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Module 9: Trusts Used In Financial Services

Module Guidelines
In Module 3 we looked at the impact IHT can have on a clients estate. The subsequent Modules then surveyed how trusts are used for a variety of wealth structuring purposes, both in relation to lifetime trusts created by a client, or a trust arising on death. This Module now looks at a specic sub-set of where trusts are used both as part of lifetime planning and on death, namely the use of trusts in conjunction with various types of insurance policy or pension policy. This Module will cover: y y y y y y the use of trusts with term and whole of life policies; MWPA trusts; the use of trusts with single premium insurance bonds; a summary of how Loan Trusts and Discounted Gift Trusts operate; spousal bypass trusts which can receive pension death benets; the IHT points which arise with the above.

This Module ends with a glossary of terms used in nancial services and it will be helpful to cross-refer to the glossary in Module 5 when reading this Module.

1. Introduction
For those in nancial services who liaise with lawyers and accountants, this Module is important. We have already seen from the glossary in Module 5 that the various professionals involved in estate planning do not all talk the same language, and for the types of trusts encountered in this Module, this problem is particularly acute. Lets be honest about the barriers to understanding here: y Financial services trusts often use marketing names, which do not refer to the critical tax/legal words which would clarify the tax behaviour of the trust, resulting in a communication barrier. y The trust wordings encountered can be written in a very different style to that which most lawyers will be familiar with, when compared to their own ofce styles, resulting in a communication barrier. y Not only are some of the trust wordings unfamiliar to those outside nancial services, but the trust asset which sits inside the trust can be something of a mystery too. Do not be surprised if, when using the word bond, the professional

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colleague you are dealing with assumes you might be referring to the type of investment which generates interest taxed at 20% and is issued by the government. The tax treatment of single premium insurance bonds is not widely understood outside nancial services. The intricacies of term policies, whole of life, critical illness benet and terminal illness benet will be known to those who have studied for nancial services exams, but only forms a small part of the training of lawyers (if at all), resulting in a communication barrier. y The legacy of sales target-driven campaigns to sell insurance bonds or other insurance products has resulted in some in wealth management circles being sceptical about the basis for recommending the use of certain insurance-based trust options. There has also been a question about the levels of tax knowledge held by those selling these trust-based insurance solutions to clients. Whilst RDR should hopefully address these key issues of adviser remuneration and qualication standards, nancial planners can encounter mistrust for these reasons. Set against this background of potential misunderstandings, there is however clear evidence of more integration between law and nancial services professionals. Some universities now give law graduates the option of studying for nancial services exams as part of their route to post-degree qualication. Some law rms with in-house nancial services teams offer trainee lawyers the option of a 6 month seat in nancial services, with some trainees then moving to be dual qualied as both a lawyer and nancial planner/investment manager. Finally, some nancial services rms are looking to recruit law graduates as future nancial planners. All of this movement between the legal and nancial services sectors will help integration. This Module is intended to give you insight to further support good working relationships between all those who deal with private clients and their trusts and estate planning needs. This Module will look at the most frequently encountered trusts used with life and pension policies, and takes as its starting point the client need which is being addressed. Being able to show how the trust (and the asset which sits inside it) meets a client need is essential if you are to communicate effectively with those outside nancial services and overcome the barriers set out above.

2. Using a Trust with a Term Policy

2.1

The term policy

The client need intended to be met by a term policy is where a capital sum is required in the event of death within a specied time period (eg. 250,000 in the event

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of death within 25 years). There is usually no investment content or surrender value to this pure life assurance policy, so the estate planning focus is on who should receive the sum assured when the life assured dies. Depending on the wording of the life policy contract, there may also be two other types of benet offered under the contract, either of which leads to the sum assured being paid out and the life policy ending at that earlier point: y Critical illness: on diagnosis of one of the listed conditions, the sum assured is paid out. y Terminal illness: on diagnoses of a terminal illness, the sum assured is paid out. The reason why the capital sum is required will drive what type of trust will meet the clients needs.

2.2

Using a trust with a term policy

It is almost easier to ask the question why not use a trust with a life policy?, rather than try to nd reasons why the sum assured should be paid to the deceaseds estate. There are both estate planning and tax points to consider here. If we assume that the life policy is assigned to a discretionary trust, with the beneciaries listed as widow, children and remoter issue, then the benets can be summarised as: y Speedier payout of sum assured. Without a trust, the life insurer would generally only pay out when probate or conrmation is granted, which could be many months after date of death. If instead the life policy is owned by trustees, there is no need to wait until probate or conrmation is granted and the trustees can send the death certicate to the life insurer and make the claim without delay. The trustees can then consider whether they wish to make any distributions from the trust, and indeed review all their other options (eg. making a loan to a beneciary). At that point, the trustees will also need to consider their investment duties if the trust assets are not being distributed (see Module 11). y Control over destination of sum assured: if the client does not have a Will, the rules of intestacy will govern the distribution of his estate. Without a trust, the term policy proceeds would be paid to his executors in due course, and distributed in line with the relevant intestate succession rules. In contrast, with a trust, the client can ringfence the policy proceeds which are then placed under the control of the trustees, not the executors of his estate. This control extends to the situation where a deed of variation is agreed by the

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family and executors. If the life policy proceeds are held in the trust, they cannot be affected by the deed of variation. y Asset protection. The points here are similar to those which arise in Module 7 when looking at the choice for a client in either leaving his estate outright to spouse, or using a NRB will trust. In the event of the clients death and the life policy proceeds being paid to a discretionary trust (rather than to the deceaseds estate), payments can be made to the surviving spouse, but the value of the trust is not aggregated with the spouses estate for IHT purposes. It also means that the trustees control the payments from the trust. This could be important in the event of re-marriage and the ability to prioritise the deceaseds children over the needs of the spouse who has now re-married. y IHT - if the life policy proceeds are owned by the trustees, they are not an asset of the deceaseds estate on which 40% IHT may be due.

2.3

Split trust
The client need intended to be met by this trust is where the client wishes the death benets to be held by the trustees, but wishes to retain one or more other benets arising under the policy. In this way, the benets are split, hence the marketing name for this trust. For example, with a critical illness benet, whilst the client may have been ill and may nd his employment affected, a critical illness may not be fatal. It is easy to see therefore why the client may wish to retain the critical illness benet, as an essential source of a capital sum after what could be a life-changing medical event. The terminal illness benet may or may not fall into this category. On one view, if the client has a very short life expectancy after diagnosis of a terminal illness, receiving a large capital sum into his estate may be unhelpful from an IHT perspective. On the other hand, it may provide funds which can be put to good use for that period. Whether or not to retain the terminal illness benet will be a personal decision for the client. Any proforma trust wording should be read carefully to check the position for each of the possible benets arising. As we shall see later with a Discounted Gift Trust, the creation of a Split Trust involves the legal concept of the carve-out. The settlor retains certain benets whilst gifting others away. The end result is that the trustees are the named policyholders, but they hold some rights under the policy absolutely for the settlor, whilst other rights are held according to the terms of the trust for the

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beneciaries. The settlor is excluded from benetting from the gifted portion, which addresses the GWROB point. Views are divided on whether it is possible to create a carve-out trust under Scots law, which has prompted some companies to only offer an English law Split Trust for this reason, available for use with clients throughout the UK.

2.4

Business protection
A specic client scenario which can involve a term policy is where a group of people are in business together, either as a partnership or a company. The client need here relates to the position on death, where the deceased business owners family inherit a business asset (but would probably prefer the cash equivalent) and the surviving business owners ideally want to consolidate their business and buy-out the familys inherited share of the business. A term policy can be used to create funds for the business owners to achieve that outcome, which can also achieve the desired result for the family. A relevant IHT point here relates to BPR (see Module 3). The deceaseds family inherit a share of a business which could qualify for 100% BPR, which is a good result for IHT purposes. Some careful drafting is required in relation to partnership agreements or shareholder agreements to avoid creating a binding obligation to sell on death, since that would prevent BPR being available on death. A crossoption agreement deals with this problem, which gives the family the option to sell but still allows BPR to apply. At one time it was common for business protection trusts to include the settlor as a potential beneciary, since that allowed the policy to go with him if he left the business at some point in the future. With the introduction of preowned asset tax (POAT - which is an income tax charge) in 2005, many business protection trust wordings were altered to remove the settlor as a potential beneciary. Whilst the HMRC Guidance Note on POAT (listed under Further Reading) takes the line that business protection trusts from which the settlor can benet are inside the scope of POAT, that view is not universally shared and arguments supporting an alternative view can be made.

2.5

Decreasing term policy

The client need intended to be met by this type of term policy is where a sum is required to pay an IHT liability relating to a lifetime gift which would be chargeable to IHT in the event of the donors death in the next 7 years. In Module 3, we saw that taper relief for IHT operates in a limited way. If the donor dies within 3 years of making

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Module 10: Taxation Of Trusts

Module Guidelines
This module focuses principally on trusts made during a clients lifetime and covers: y y y Inheritance tax; Capital gains tax; and Income tax.

Tax year 2011/2012 is the reference year for all gures in this module, unless otherwise indicated. The glossary of terms in module 5 will assist you in working through module 10 and the two modules should be read together.

1. Introduction
Financial planners need to be aware of the effect of the three main taxes on trusts: IHT CGT and IT. Tax is important both on creation and throughout the life of a trust and is relevant not only for the trustees, but also for the settlor as well as the beneciaries. Tax is an important consideration for a client when deciding whether to set up a trust at all, or whether an existing trust should be continued, amended or brought to an end. Each of these three taxes will be considered in turn.

2. Inheritance Tax (IHT)

2.1

The 22 March 2006 Budget

Without any warning or consultation, the 2006 Budget made sweeping changes to the IHT treatment of trusts which radically transformed the trusts landscape. Before 22 March 2006, there were three types of trust for IHT purposes: RPR trusts (usually discretionary trusts), IIP trusts and A&M trusts (see glossary to Module 5). On that date, the relevant property regime (RPR) was extended to all nearly all new lifetime trusts and additions to all existing trusts (with the exception of disabled trusts, bare trusts and some premiums paid in respect of life policy trusts). Transitional rules were given to existing IIP and A&M trusts, but with a view to bringing those trusts within the RPR in the longer term. The result was to make trusts less attractive for IHT purposes, although trusts remain attractive for a whole host of non-tax reasons connected with asset protection.
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In particular, the RPR meant there was an immediate disadvantage to forming a new trust because this could trigger an immediate IHT charge for the settlor, rather than qualify as a PET. Depending on the values involved, however, no 20% IHT charge may apply. Similarly, there could be ongoing IHT charges throughout the life of the trust, not just on the death of a beneciary. HMRC Research Report 25 in 2006 indicated that the average gift to a trust between 2000 and 2002 was 100,000, however, at which level IHT is not generally an issue unless a client has an extensive history of making gifts to certain trusts.

2.2

IHT Position before 22 March 2006

There was no distinction in tax terms between trusts created during lifetime and trusts created on death. The crucial question was whether the beneciary/ies had an IIP, whether the trust was discretionary or whether it was an A&M trust. The tax treatment of these three types of trust was broadly as follows: IIP y a lifetime transfer to an IIP trust was a PET for IHT purposes by the settlor; y although the income beneciary only had a right to trust income, he was treated for IHT purposes as the owner of the capital assets so that an IHT charge would arise on his death or on the lifetime termination of his interest. The trustees would pay the IHT from the trust fund. For this reason, some trustees of large IIP trusts would take out a life assurance policy on the life of the income beneciary, to help fund the anticipated IHT bill. Discretionary y A lifetime transfer to a discretionary trust could trigger an immediate IHT charge on the settlor. y The RPR involved the trust being taxed on every tenyear anniversary and whenever capital was paid out to beneciaries (exit charge). There was usually no IHT charge on a beneciarys death. A&M y A lifetime gift to an A&M trust was a PET by the settlor y These trusts had special IHT treatment while the beneciaries were under 25, provided the necessary conditions were met (basically, the beneciaries had to become entitled to income and/or capital by 25 at the latest and share a common grandparent). Typically

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there was a discretionary phase until the beneciaries became entitled to income or capital. However, during this time the RPR did not apply, nor was there any IHT if a beneciary died.

2.3

IHT Position after 22 March 2006

Different rules apply to trusts made in lifetime and trusts arising on death. We have already looked at trusts arising on death in module 6 and so they will only be summarised here. New lifetime trusts made on/after 22 March 2006: y The IHT rules described above no longer apply to new IIP or A&M trusts. All new lifetime trusts, even if written in IIP/A&M terms, are taxed in the same way as discretionary trusts for IHT purposes only. Therefore, (with the exception of disabled trusts and bare trusts), the RPR applies to all new lifetime trusts. Existing trusts made before 22 March 2006: y Funds added to any existing trust after 22 March 2006 are subject to the RPR. There is one exception to this relating to trusts holding life policies. The ongoing payment of premiums under a life policy which was already in trust prior to 22 March 2006 will not generally fall foul of this rule, and will continue to receive PET treatment as before, and will not cause the trust to fall into the RPR. (see Module 9 Section 5.1). y For IIP trusts, there was no immediate change on 22 March 2006. The old IHT treatment continues to apply for as long as the pre-22 March 2006 IIP continues to subsist. However, when that IIP comes to an end, if the funds remain in trust, the RPR will apply going forwards. The one exception is if IIP beneciary dies and his or her spouse or civil partner immediately becomes entitled to a successive IIP. The spouse/civil partner takes what is called a transitional serial interest (TSI) which also receives the qualifying IIP treatment. After that interest ends, the RPR must apply if the trust continues further. Note that it is not possible for a spouse/civil partner TSI to arise if the pre-Budget income beneciarys interest is terminated during his/her lifetime; this type of TSI can only arise if the rst spouse dies. There was a limited window to make a TSI by taking away a pre-Budget income beneciarys IIP during his lifetime and replacing it with a new IIP in this case for the spouse/civil partner or indeed anyone else but that

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opportunity closed on 6 October 2008. If this type of TSI exists, the spouse/civil partner TSI option described above does not apply subsequently as there can never be successive TSIs in a trust. y For A&M trusts, the old rules continued to apply from Budget Day 2006 to 6 April 2008. The old rules only apply beyond 6 April 2008 if the age the beneciaries become entitled was lowered to 18 and if they become entitled to capital at that point, not just income. If the age of capital entitlement was changed to fall between age 18 and 25, the new 18-25 trust rules apply (see module 6) so that an IHT exit charge may apply when capital is paid out, but there would not be any ten year charge within the trust. Finally, if the age of capital entitlement was above age 25, the A&M trust would move into the RPR regime from 6 April 2008. Trustees of A&M trusts had to arrive at a decision to either modify the trust or leave it unchanged in that two year transition period, considering factors such as the value of the trust, whether an IHT charge would in fact arise, and whether the better asset protection outcome was to preserve an older age (e.g. 35, 45) for capital entitlement for the beneciary and so fall within the RPR regime. y One practical point to watch with A&Ms is that a trust might be called an A&M but it can be subject to various different IHT regimes. This can give rise to a mixed trust. Example 1 Bill made an A&M trust on 10 September 1995 for his 3 grandchildren, Amy, Beatrice and Charlie. The terms of the trust said that at age 25 they would become entitled to income for the rest of their lives. Amy was 25 on 2 October 2004. Beatrice was 25 on 12 May 2006. Charlie is still under 25 but will become entitled to capital as well as income on his 25th birthday as a result of a change made to the terms on the trust on 26 March 2008, when the trustees signed a Deed of Appointment to alter the trust. How is this trust taxed to IHT? Amys share of the trust is subject to the old IIP rules as she had a life interest in her share of the trust prior to Budget Day 2006. There will be an IHT charge on her death. Beatrices share of the trust is subject to the RPR because her IIP arose after the 2006 Budget, but before the trustees had taken action to alter the terms of the trust. There will be an IHT charge on this part of the trust fund every 10 years and when capital is paid out.
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Charlies share is subject to the 18-25 trust rules. There will be an IHT exit charge on his 25th birthday.

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2.4

Summary: how to work out which regime applies

A&M trusts are complex. Leaving aside the special rules which apply to A&Ms, the two main IHT regimes for trusts are the RPR and qualifying IIP regimes. The RPR applies to: y All discretionary trusts whenever created, i.e whether created before or after 22 March 2006 y All funds added after 22 March 2006 by a living settlor to any type of trust, whether that trust was created before or after 22 March 2006 (other than a bare trust or disabled trust, or ongoing life policy premiums paid) y All new trusts created by a living settlor after 22 March 2006 (except bare trusts and disabled trusts) y Trusts which continue on the ending of a qualifying IIP or TSI y A&M trusts made before 22 March 2006 - the RPR applies from 6 April 2008 unless the age of capital entitlement was reduced to age 25 or less before 6 April 2008 y A&M trusts made before 22 March 2006 where a beneciary took an IIP after 22 March 2006 but before 6 April 2008, where the RPR applies from the date the IIP arose. Qualifying IIP trusts which are still subject to the old IIP rules are, after 22 March 2006, restricted to:y IIP trusts already in existence and with the same income beneciary as at 22 March 2006 y IIP trusts created after 22 March 2006 which are either: y a TSI; or y a disabled trust within either section 89 or section 89A IHTA 1984; or y an IPDI which can only be made at death (i.e. by Will or intestacy). IHT for qualifying IIPs and RPR trusts is now explained in more detail below.

2.5

IHT and qualifying IIP trusts

IHT charges potentially apply on: 1. The death of the settlor within seven years of making an IIP trust 2. The death of an IIP beneciary 3. The lifetime termination of a beneciarys IIP
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