The current system of trusts for taxation purposes is being modernised in a bid to provide greater consistency between income and capital gains tax (CGT) in relation to trusts, and a new test will be put in place from 2007 to test UK residency, says HMRC.
Details of the Regulatory Impact Assessment for trust modernisation point out taxation of trusts is currently a complex area, so changes are being made to clarify common meanings which determine who is the trustee, who gains from the trust, and how it should be treated for tax purposes.
More importantly, additional moves to align inheritance tax treatment of trusts will also affect people currently holding 'interest in possession' trusts (IIPs) as they will no longer meet IHT rules, as is the case for 'accumulation and maintenance trusts' (A&Ms).
This essentially means most assets held in trust will be subject to chargeable gains when paid to the beneficiary, except in one specific case, according to BN25.
IIP trusts are currently subject to special treatment from "relevant property trusts" IHT rules as they are likely to be set up, for example, to be exempt from IHT on the death of a parent and to hold assets in trust for a minor child who is entitled to the assets at 18 - ie no person holds an interest in possession.
However, this loophole is being closed from today (March 22) so only IIP trusts set up for a disabled person on the death of a settlor which then receive lifetime transfers - will be exempt from treatment as "relevant property".
This means unless a new trust is created for charitable purposes, the settlement of a trust will be subject to chargeable gains and treated as "relevant property" with a CGT charge of 20%, minus the nil rate band tax charge.
Such trusts will be subject to a 20% "entry charge" on lifetime transfers exceeding the IHT threshold, there is then further "periodic" 6% tax charge on the value of assets once every ten years if the assets exceed the IHT threshold, along with an "exit charge" if funds proportionate to the periodic charge where funds are taken out between the ten-year anniversaries.
Many of the changes are being implemented from 2006, however, a new common residency test will be delayed until April 2007, to give trustees time to settle existing affairs.
Among the key changes, HMRC's BN35 says beneficiaries of trust monies or 'settlor-interested settlements' will see it treated as income for tax purposes as this is how it would be treated had "it arisen directly to him or her".
At the same time, new legislation is being put in place to ensure payments to beneficiaries of settlor-interested trusts are not chargeable to beneficiaries.
Further work is still needed on the tax treatment of chargeable gains of estates, according to HMRC, but initial proposals suggest CGT on such trusts will be reduced from 40% to 20% for up to a specified limit, on payments made to "personal representatives" in the tax year of the deceased death, and the two subsequent years.
It is suggested the majority of people who benefit from this move are lower or basic rate taxpayers who would not normally pay the 40% rate anyway.
The comment residence test will in the future be modelled, for tax purposes, on the residency income tax test, to look at the residency status of the trustees and then assesses the residence and domicile status of the settlors in circumstances where the trustees - now treated as a single person for tax purposes - are made up of a mixture of UK and non-UK residents.
HMRC says previous respondents to the trusts consultation opposed changes to the 'settlor-interested' rules for CGT because it would stop parents who settle business interests on their dependent children from claiming CGT relief on the gift.
If you have any comments you would like to add to this story or would like to speak to its author about a similar subject, telephone Julie Henderson on 020 7968 4571 or email [email protected] or Matthew West on 020 7484 9893.IFAonline
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