Most types of trusts were hit by major tax changes in the UK 2006 Finance Act, and those changes will come into effect by 5 April 2008. With only four months to go, clients, trustees and advisors who have not already taken action may be faced with a series of tough choices.

For centuries, trusts have been highly popular structures used by a wide range of people, wealthy and otherwise, commonly used to protect assets from being mis-managed by the beneficial owners. However, most types of trusts were hit by major tax changes in the UK 2006 Finance Act, and those changes will come into effect by 5 April 2008. With only four months to go, clients, trustees and advisors who have not already taken action may be faced with a series of tough choices – many of which involve weighing up the merits of tax-saving verses against the risks that these may present to assets currently held in trust. The 2006 Finance Act introduced sweeping changes to the ways that many trusts are taxed and, as a result, higher levies on the use of trusts come into effect from 6 April next year. Prior to the act, gifts to the trusts affected were exempt from Inheritance Tax if the donor survived seven years. Not only will new gifts into these trusts be subject to a 20 per cent entry charge, but there will also be a ten year anniversary IHT charge and an IHT exit charge applied to both new and existing trusts. In many cases, trustees will want to take action that can reduce or prevent entirely these new tax charges, but time is running out for that action to be taken. Quite apart from the time it inevitably takes to prepare and agree the legal documentation that is likely to be required, the decisions that need to be taken may affect young and potentially vulnerable beneficiaries for rest of their lives, and so these decisions should not be taken lightly. Four months is not long. The main types of trusts affected are life interest (or interest in possession, IIP) trusts and accumulation & maintenance (A&M) trusts. An IIP trust is where a specific beneficiary has a right to the income arising on a specific proportion (sometimes all) of the trust’s assets. An A&M trust is a special type of discretionary trust created for younger beneficiaries which used to benefit from a non-discretionary trust tax regime. Not surprisingly, A&M trusts in particular were popular as they enjoyed the flexibility of discretionary trusts without the burden of inheritance tax. Four Tough Choices What can be done with existing trusts under the post Finance Act 2006 regime? Fundamentally, trustees of pre-existing trusts are faced with four difficult choices before they become subject to the new regime: The first option is to do nothing and pay the new IHT charges. Under the transitional arrangements, the effect of the new regime is tapered in over the next 10 years. So initially, any IHT payable may be fairly modest, especially with smaller ‘school fees’ type trusts. However, in the long-term, the new IHT charges may become significantly greater, and therefore trustees may wish to consider other options. The second option is for the trustees to amend the trust terms (if they have the power) to provide that each beneficiary becomes absolutely entitled to their share of the trust capital at the age of 18. Such amendments must be irrevocable but the trust does not have to be divided up equally amongst the beneficiaries. Under the transitional rules, the A&M trust remains outside of the new regime. However, do they really want the beneficiaries to have capital at 18? Is this just too young? The third option is for the trustees to amend the trust terms to provide that the beneficiaries become absolutely entitled to a fixed share of the trust capital at age 25. Under the transitional rules, the trust would remain exempt from ten year charges and instead pay a one off IHT charge of 4.2 per cent when the beneficiary becomes absolutely entitled to their trust capital. For the older beneficiary, this would defer a charge on any imminent ten year anniversaries, but probably not result in much tax being saved. In respect of capital allocated to very young beneficiaries, this could potentially eliminate the IHT charges on the next two ten year anniversaries and on the advancement of capital while they are under the age of 18. However, the trustees will lose all future flexibility to vary beneficiaries’ share of trust fund and its income, if this option is taken. Finally, the fourth option is to wind up the trust before either 6 April 2008 or the date on which the beneficiaries become entitled to their share of the income (if earlier) and advance out all the capital. The trust would therefore come to an end and fall outside the new regime. If this is done while the beneficiaries are minors, then the trustees, or the children’s parents, could continue to hold the investments on “bare trust” until they reach the age of 18. The fourth option is the most “drastic” of those outlined above, but is being considered by trustees where a significant proportion of the trust capital and income is expected to be depleted through normal expenditure on school fees etc before the beneficiaries reach 18. There are also potentially significant income and capital gains tax advantages that might make this a very attractive option. As can be seen, trustees have some very difficult decisions to make – and if they have not done so already, now is a good time to start planning. People should really be reviewing current arrangements now – as trusts are such complex legal structures, it could easily take a few months to amend them in order to minimise the impact of the new taxes. Finally, it should be noted that, none of the options are mutually exclusive and therefore trustees could well make different decisions in respect of different beneficiaries. But now is certainly the optimum time to act, and I fully expect to see a flurry of activity in January on this front.