the distinction between legal and beneficial or equitable ownership is crucial to trusts
A trust in its simplest terms is a means of deferring a gift (an inter-vivos trust) or a legacy (a will trust). A trust works because of the distinction found in common law (as opposed to civil law systems) between legal and beneficial or equitable ownership (the question of trusts in relation to civil law legal systems will be covered in a future article).
The settlor is initially the legal and beneficial owner of the asset, that is, they are fully connected to the asset. They transfer legal ownership or title to trustees and defines how the trustees are to benefit the beneficiaries. The terms of the trust, that is, the definition of the beneficial interests, determines the type of trust.
In addition to the distinction between legal and beneficial ownership, there are also distinctions between (1) interests in capital and income and (2) vested (sometimes referred to as fixed) and contingent interests. Under the terms of a trust, a beneficiary may have a vested or contingent interest in either or both of the capital or income of the trust.
These interests may be dependent upon an event (for example, the beneficiary attaining a certain age) or dependent upon the exercise of the trustees' discretion. If the trustees own a bank account, for instance, then interest arising on the account is treated as income and the initial settled deposit is treated as capital in the trust.
If a beneficiary has a fixed interest in the income then all of the interest is theirs absolutely and will be paid away to them periodically or even mandated directly to them by the trustees. If they have a contingent interest in the income then they may become entitled to the income once they attain the age of 18, for instance, or they may only become entitled to the income as and when the trustees see fit to make payments of income to him.
If they have a contingent interest in the capital then, again, they may become entitled to the capital once they attain the age of 25 or they may only become entitled to the capital as and when the trustees see fit to make payments of capital to them. Once they have a vested or fixed interest in the income and the capital the trustees are holding the property for them as nominees or bare trustees and the trust, or the relevant part of it, has come to an end and full ownership has passed to the beneficiary.
If a beneficiary has a vested interest in income this is known as an interest in possession (IIP) and they are known as a life tenant. A beneficiary who will subsequently become entitled, say on the death of the life tenant, to the life interest or the capital supporting the life interest is referred to as a remainderman and their interest as being a reversionary interest.
Types of trusts
For most purposes there are two basic types of trust: (1) an interest in possession trust (sometimes referred to as a flow-through trust) and (2) a discretionary trust (a non-flow through trust). Under a discretionary trust there are no interests in possession and beneficiaries only receive income and/or capital as and when the trustees exercise their discretion in the beneficiaries' favour, guided by the letter of wishes discussed in last month's article.
Under an IIP trust, one or more beneficiaries is entitled to a fixed share of the income, for example 25% or "equally divided between my children who have attained the age of 18". In the latter case, the interests of the beneficiaries will be diluted as members of the beneficial class attain their interests. The income due is usually calculated after charging trust management expenses (TMEs), which are usually charged to both income and capital on an appropriate basis (40% income to 60% capital is a typical ratio), although the Revenue have promised a statement of practice and possibly legislation on the question of tax deductible TMEs.
One of the most common variations on the two basic types of trust is known as an accumulation and maintenance trust. In this type of trust, the settlor is usually a parent or grandparent settling trusts on the class of their children or grandchildren (one of whom must have been born at the time of creating the trust).
The trust begins by being fully discretionary as to income and capital and the beneficiaries acquire an interest in the income of the trust once they attain a certain age. They may then either acquire an interest in the capital or remain discretionary beneficiaries as to capital. Under UK inheritance tax rules, this type of trust avoids IHT so long as the beneficiaries attain at least an interest in possession by age 25. The paradigm structure is a two-tier structure where the asset is owned by a corporate vehicle and the corporate vehicle by a trust.
The trust wrapper disconnects the owner from the underlying company and achieves the individual's and their family's estate planning objectives; the corporate wrapper disconnects the investment property from its situs jurisdiction and achieves the tax planning objectives. On general principles, such an arrangement enables the individual and their family to become connected with any jurisdiction in the world without the family's investment property becoming exposed to those jurisdictions' often archaic and usually punitive tax, family and inheritance rules. And under general principles, the paradigm structure would achieve these objectives and beneficiaries would be able to receive payments tax-free, as and when required, to achieve the family's financial objectives.
Income and gains would roll up within the structure tax-free. The limitations on the success of the paradigm solution (in addition to the question of the recognition of trusts in civil law jurisdictions) are twofold: (1) the tax anti-avoidance rules and (2) the public policy rules operating in the jurisdiction(s) with which the individual and members of their family are or will become connected.
The impact of tax anti-avoidance rules will be covered in next month's article.
The public policy rules usually offended by the structure are those of forced heirship. (These rules should be distinguished from intestacy rules, which apply in common law jurisdictions if the deceased has left no will.)
Forced heirship rules override a will and severely restrict both testamentary freedom and the ability to make inter vivos gifts to individuals outside the immediate family, and indeed within the family. The rules typically would insist that a third of the deceased's estate went to their widowed spouse absolutely, a third to their children absolutely and a third to their widowed spouse for life.
Obviously a trust could potentially override these rules completely. Trust laws such as those in Jersey would resist the application of these rules and the trust should succeed in avoiding them. Nevertheless, the paradigm solution is the ultimate goal and the key is its achievement at the minimum initial, and ongoing, tax and administrative cost.
An ambitious objective
'Something completely new'
'Illusion of control'
Reasons to be cheerful
Total investment reaches £9m