HMRC The Taxation of Trusts: A Review

Summary

Interest in Possession (IIP) trusts can be useful for protecting the financial security of women who are bereaved or suffer a relationship breakdown, where the deceased or former partner wanted ultimately to pass his assets to children from a former relationship or other original family members.

Given that complex families are commonplace these days, we urge HMRC to carry out an impact analysis of any changes it proposes to the trust regime and, within that analysis, to give particular regard to the impact on women in situations of bereavement and relationship breakdown.

The use of IIP trusts has declined by 28% since the introduction of harsher tax rules since 2006. While IIP trusts are used by a minority, they have a useful and legitimate role. Therefore we urge HMRC to:
• avoid changes that would further detract from the use of IIP trusts as a means of providing for bereaved partners; and
• consider whether reducing the complexity of the tax regime might help to extend the opportunity to use IIP trusts to people with lesser wealth and so increase the number of women who are financially protected when relationships break down.

1. We welcome the opportunity to respond to the HMRC consultation: The Taxation of Trusts: A Review. Trusts (arrangements where the legal ownership of assets rest with one or more people – the trustees – who have the duty to apply those assets for the benefit of a specified person or group – called the beneficiaries) are ancient arrangements that enable a person (the settlor) to give away assets but retain some control over them.

Trusts in the context of complex family structures
2. While trusts may be used for tax avoidance and have been subject to repeated changes in tax legislation to tackle this, they also have legitimate uses. HMRC lists some of these in its consultation document (paragraphs 3.4.1 to 3.4.5) but worryingly omits a key use that is particularly relevant to women: providing a lifetime income, home or other use of assets for a widowed or divorced partner, while the assets themselves are eventually passed to other beneficiaries, often children or grandchildren from a former relationship.

3. In England and Wales, women who are married or in a civil partnership are more likely than men to outlive their partner (with 75% of widowed people of all ages being women (1)) and, given women’s longer life expectancy (2), the same is almost certainly true for unmarried partners. Recent data are not available, but in 2011 around 11% of couple families (married, civil partners or cohabiting) had dependent stepchildren (3); and, in a third of new marriages, one or both partners has previously been married (a proportion which increases with age(4)).

4. Given that complex families are commonplace these days, we urge HMRC to carry out an impact analysis of any changes it proposes to the trust regime and, within that analysis, to give particular regard to the impact on women in situations of bereavement and relationship breakdown.

Decline in use of IIP trusts due to tax changes

5. Under an IIP trust, the settlor puts assets into trust and a beneficiary (or possibly more than one) is given a life interest in the trust assets. The life interest takes the form of income produced by the assets or use of the assets (eg a house) during that beneficiary’s lifetime or until a specified event (such as remarriage). However, there is no entitlement for this beneficiary to take outright control of the assets. The trustees instead preserve these assets to be passed on eventually to the residual beneficiaries, eg the children or grandchildren of the settlor from a previous relationship.

6. Prior to 2006, IIP trusts set up during the settlor’s lifetime were treated in the same way as outright gifts to a person, ie as potentially exempt transfers with no inheritance tax due provided the settlor survived for seven years after making the transfer into trust. Continuing that logic, the person with the life interest was then treated as if they owned the assets for the purposes of income tax, capital gains tax and inheritance tax. From 2006, the inheritance tax treatment changed and, in particular: 

• lifetime transfers into an IIP became treated as chargeable transfers in the same way as gifts to most other forms of trust and subject to the ‘relevant property regime’ which imposes 10-yearly tax charges. The person with the life interest is no longer treated as owning the assets which, among other consequences, means one spouse or civil partner setting up a trust in their lifetime giving an interest in possession to the other no longer has exemption from inheritance tax under the spouse exemption.

• However, IIP trusts set up in a will continue to be treated favourably, provided they meet a set of narrow conditions. For example, a trust giving an IIP to a surviving spouse immediately on death of the settlor, with the property passing absolutely to the deceased’s adult children when the IIP ends would qualify.

• The only lifetime transfers into IIPs treated favourably are those where the person deemed to have the life interest has a disability.

7. Since 2006, there has been a fall in the number of IIP trusts from 74,500 in 2005-6 to 53,500 in 2015-16 (a fall of 28%) and HMRC acknowledges that this is likely due to the changes in tax treatment (5).

IIP trusts and bereavement

8. The data indicate that it is far from uncommon for women to be in relationships where their partner may be torn between providing an inheritance for previous or original family and ensuring financial security for their current partner. Interest in possession (IIP) trusts are a traditional way to address this problem.

9. Therefore, we urge HMRC, in its current review, to avoid any changes that would further impede the use of IIP trusts in wills as a means of providing for bereaved partners.

IIP trusts and relationship breakdown

10. Divorce is widespread: 1 in 3 people married in 1998 were divorced by their 15th wedding anniversary and financial insecurity is greater among divorced women than men, with for example 43% of divorced women reporting debt as a burden compared with 34% of men.(6)

11. When a relationship breaks down, IIP trusts may be used to give one of the former partners (usually the woman) use of assets, such as the family home, eg while children are still dependant or until remarriage, with the assets subsequently being passed on within the original family. However, this has become an unattractive arrangement since 2006 because such a trust may trigger an immediate inheritance tax charge (unless a court has ordered that the trust be set up) and is subject to the complicated ‘relevant property regime’.

12. Currently, IIP trusts are used by a minority on relationship breakdown and typically only where the parties are wealthy. However, they have a useful and legitimate role in the context of complicated family structures. The tax complexity, and related high charges for expert advice, no doubt contribute to the limited use of IIP trusts on relationship breakdown. Research commissioned by HMRC for the purpose of this consultation was limited to users of trusts but even so found limited prior understanding of what trusts might be used for (7). Awareness of trusts and their uses in the general population is likely to be very low. However, greater use of IIP trusts on relationship breakdown might reduce the incidence of wealthier partners hiding assets (since they could be confident that the assets would revert to family members in time) and spread the financial protection IIPs can afford beyond the wealthy elite.

13. HMRC should consider whether reducing the complexity of the tax regime might help to extend the opportunity to use IIP trusts to people with lesser wealth and so increase the number of women who are financially protected when relationships break down.

Written by

Jonquil Lowe, Senior Lecturer in Economics and Personal Finance, The Open University, jonquil.lowe@open.ac.uk

Mary-Ann Stephenson, Director of Women’s Budget Group, maryann.stephenson@wbg.org.uk