You’ll probably have seen the headlines over the last few months crying foul at the
new Inheritance Tax (“IHT”) rules relating to trusts, which were introduced in the
Chancellor’s last budget. Apart from a few relativity minor changes along the way,
those budget proposals became law on 19th July. So what are the changes and how
might they affect shareholders in a typical business? To understand the
changes we need to know a little about the previous position.

Essentially, there have been three main types of trusts for a long, long time – interest
in possession trusts, discretionary trusts and accumulation and maintenance trusts. In
the case of an interest and possession (“IIP”) trust one or more beneficiaries are
entitled to any income generated by the assets or to the use of those assets. In the case
of a discretionary trust, no one is entitled to anything and the trustees decide which of
the potential beneficiaries receives any income or capital. An accumulation and
maintenance (A&M) trust is a sort of hybrid, in that it can be discretionary until the
beneficiary attains a maximum of 25 yrs of age, then either it must become an IIP
trust or the beneficiary must have the assets.

There was no IHT on a transfer of assets into an IIP trust – no matter what their value.
In the case of a discretionary trust the value of the assets transferred to the trustees
was a chargeable transfer and gave rise to an IHT charge if the value of those assets
(and of any other gifts in the previous 7 years) exceeded the nil rate band – which is
currently £285,000. In addition, there may well be a tax charge every 10 years and/or
on the transfer out of a discretionary trust of some or all the assets (depending on
value). There was no IHT charge when assets were transferred to an A&M trust –
again, no matter what their value – and there was no 10 yearly or exit charges.

And what has changed? Basically, all trusts are now treated as discretionary trusts in
the sense that there is a charge to IHT in respect of assets transferred to the trustees if
the value of those assets (and any other gifts made in the previous 7 years) exceeds
the nil rate band. Furthermore, depending on the nature of the asset and its value,
there may well be a charge to IHT every 10 years and/or whenever assets are
transferred out of trust to a beneficiary. This is a very significant change in the
treatment of trusts for IHT purposes – but what impact will it have on shareholders in
a typical company?

Shareholders in a private trading company are in a very privileged position in that the
value of their shares doesn’t count for IHT purposes if they have been held for at least
2 years. If such shares are held until death there would be no IHT (plus some CGT
benefits) and if the shares were sold prior to death there would effectively be a 10%
CGT charge. Following a sale steps could be taken to reduce the IHT charge that
would arise on death whilst holding a considerable amount of cash (which doesn’t
qualify for any sort of relief from IHT). Until this year, the most likely course of
action would be for the fortunate former shareholder to transfer a substantial amount
of cash into a trust for children or grandchildren etc and, provided he/she survived for
at least 7 years thereafter, that cash wouldn’t be included in the value of assets subject
to IHT on death.

However, as a result of the new rules it won’t now be possible for an individual to
transfer a substantial amount of cash into a trust without triggering an IHT liability.
So what should that typical shareholder do following Finance Act 2006?

You could do the same as before – keep the shares until death and enjoy the
exemption from Inheritance Tax or sell the shares during your lifetime and make an
outright gift of cash to children and/or grandchildren etc, again hoping that you will
survive for at least 7 years thereafter. But what if the lucky beneficiaries of your
generosity are too young or too reckless (or both) to be trusted with an outright gift? It
will not now be possible to put a substantial sum of money into a trust without
triggering a charge to IHT.

Perhaps the best course of action now is to set up a trust straight away into which the
shares are transferred without any IHT liability (because they qualify for the generous
business property relief). If, say 10 years later, the shares are sold and there is a
substantial amount of cash in the trust there would be no question of going back to the
time of the gift into trust and charging IHT – but there might still be a potential
problem with the 10 yearly charge and the exit charge.

In summary then, the new rules limiting the tax opportunities with trusts are actually a
spur for shareholders in private trading companies to set up trusts earlier than they
might otherwise have done and to transfer to the trustees shares in the company rather
than, at sometime in the future, the cash proceeds from the sale of those shares. As for
those very wealthy individuals whose wealth is not represented by shares in trading
companies – the new rules are very bad news indeed!