This articles delves deeper and deals with the tax treatment where a Life Interest Will Trust becomes a purely Discretionary Will Trust, the tax consequences of distributions being made from a Discretionary Will Trust within two years of death and what happens where trust assets are appointed out to another trust, perhaps for a particular family members own family and the treatment of annuities within a Discretionary Will Trust.

Trusts starting out as Life Interest Will Trusts and becoming Discretionary Trusts

It is possible for a Will Trust to start its life as a Life Interest Will Trust and then to become a Discretionary Trust later. For example, a Will Trust could have been set up giving an individual a right to the income of the underlying trust assets or the right to occupy a property. The terms of the trust are that, on the happening of a certain event, for example, the death of the life tenant, or the life tenant reaching a certain age, the trust becomes a Discretionary Trust. On that given event, the Life Interest Will Trust will stop being a Life Interest Trust and will become a Discretionary Trust, liable to exit and principal charges.

Generally, it is the spouse of the deceased that has the right to income for their life and then on their death the underlying assets of the trust are held on a Discretionary Trust. The property now held on Discretionary Trust is treated as a separate trust, made by the person who last had the right to income i.e. the spouse. This is important for exit and principal charge purposes, because it is the spouse’s clock that we take into account for calculating the tax rate i.e. to calculate the actual rate of tax, you look at the Inheritance Tax history of the spouse who had the life interest in the Life Interest Will Trust because it is affected by their cumulative chargeable transfers (i.e. the number of other trusts they’ve set up) in the seven years before their death and the creation of the current Discretionary Trust and by any other trusts set up by them on the same day (i.e. where they have set up a trust in their will). However, the principal charges occur on one of the 10-year anniversaries of death of the original testator i.e. the date the original Life Interest Trust was created, not the date that the trust became discretionary, although the 10-year anniversary only becomes chargeable once the trust has become a Discretionary Trust.

Annuities and Discretionary Will Trusts

An annuity normally takes the form of a fixed amount of annual income to be paid out of trust, for example, a Discretionary Trust could be required to pay a fixed amount every year to a nominated person.

If a beneficiary is entitled to receive an annuity from a trust they will do so net of basic rate tax, so the Trustees will withhold 20% at source. The annuity is generally expressed as a gross amount in the trust deed and the Trustees deduct this as a deductible payment in the income tax computation, deducted from non-savings income, in priority to interest and dividends. The withheld tax is paid by the trustees to HMRC on their normal self-assessment due date and they will provide a tax deduction certificate to the beneficiary. The recipient of the annuity will declare the income on their tax return and either pay further tax or obtain a tax repayment dependant on their marginal tax rate.

Annuities can be expressed as a net amount, i.e. free of tax annuities. This guarantees the beneficiary the same net amount each year. This will then be grossed up for basic rate tax and paid to HMRC by the Trustees. Since the annuitant (person receiving the annuity) has a present right to enjoy some of the income of the trust, they have an interest in possession of part of the trust fund. Since this is part of a Will Trust, part of the trust fund will form part of the annuitant’s death estate. The capital value of the annuity will need to be valued i.e. the amount of capital in the trust required to provide the annuity. The capital value, or so-called annuity slice, is usually arrived at by an apportionment of trust income, arising in the previous year. The Trustees multiple the capital value of the trust by the proportion that the annuitant’s income entitlement bares to the total income of the trust fund in the preceding tax year.

To prevent the annuity slice being artificially reduced to avoid inheritance tax in circumstances that the annuitant is expected to die, HMRC have introduced anti-avoidance legislation so that they can replace actual income with a deemed income yield when calculating the part of the fund which is chargeable to Inheritance Tax. This prevents the Trustees from changing the asset base of the trust to high-income yield investments, to produce more income, thereby artificially creating a lower percentage of total trust income, making up the annuity. 

Transfer of assets between Trusts

Providing the Trustees have the legal power in the terms of the original Will Trust, they may transfer assets to another trust. When assets are transferred from one trust to another, the assets are treated as remaining in the first trust, for inheritance tax purposes and therefore it does not incur an exit charge. The principal charges on those assets in the second trust arise on the 10-year anniversary of the commencement of the original trust.

In a Discretionary Will Trust, this power may be created so that different trusts for different family members can be set up down the line to be managed by their own Trustees, if so required.

For capital gains tax purposes, on the transfer of assets from the original will trust to a second trust, there will be a deemed disposal if the second trust is a ‘different settlement’. The meaning of different settlement is dealt with by a statement of practice, which says that each case must be considered on its own facts and should include an objective examination of the powers exercised by the Trustees.

Where the appointment to the second trust is revocable, or there is a possibility of the property being transferred to the second trust, reverting back to the original will trust, at some future point, there is no deemed disposal and no gains will arise in the original will trust. An example of this would be where the Trustees created a revocable Life Interest Trust for the purposes of (say) obtaining a tax relief, this would not be a different settlement and there would be no disposal for capital gains tax, e.g. to claim Business Asset Disposal Relief.

It is also unlikely to be a different settlement where the second trust funds continue to be administered by the original Trustees, under the powers given to them by the original will trust.

If there is a different settlement, the Trustees of the original will trust will be deemed to dispose of the chargeable assets transferred to trust two, which will take place at market value. The Trustees would need to consider whether the gains chargeable to capital gains tax, could be reduced by Business Asset Disposal Relief or Gift Relief.

Appointments out of the Discretionary Will Trust within two years of death

Any distributions to discretionary beneficiaries within two years of the death of the testator are deemed to have been made by the deceased in their Will. This will avoid any inheritance tax exit charges from the trust (see below). This treatment is automatic.

It means that any distributions made by the Trustees to a spouse or charity would be treated as if they had been made directly from the Will and so exempt from inheritance tax. A discretionary trust as a beneficiary is not an exempt beneficiary and therefore the executors would have paid inheritance tax on the assets transferred to the discretionary trust. The inheritance tax applicable to the transfer to the exempt beneficiary can be reclaimed and paid to the trust.

Often this strategy is used to appoint the whole estate to the spouse to reclaim all the inheritance tax paid and thereafter allow the surviving spouse to distribute the estate by means of Potentially Exempt Transfers, which is very effective where the surviving spouse has a life expectancy of more than seven years. It is also sometimes used to appoint the assets to the value of the unused nil rate band to children, or on trust for the children, with the remainder passing to the spouse.

Once two years have elapsed from the date of death, the normal exit and principal ten-year charges apply to distributions made. This two-year rule does not apply for Capital Gains Tax purposes and the usual rules for discretionary trusts apply.

If you have any questions about any of the above, please contact us on 020 7481 2422 or by email at wellers.wealth@wellerslawgroup.com