Trusts are going to be in the AF1 exam. It’s an integral part of the syllabus and could be worth 20-30 marks.
One important trust topic is the 10 year anniversary charge on relevant property trusts and it’s worth going through some basic principles on this key topic. In my years of experience teaching this topic, the best way to ‘get’ this process and make it ‘click’, is by going through a number of examples. There is no better way to make this stick.
Here is the process:
- The Principal charge
A principal charge will be levied on each 10-year anniversary following the commencement of a relevant property trust, such as a discretionary trust.
The principal charge is a percentage of the trust’s value at the 10 year anniversary, i.e:
Value of relevant property at the 10-year anniversary x actual rate of tax.
For the purposes of the charge, the trustees are deemed to have made a transfer of value equal to the value of the trust at the 10-year anniversary date.
As this is considered a chargeable transfer, the value of the relevant property at the date of the principal charge can be reduced by APR or BPR.
The actual rate of tax is arrived at by determining the effective rate of tax and multiplying it by 30%.
- The Effective rate
The effective rate is a notional rate of IHT that would be charged on a notional transfer. To work out the effective rate, we use the IHT history of the settlor of the trust. To calculate the effective rate, we pretend that the settlor had made a transfer of value equal to the relevant property in the trust at the 10-year anniversary.
To calculate the notional tax, we use the IHT nil rate band available at the 10-year anniversary. Therefore, for a 10-year charge falling into 2015/16, we use a nil rate band of £325,000.
The nil rate band will be reduced by the settlor’s cumulative chargeable transfers. Here we look back at the settlor’s transfers in the 7 years before the creation of the trust.
The nil rate band is then further reduced by any distributions made by the trustees in the 10 years before the principal charge. Therefore, any exits made in the initial 10 years of the trust will have an impact on the first principal charge.
Once we have the nil rate band remaining, we can calculate the notional tax and therefore calculate the effective rate.
The process could be illustrated using the following table:
| £ | £ | |
| Current value of relevant property at 10 year anniversary (net of APR/BPR) | V | |
| Nil rate band at date of principal charge | NB | |
| Less: Settlor’s chargeable transfers in 7 years before creation of trust | (CTs) | |
| Less: Distributions by trustees in last 10 years | (Ds) | |
| Nil rate band remaining | (NBR) | |
| B | ||
| Notional tax (B x 20%) | NT | |
| Effective rate: NT/V x 100 | ER (%) | |
| Actual rate: ER% x 30% | AR (%) | |
| Principal charge: Current value x AR (%) | PC | |
This could be further illustrated using an example with numbers:
On 7 August 2005, Bob created a discretionary trust with £600,000 in cash.
Bob paid the IHT on the creation of the trust. His chargeable transfers in the 7 years prior to setting up the trust were £125,000
On 15 December 2009, the trustees distributed £80,000 to a beneficiary. This gave rise to an IHT exit charge. The beneficiary paid the tax on the exit.
On 7 August 2015 – i.e. 10 years after the commencement of the trust – th relevant property within the trust was worth £800,000.
| £ | £ | |
| Current value of relevant property at 10 year anniversary (net of APR/BPR) | 800,000 | |
| Nil rate band at date of principal charge | 325,000 | |
| Less: Settlor’s chargeable transfers in 7 years before creation of trust | (125,000) | |
| Less: Distributions by trustees in last 10 years | (80,000) | |
| Nil rate band remaining | (120,000) | |
| 680,000 | ||
| Notional tax at 20% | 136,000 | |
| Effective rate: 136,000/800,000 x 100 | 17 (%) | |
| Actual rate: 17% x 30% x 40/40 | 5.1 (%) | |
| Principal charge: £800,000 x 5.1% | 40,800 | |
Under no circumstances can the actual rate ever exceed 6%. This tax is payable by the trustees on 28 February 2015. (6 months from the end of the month of the transfer).
Even though this tax is payable by the Trustees, no grossing up is necessary as the only asset leaving the trust is the cash being used to pay the IHT.
The calculation of tax on a principal charge is very similar to the calculation of tax on an exit charge.
I will go through an example of one of those before the exam. This could secure you 20+ marks in the exam; it is well worth knowing inside out.
See you in the forum.
Cris.
