Article by Francis Fitzpatrick, Barrister in the chambers of John Gardiner QC, published in the May 2001 issue of Tax Adviser. KEY POINTS
• A&M trusts are in the news as the 25 year period for some A&M trusts runs out on 15 April 2001 giving rise to a charge to tax at a rate of 21 per cent.
• If an income interest in an A&M trust has arisen, there is prima facie no CGT holdover relief on absolute vesting.
• For some A& M trusts there is a method whereby hold-over relief can be obtained even if an interest in income has arisen.
Accumulation and maintenance trusts (‘A&M trusts’) are currently in the news with articles in the Financial Times (14 October 2000) and in the Revenue’s December Tax Bulletin as for some A&M trusts their time is up as a 25 year deadline expires on 15 April 2001. This article considers the 25 year rule and what to do about it and also considers a perennial problem with A&M trusts (which those who seek to avoid the consequences of the 25 year rule by appointing an interest in income will also have to face) which is that where an interest in income has arisen, no hold-over relief from capital gains tax is available on absolute vesting occurring at a later date.
This article suggests that for some A&M settlements, it may be possible to obtain hold-over relief even where an interest in income has arisen, with a relatively insignificant tax risk attached, which is therefore well worth considering by advisers and trustees with A&M settlements where an interest in income has arisen and capital vesting is approaching with an attendant capital gains tax charge.
What is an A&M settlement?
An A&M settlement is one which meets the requirements of Inheritance Tax Act 1984, s. 71 (‘IHTA 1984’) and so qualifies for favoured inheritance tax treatment. In outline, an A&M settlement is one where the property is held on trusts such that no-one is entitled to an interest in possession, but one or more beneficiaries will on or before attaining the age of 25 obtain an interest in possession, and the income in the meantime is to be accumulated so far as not applied for the maintenance, education or benefit of a beneficiary.
IHT advantages
The inheritance tax advantages are that:
• a gift to an A&M settlement is a potentially exempt transfer;
• no charges arise under the inheritance tax discretionary trust charging regime whilst it remains an A&M settlement; and
• no exit charge arises on a beneficiary attaining an interest in possession on or before attaining 25.
What is the 25 year rule?
The legislation restricts the availability of these reliefs where, in summary, not all of the beneficiaries (who on or before attaining the age of 25 will attain an interest in possession) are grandchildren of a common grandparent (or children, widows or widowers of such grandchildren who died before attaining an interest in possession). So if, for example, the class of beneficiaries includes the settlor’s children and grandchildren (more than one generation), the A&M conditions will only be satisfied for 25 years. The effective commencement date for this rule is 15 April 1976 for then existing settlements, and for an A&M settlement meeting the conditions for A&M relief on that date, the 25 year period begins then and thus expired on 15 April 2001. For A&M settlements which commenced after that date or where the A&M conditions were satisfied at a later date, the commencement date is the date of commencement or the date on which the conditions were satisfied.
A&M settlements with protective trusts
It should be noted that a lot of early A&M settlements imposed protective trusts on beneficiaries’ prospective income interests. The imposition of protective trusts in fact meant that the A&M conditions were not satisfied, as the beneficiary might have forfeited his prospective interest before getting an entitlement to income (see Inglewood v IRC [1983] 1 WLR 366 at p. 374). Such settlements would not have been qualifying A&M settlements until the law was changed on 11 April 1978 (Finance Act 1978, s. 71(2)), so that for such settlements the 25 year period would not commence until 11 April 1978 and would expire on 11 April 2003.
What happens if the 25 year period runs out?
If an A&M settlement ceases to be a qualifying A&M settlement by reason of the 25 year period running out, then there will be an exit charge to inheritance tax at a rate of 21 per cent (being a rate of 10 per cent for the first ten years plus 8 per cent for the next ten plus 3 per cent for the next five giving a cumulative rate of 21 per cent – see IHTA 1984, s. 71(3), (5) and s. 70(6)).
How to avoid the IHT charge
The charge can be avoided if before the 25 year period runs out, the beneficiaries acquire an interest in possession, as where an A&M ceases to be a qualifying A&M by reason of a beneficiary acquiring an interest in possession prior to or on attaining 25 no charge to inheritance tax arises, IHTA 1984, s. 71(4). If the trustees of an A&M settlement decided to do this, then they will run into the problem discussed below, being the unavailability of hold-over relief on capital vesting where an interest in possession has already arisen.
CGT hold-over relief
Provided the capital and income of an A&M settlement vest at the same time, on or before a beneficiary attaining 25, the beneficiary and the trustees can elect for capital gains tax hold-over relief under Taxation of Chargeable Gains Act 1992, s. 260 (TCGA 1992), so that no charge to capital gains tax arises on absolute vesting, but the beneficiary instead obtains assets which are pregnant with gain which will come into charge when the beneficiary disposes of the assets.
Whilst hold-over relief under TCGA 1992, s. 260 is normally only available where the event which gives rise to the charge to capital gains tax also gives rise to a charge to inheritance tax, there is special provision for the relief to apply where no charge to inheritance tax arises by reason of the occasion of charge being a beneficiary obtaining an interest in possession in an A&M settlement for which relief is given by IHTA 1984, s. 71(4), see TCGA 1992, s. 260(2)(d).
However, hold-over relief is not available where at the time of capital vesting, the beneficiary concerned has already attained an interest in income as whilst no charge to inheritance tax will arise by reason of his interest in possession being enlarged to an absolute interest, the reason is not because of IHTA 1984, s. 71(4), but because a person with an interest in possession is already treated as entitled to capital by reason of IHTA 1984, s. 49(1).
The problem
Consider the following example. A settlement where the capital and income of the Trust Fund is to be held on trust for such of the settlor’s three existing children (‘the Children’) as they attain the age of 25 years. There is no direction or power to accumulate. The Children are all over 18 and below the age of 25. The Trust Fund consists of a portfolio of quoted securities.
The Children have all been entitled to the income of the Trust Fund since each attained the age of 18 by the operation of Trustee Act 1925, s. 31, which conferred a right to income as each attained majority. It follows that each of the children has an interest in possession for the purposes of inheritance tax so that the Trust Fund is property in which interests in possession subsist. The result is that whilst the settlement was originally a qualifying A&M settlement, it ceased to be such on the children attaining 18 and hence obtaining an interest in possession in their presumptive share of capital.
When the capital of each child’s presumptive share vests either on attaining 18 or on capital vesting being accelerated by the exercise of a power of appointment or advancement by the trustees, no hold-over relief from the charge to capital gains tax arising on absolute vesting will be available under TCGA 1992, s. 260 for the reasons explained above. It follows that whether the trustees wait until a child attains 25 or advance his share of capital to him at an earlier date, there will be a substantial charge to capital gains tax with no right to hold-over the gain.
The solution
However, if each child directs the trustees to hold the income of his presumptive capital share on accumulation and maintenance trusts for him until he attains 25, so in effect assigning his income interest to them, and subject thereto on the trusts of the settlement, hold-over relief should, as I explain below, be available on capital vesting. The fiscal consequences of the solution are explained below.
Inheritance tax
A child’s direction to the trustees to hold the income of his presumptive share on A&M trusts for him will amount to a disposal of his interest in possession in his presumptive share Accordingly each child will be treated as making a transfer of value equivalent to the value of his one-third presumptive share in the capital of the Trust Fund (IHTA 1984, s. 52). For inheritance tax purposes a beneficiary, with an interest in possession is treated as entitled to the property in which his interest in possession subsists (IHTA 1984, s. 49(1)). However as, following the transfer, his one-third share should be treated as held on qualifying A&M trusts, the transfer should be treated as a potentially exempt transfer giving rise to no immediate charge to inheritance tax.
If a child dies before attaining the age of 25 (so within seven years of the transfer), the PET will become chargeable. The trustees will be primarily responsible for payment of the tax. There is a potential double charge as the one third presumptive share in the capital will be treated as forming part of the child’s estate by reason of the reservation of benefit rules, although relief should be available under the Inheritance Tax (Double Charges Relief) Regulations 1987.
If a child dies after having attained the age of 25 but within seven years of the PET, the PET will become chargeable and, as capital will have vested, the capital will form part of the child’s estate on death, giving rise to a potential double charge, although once again relief should be available under the Double Charges Relief Regulations.
As the Trust Fund should be treated as held on accumulation and maintenance trusts, no charges should arise under the discretionary trust charging regime, and there will be no charge to inheritance tax when the childrens’ interests vest.
Income tax
Each child will be treated as the settlor of his income interest assigned to the trustees so that each child will be liable to income tax on an arising basis in respect of the income of his presumptive share whether or not the income is paid to him, by reason of the application of the income tax anti-avoidance settlement rules in Income and Corporation Taxes Act 1988, s. 660A. Each child will have a statutory right of reimbursement against the trustees in respect of income tax which they pay as a result.
Capital gains tax
The children’s disposal of their interests in possession should not give rise to any charge to capital gains tax by reason of TCGA 1992, s. 76 (assuming that the trustees have never been non-resident).
Each child will be treated as a settlor in relation to the Trust Fund in respect of the assigned income interest and hence liable in respect of any gains arising from such assigned property. On absolute vesting there should be no attributable gains as hold-over relief should be available.
Hold-over relief on absolute vesting
When a child attains the age of 25, such child will become absolutely entitled to the capital of his presumptive one-third share. This will give rise to a deemed disposal by the trustees at market value of the assets to which the child becomes absolutely entitled.
No charge to inheritance tax should arise by reason of IHTA 1984, s. 71(4). It follows that capital gains tax hold-over relief should be available as the conditions of TCGA 1992, s. 260(2)(d) are satisfied.
There should be at least a full three month period between assignment of the income interest and its re-vesting on a child attaining 25. This is important as if this period is less than three months, then arguably no exit charge would arise under IHTA 1984, s. 71(3) (see IHTA 1984, s. 70(6)), so that if capital vested within this period, it could be argued that the conditions for hold-over relief are not met as the reason why no charge to inheritance tax arises is not due to the application of IHTA 1984, s. 71(4), but to no exit charge arising under IHTA 1984, s. 71(3), so that the conditions for the application of TCGA 1992, s. 260(2)(d) are not satisfied. It is preferable to be in the position that were it not for IHTA 1984, s. 71(4), a charge to inheritance tax would definitely arise.
Complications
The rule in Crowe v Appleby
The position is more difficult where the Trust Fund consists in whole or in part of assets, such as land or possibly shares in private companies, which are not readily divisible assets, as by reason of the operation of the rule in Crowe v Appleby (1975) TC 502, absolute entitlement to such assets may not arise until all of the presumptive beneficiaries have attained the vesting age. In order for hold-over relief to be available, capital vesting must occur at an age no later than 25 as otherwise the exemption in IHTA 1984, s. 71(4) would not apply so that the conditions for TCGA 1992, s. 260(2)(d) hold-over relief would not be met. This is a particular problem where there is an open class of beneficiaries. It may be possible, if the trustees have a sufficiently wide power of advancement, to overcome this problem by effectively closing the class of beneficiaries and advancing the date of capital vesting by advancing the Trust Fund onto new trusts in favour of existing beneficiaries, subject to ensuring that the trust power was exercised properly and did not amount to a fraud on a power.
Minor beneficiaries
Where the beneficiaries include both adult and minor beneficiaries, only the adult children would be able to legally assign their interests in income, and in such a case the Trustees may consider apportioning the Trust Fund between adult and minor beneficiaries if they have power to do so.
ACTION POINTS
Check whether you have any ‘more than one generation’ A&M trusts which may be affected by the 25 year rule and ascertain when the 25 year period will run out.
If you do have such a settlement, consider whether the charge can be avoided by the appointment of an interest in possession oran advance of the assets absolutely to one or more of the beneficiaries.
Check to see whether you have any former A&M settlements where a right to income has arisen so that no hold-over relief will be available under TCGA 1992, s. 260(2)(d).
If you do have such a settlement, consider whether the solution identified above may help.
Technical Department
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