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Trusts - one size does not fit all

When we talk about tax or estate planning using trusts, it’s vitally important that both client and adviser understand that, as far as trust planning is concerned, there is no such thing as a “one size fits all” approach.

I have many conversations with advisers on this subject, usually triggered by the question:


“I need to put this investment in trust, but which one shall I use?”


My response is usually to ask the following questions to help them ascertain what the client’s actual requirements are:


  • Client’s domicile?
  • Client’s objective?
  • Will the client require access and, if so, how much?
  • Does the client have fixed beneficiaries in mind which will never change, or do they require that the trustees have flexibility as to who should benefit?

So why is it important that these factors are considered?


Domicile


If the client is UK domiciled, then the transfer will be a tax event for UK Inheritance Tax (UK IHT) purposes and, depending upon the trust terms, the amount of the transfer and the client’s history of undertaking similar types of transactions, there could be an immediate UK IHT liability.


If the client is not UK domiciled, for example, from a Civil Law jurisdiction, then that has its own complications. Where Civil Law jurisdictions are concerned, the question arises as to how the creation of the trust is viewed by the tax authorities of that particular country.


Furthermore, consideration needs to be given as to whether the trust must be structured in a particular way to ensure it is fit for purpose and not going to have an adverse effect on the client in the future.


Objective


Is the objective to remove assets from the client’s taxable estate, achieve specific succession planning or simply to avoid obtaining probate for the asset following death? It is of course possible to achieve all of this with one trust, but not without there being restrictions on access or possibly having to pay a tax charge.


A common client misconception is that you can have effective UK IHT planning whilst having unfettered access to the original capital, just because the asset is in trust. This is certainly not the case for UK domiciled clients as it would be a ‘Gift with Reservation’ under the Finance Act 1986. However, for non UK domiciles moving to the UK it is possible, but you have to know which trust is right for them and, more importantly, the assets that can be held within it.


Access


Where a UK domiciled individual is concerned, having access results in the trust fund in which they have an interest being deemed part of their estate for UK IHT, irrespective of whether they actually benefit or not. As such, where UK IHT planning is concerned, access is either prohibited altogether or restricted to certain rights.


For example, where an outright gift is made under trust, the donor is usually excluded from all benefit; however, under structures such as Loan Trusts or Discounted Gift Trusts, there is restricted access.


Fixed or Discretionary Beneficiaries


This decision will usually be based on tax reasons or succession planning requirements.


Transfers into trusts by UK domiciled individuals fall into two camps:


  • Potentially Exempt Transfers (PET)
  • Chargeable Lifetime Transfers (CLT)

Following the changes to the taxation of trusts in the 2006 Finance Act, to qualify as a PET there must be fixed beneficiaries which cannot be changed. If the donor survives seven years from the date of the transfer, the amount transferred is exempt from UK IHT and none is payable at the time of the transfer, irrespective of the amount.


Where there are discretionary beneficiaries the transfer will, in most cases, be a CLT and immediately chargeable where the value exceeds the donor’s available nil rate band (currently £325,000).


Therefore, the decision for UK domiciles is, whether tax is more important than flexibility or vice versa.


Where the donor is not UK domiciled, tax may be less important. However, the donor may still have concerns as to who should benefit and therefore, in some circumstances, having discretionary beneficiaries may be more important to ensure flexibility. Again, the reverse is also true.


For example, a client concerned that his children may squander their inheritance may lean towards a flexible trust so that the trustees can determine whether or not a beneficiary is financially and mentally capable of using the distribution in accordance with the original wishes of the client.


On the other hand, where a savings plan is funded to pay for a specific child’s future education needs (and where there are concerns that other family members may try and get access), the plan might be better placed in a trust with fixed beneficiaries so that only that child could benefit.


Fixed beneficiary trusts can also be useful in jurisdictions with forced heirship rules as they can provide for individuals who would otherwise be excluded from benefiting directly from an estate. However, care is required in this particular area of planning.


Most international life companies will have a good range of trusts which are free to use with their products, but each trust will usually have a defined purpose. In most cases, unless the client is prepared to pay significant legal fees to have a specific trust drafted for their exact circumstances, there has to be a compromise. As such, whilst ‘off the shelf’ trusts are not suitable for everybody, they will usually do the job for most clients providing they understand what they are signing up to.


Trusts are legal documents evidencing the transfer of ownership from one party to another. Therefore, should it transpire that the client needs the capital back years down the line, it’s not simply a case of ripping up the trust and pretending it never existed (yes, this is sometimes suggested!).


Unwinding a trust can be an expensive and lengthy process which can involve the matter going to court where it is not possible bring the trust to an end in accordance with the desired end result and, more importantly, within the provisions of the trust. Should court be the only option, it must be understood that all supporting documents evidencing the original intentions for the planning will be reviewed and, therefore, it is unlikely that a trust would be declared null and void just because a client’s personal circumstances have changed.


Life companies can provide very good technical support and should be able to discuss a client’s particular circumstances with an adviser to ensure that all of the factors covered in this article have been considered.