Inheritance Tax and Discretionary Trusts

Discretionary trusts fall within the "relevant property" regime under IHTA 1984, which subjects them to IHT at three potential points: on entry, on each ten-year anniversary, and on exit.

What the law says

1. Entry Charge (on creation / transfer in)

When a settlor transfers property into a discretionary trust during their lifetime, this is an immediately chargeable transfer (not a potentially exempt transfer). Tax is charged at the lifetime rate of 20% on the value exceeding the available nil rate band, after cumulating chargeable transfers in the preceding seven years.

2. Ten-Year Anniversary (Principal) Charge — IHTA 1984, s.64

Where immediately before a ten-year anniversary all or any part of the property comprised in a settlement is relevant property, tax is charged at the rate applicable under ss.66 and 67 on the value of that property at that time.

3. Exit (Proportionate) Charge — IHTA 1984, s.65

A charge arises:

• where property comprised in a settlement ceases to be relevant property (whether because it leaves the settlement or otherwise); or
• where the trustees make a disposition that reduces the value of relevant property in the settlement.

The amount charged is the reduction in value of relevant property immediately after the event. No exit charge arises if the event occurs in the first quarter of the settlement's life or in the quarter beginning with a ten-year anniversary.

Payments of costs/expenses fairly attributable to relevant property, and payments that constitute income for income tax purposes, are exempt from the exit charge.

4. Rate between ten-year anniversaries — IHTA 1984, s.69

The exit charge rate is the appropriate fraction of the rate last charged (or that would have been charged) at the most recent ten-year anniversary under s.64.

5. Excluded / "Special" Trusts

Certain discretionary trusts do not contain relevant property and are therefore not subject to the ten-year and exit charges under ss.64 and 65. These include trusts for disabled persons, employee trusts (meeting IHTA 1984, s.86 conditions), protective trusts, temporary charitable trusts, pension funds, and heritage maintenance trusts.

HMRC Guidance / Practice

Overall design of the regime

HMRC explains that the underlying design is that IHT on relevant property trusts should be comparable to a charge of 40% once a generation. In practice this means a 20% lifetime entry charge on the settlor and three ten-year anniversary (TYA) charges at up to 6% (3/10ths of 20%) on the trustees. The rate cannot exceed 6%.

Calculating the TYA charge

The rate is based on a notional lifetime transfer as if the trust funds were hypothetically transferred at the date of the TYA. The nil rate band available is reduced to account for previous cumulative transfers. A reduction is available for assets that have not been in the trust for the whole ten years.

Interaction with gifts with reservation (GWR)

The normal discretionary trust charges (TYA and proportionate charges) are unaffected by any GWR claim. GWR double charges relief applies only to charges on the settlor as an individual and does not affect TYA or proportionate charges. The rate for later proportionate charges remains based on the original "historic" value at set-up or the last TYA — not any higher death-estate value.

Liability of trustees

Any IHT due from the trust because of the settlor's death or a failed PET is a liability of the trustees.

Cumulation with death estate

Chargeable transfers into discretionary trusts (being immediately chargeable transfers) cumulate with the death estate when calculating IHT on death, within the seven-year window.

Practical example of entry charge

HMRC illustrates: a transfer of £250,000 into a discretionary trust, with £80,000 of prior chargeable transfers in the preceding seven years, gives a total of £330,000. After deducting the nil rate band (£325,000 at the time), the excess of £5,000 is taxed at 20%, producing £1,000 of lifetime tax.

Summary Table