The Finance Act 2006 (FA 2006) introduced some significant changes to the inheritance tax regime for trusts and in so doing focused attention again on the use of trusts as vehicles for estate planning and asset protection. This briefing provides some background on what a trust is, how and why it may be used and outlines the tax issues which relate to trusts. It is always important to obtain professional advice in this area.
Trusts are by no means modern arrangements. Their origins can be traced back to the time of the Normans when the barons set up legal arrangements to protect their assets, alongside the more tangible castles which had a similar practical purpose.
A trust is essentially a legal arrangement that allows the ownership of an asset to be separated from the right to benefit from that asset. The legal owners of the asset are the ‘trustees’; those with the right to benefit are called the ‘beneficiaries’. The document which sets out the arrangement is the ‘trust deed’ and it is that document that forms the basis of the whole arrangement. Trusts are governed by what are known as the rules of equity, which is a specific branch of law, and arguments about trusts will ultimately be matters for the courts to decide.
A trust is a separate legal entity and for tax purposes exists as a taxable person. In English law a trust can have a life of up to 80 years. The person who sets up the trust is referred to as the ‘settlor’. It is always important to be clear who this person is because, as will become clear later, there are some UK tax consequences which can follow.
The human face of the trust are the trustees and it is they who have the ultimate responsibility for what the trust does. The role of trustees is therefore critical and the choice of trustees is very important. Those accepting the role of trustee must understand the responsibilities that go with the job. The trustees have the task of managing the trust assets, deciding how the trust income will be earned and how the capital and income will be dealt with in accordance with the trust deed.
The identification of the beneficiaries is obviously very important. They can be specifically identified by name or by class eg ‘all my children’. Given that a trust can potentially last a long time it is usual to include the possibility of future generations becoming beneficiaries. It is also common practice to allow new beneficiaries to be added by the trustees although this usually involves having the consent of the settlor in their lifetime.
Beneficiaries will have interests in either the capital or the income of the trust or, in some cases, interests in both. The trust deed needs to spell out those interests so that there can be no room for doubt. In some cases the trust deed will state that a beneficiary has a right to receive the trust income. This is referred to as an ‘interest in possession’ (sometimes called a ‘life interest’). Where this is in place the trustees have no choice in what they do with the income each year. In other cases the decision as to what to do with the income may be left to the trustees’ discretion. They may choose to pay out some or all of the income to beneficiaries and may also have complete discretion as to which beneficiaries should receive anything. They could also decide to simply accumulate the income.
The right of the beneficiaries to receive the capital from the trust will also be set out in the deed. The right may arise when the beneficiary reaches a specific age or it may be that it is left at the discretion of the trustees. There will usually be a power to enable the trustees to advance capital at any time if they decide that this is the right thing to do. When a beneficiary receives capital, it is said that they become ‘absolutely entitled’ to the assets and this has specific tax consequences.
The specific powers in the trust deed give rise to the two basic types of trust which are used. A trust where the beneficiary has the right to receive the income directly is referred to as an ‘interest in possession’ or ‘life interest’ trust. Where the trustees have the right to take the decisions, the trust will be referred to as a ‘discretionary trust’.