the trust fund?
• Have there been any distributions from the trusts (regular withdrawals from the bond) in the last ten years? (This would exclude regular withdrawals to the settlor on DGTs and loan repayments for loan trusts).
• Are you planning to distribute the trust assets soon?

This list is not exhaustive but will cover most circumstances.

The charge

Once you have the answers to the above questions, you can then consider whether there is a real likelihood that IHT will become payable by the trustees and what options are available to them.

It is the trustees’ responsibility (in conjunction with their tax adviser), to calculate, report and pay any periodic charge for the trust.

Our quick reference guides provide an illustrated explanation of how to calculate periodic charges, but a brief summary is given below:

The periodic charge is based on:

• the value of the trust fund the day before the ten year review, PLUS
• the ‘historic value of any related settlements (other discretionary trusts created on the same day by the same settlor), PLUS
• the value of any addition made to another trust created by the same settlor on the same day as an addition to this trust (same day addition), PLUS
• any previous chargeable transfers in the seven years prior to creating the trust, PLUS
• any distributions that gave rise to an exit charge in the past ten years, LESS the current NRB at the time of the review.

The resulting sum will represent the excess liable to charge. This excess is then multiplied by the lifetime rate (20%) and then the actual charge is 30% of this, as follows:

Excess = £100,000

£100,000 x 20% = £20,000

£20,000 x 30% = £6,000

If the settlor has trusts created on the same day, then these are likely to be related settlements. Therefore only one nil-rate band will be available to calculate the periodic charge based on the combined values of the trusts. This also applies where additions have been made to unrelated settlements on the same day. The additions have the effect of making these settlements related.

To help with the process we have made a 'Discretionary Trust Tax calculator' available. This will prompt you to enter the above data items and calculates the tax charge payable for you.

Considerations

• It may be worth looking at whether the trust is still needed. If there was no initial charge on creating the trust then, generally, there will be no exit charges on distributions from the trust before the ten year review. However, careful consideration of the chargeable events position must be given.
• Is the trust is still needed? If so how will the trustees fund the payment of tax for the periodic charge?

Example

• If, for example, a bond was the only asset within the trust fund, it would be necessary for the trustees to make an encashment from the bond.
• If the settlor is alive and UK resident at that time and the amount exceeds the 5% tax deferred withdrawal allowance, then the settlor will be assessed and liable to pay income tax on the chargeable gain at their highest rate of income tax.
• If the settlor is not UK resident, but it is a UK resident trust then the trustees will be liable to pay the income tax at 45% (currently) for any gain in excess of the first £1,000 (which is currently payable at 20%).
• If the settlor is not UK resident, and it is not a UK resident trust, then no UK income tax will be payable, but there may be local taxes payable by the trustees.
• Timing of the encashment may therefore be crucial to maximise income tax allowances.
• If a periodic charge is payable, the Trustees will need to complete an IHT100D form to HM Revenue and Customs and pay the inheritance tax due.
• They must ensure they keep accurate and up to date records of the review and the tax return.
• The events that may happen in the next ten years in terms of adding to the trust or making distributions.
• Distributions to beneficiaries may be impacted by the periodic charge as future exit charges will be calculated as a fraction of the periodic charge.

Discounted gift schemes

Discretionary trusts written as discounted gift schemes offer the settlor(s) a right to fixed withdrawals throughout their lifetime. As part of the gift is retained, the value attached to the gift is discounted by the market value of the right to receive income, i.e. what someone might pay for that income stream on the open market. For example:

A gift of £500,000 with income of 5% of the initial premium (£25,000 per annum) might be discounted by £280,000 leaving a discounted gift of £220,000. This would bring the gift under the Nil Rate Band (assuming no other gifts) and avoid an entry charge.

At the 10th (and 20th/30th etc.) anniversary, the relevant property within such an arrangement must be valued to establish whether there is a charge to IHT. This is explained within HMRC guidance - Brief 22 Discounted Gift Schemes. The guidance confirms that the value associated to the income stream retained by the settlor(s) must be revalued when a periodic charge calculation is due.

To establish the revised value associated with the right to withdrawals, an actuarial calculation is required using the age at commencement (including any additional years for poor health) plus 10 years (or 20/30 etc.). As this calculation is complex, trustees should look for guidance from the insurer who issued the scheme and calculated the ‘discount’ value at commencement.

Once the revised value of the income has been established, the calculation described in the previous section can be performed using the trust fund value, minus the value associated to the income: the ‘discount’.

Updated: August 2020