Will drafting after the Finance Act 2006

The Finance (No 2) Bill 2006 received Royal Assent on 19 July 2006. Barrister Karen Hepworth considers the options that elderly clients now have when drafting their wills.

Readers will be all too familiar with the main implications of BN25, the Finance (No 2) Bill 2006 and the amendments that were subsequently made to the draft legislation in response to the many criticisms that were levied against the wholesale overhaul (or, as the government calls it, ‘alignment’) of the relevant property regime. One question that has been pressing on the mind of probate practitioners since Gordon Brown first delivered his bombshell earlier this year is, what advice should clients be given in relation to the drafting of their wills and who needs to review their wills?

Schedule 20 to the Finance Act 2006

The individuals most likely to be affected by the changes introduced by Schedule 20 in its final form are those with estates worth more than £285,000 and in particular:

Grandparents, who will no longer be able to set up accumulation and maintenance (A&M) trusts that attract tax privileges for their grandchildren;
Anyone who wants to leave assets in trust for their children, step-children or children for whom they have ‘parental responsibility’ within the meaning of the Children Act 1989;
Anyone who currently has a will containing a life interest, depending on the terms of the life interest; and
Those testators who wish to benefit disabled beneficiaries who will now fall within the wider definition of a ‘disabled person’s interest’ for the purposes of the Inheritance Tax Act 1984 (IHTA).

Gifts to spouses and civil partners etc

Outright gifts to spouses are not affected by the changes introduced by the Finance Act. Similarly, as was the case pre-budget, testators should take advantage of APR and BPR if it makes sense to divert business or agricultural property to non-exempt beneficiaries, such as children. As we know, however, matters are not so simple when a testator wishes to settle his assets on trust.

One of the most controversial aspects of the first draft of the Finance Bill was its impact on the loss of spouse exemption in relation to some will trusts, leading to an IHT charge on the death of the first spouse. Thankfully, the government has backtracked on its proposals and although interest in possession trusts will be subject to the same ten-year anniversary and exit charges as discretionary trusts unless they create an ‘immediate post death interest’ (IPDI), the requirements of an IPDI are now less stringent than those originally set out in the Finance Bill, as the requirements relating to overriding powers and the ultimate devolution of the trust property have been removed (original conditions 3 and 4).

IPDIs are of course not confined to use where spouses or civil partners are concerned; they may be used for children, friends or unmarried partners. However, for will-drafting purposes, one is most likely to encounter the use of a life interest, which for tax purposes should be an IPDI where either (a) the testator wishes to benefit their spouse or civil partner but only give them a life interest, perhaps because they have children from an earlier relationship who will be named as the remaindermen; or (b) when a testator wishes to benefit their minor grandchildren and avoid periodic and exit charges but (for the reasons set out below) cannot establish a “trust for a bereaved minor” or a “trust for 18 to 25 year olds”.

New section 49A sets out four conditions that must be satisfied in order to create an IPDI by a will (references to section numbers being references to new sections in the IHTA):

Condition 1: A settlement must be created: section 49A(2). This is not a difficult condition to satisfy.

Condition 2: A person ‘L’ must become beneficially entitled to an interest in possession (IIP) in the settled property on the testator’s death: section 49A(3). L must therefore have a present right to present enjoyment of the trust property from day one, which is a concept practitioners already encounter on a daily basis when undertaking inheritance tax planning (albeit usually when seeking to ensure that a beneficiary does not have an IIP).

Condition 3: Section 71A of the IHTA must not apply to the property in which L has an interest and L’s interest must not be a disabled person’s interest: section 49A(4). This requires practitioners to familiarise themselves with the new section 71A and the extended meaning of a disabled person’s interest set out in new section 89B.

Condition 4: Once L becomes beneficially entitled to an IIP, condition 3 must remain satisfied: section 49A(5).

Thus, unless an unusual quirk is incorporated in a will, such as the inclusion of a short-term discretionary trust before the life interest takes effect, or the inclusion of a power of accumulation (possibly inadvertently), most intended life interests will qualify as IPDIs. This will be a relief for most testators and their advisors alike. It will not be necessary to consider a potential minefield in order to preserve the spouse exemption.

“Trusts for bereaved minors” and “age 18-to-25 trusts”

Elderly clients who wish to skip a generation and draft their wills so as to benefit their minor grandchildren rather than their children will need to reconsider their testamentary options if their current will includes an A&M trust. This is because new A&M trusts will no longer receive preferential tax treatment. Section 71 of the IHTA has been amended and new sections 71A-H have been introduced – A&Ms have been replaced from 23 March 2006 by “trusts for bereaved minors” and “age 18-to-25 trusts”. The testator will therefore need to understand how the trust that their will currently establishes will be taxed and decide whether or not they wish to leave their will in its present form (accepting the tax consequences but preferring the dispositive consequences) or amend it.
As ever, some testators will want to achieve a particular objective, regardless of the tax consequences!

Trusts for bereaved minors cannot be established under the will of a grandparent unless the grandparent has ‘parental responsibility’ for the child. Consequently, the government has dealt a blow to grandparents who wish to settle property on trust for their minor grandchildren while at the same time broadening options for ‘parents’. Parents, step-parents and any other person with parental responsibility have the option of bringing their will within the new rules.

A trust for a bereaved minor will exist if the following conditions are satisfied:

Property is settled by the will of a deceased “parent”, which is defined by new section 71H of the IHTA to mean a testator who immediately before his death had “parental responsibility” for the minor within the meaning of the Children Act 1989. If someone else’s children live with a testator it will therefore be necessary to confirm that the testator actually has “parental responsibility”;
The property is settled for a person who has not yet reached 18 years old, and at least one of whose “parents” has died (“the bereaved minor”);
The trust’s terms “secure” that while the bereaved minor is living and under 18 any income that is applied is applied for his “benefit” and that either all income shall be applied for his benefit or no income may be applied for the benefit of anyone else; and
On or before his 18th birthday, the bereaved minor must become absolutely entitled to the capital and the actual or any accumulated income arising therefrom.

Section 71A will still apply if the trustees have the power conferred by section 32 of the Trustee Act 1925 (in its original or commonly amended form) or if they have “powers to the like effect”. If bespoke powers are incorporated then careful consideration should be given to the meaning of the words “to the like effect”, as should the inclusion of overriding powers of appointment which could be used to deprive the bereaved minor of his entitlement.

An umbrella clause preventing trustees from exercising their powers in any way that is inconsistent with section 71A may prove useful, as it did in relation to A&M trusts. The advantage of a trust for a bereaved minor is that there will be no tax charge when the minor becomes absolutely entitled to capital, if he dies under 18, or when the trust property is paid or applied to or for the minor’s benefit. For testators who want to avoid paying tax (perhaps because they view that route as the ‘simplest’ way to do things), this option is therefore attractive.

However, many testators will consider that 18 is too young for the child beneficiary to become absolutely entitled to capital. In response to this outcry, the government has given us “trusts for 18-to-25 year olds” and a new section 71D of the IHTA. This allows testators to provide that a beneficiary shall become entitled to capital at any age up to 25. The rules are similar to those for a trust for bereaved minors and the same fiscal advantages apply while the beneficiary is aged under 18. Tax charges will arise when the beneficiary is aged between 18 and 25 (up to 4.2 per cent). The rules that dictate how the tax will be calculated are set out in new sections 71F and 71G and many testators are likely to find this charge acceptable when faced with the alternative scheme offered by a “trust for bereaved minors”; that is, that the children will become entitled to capital at 18 or earlier.

What options are available for grandparents then? Well, a simple discretionary trust ought not to be ruled out. Discretionary trusts should not be seen as the enemy, to be avoided at all costs. They are an attractive and reasonable option in a number of cases. At present, the charges on ten-year anniversaries and when an exit charge arises are not overly onerous. An IIP trust could also be an attractive option. Thus, if grandparents are not deterred from using trusts full stop, they still have options to settle their assets on trust and advisors will be able to consider these where appropriate.

Parents, step-parents and individuals with parental responsibility must also not assume that they must set up either a trust for a bereaved minor or a trust for an 18-to-25 year old, as opposed to, say, a fully flexible discretionary trust.

NRB gifts etc

A gift of assets equal in value to the testator’s available nil-rate band will continue to constitute basic tax planning for testators with a spouse or civil partner. Given that the value of the trust fund will fall below the nil-rate band, periodic and exit charges may not be a primary cause for concern when the property is settled on discretionary trust. Section 144 appointments also continue to have relevance, which means that those testators who are unsure about their surviving partner’s needs should continue to be advised about the benefits of a two-year discretionary trust.

When the Finance Bill was published, concern was raised about how the amendments would affect wills that create two trusts, one of which includes an IIP for a spouse or civil partner. Where section 80 of the IHTA applied, it deferred the deemed date of commencement of the spouse/civil partner interested trust to avoid the related settlement provisions applying. The original Finance Bill excluded the operation of section 80 in relation to settlements created after 22 March 2006. However, the government has listened to the concerns raised and section 80 has been amended so that if a will contains two trusts and one either involves an IPDI for a spouse or civil partner or a disabled person’s interest, the deemed date for the commencement of the trust for IHT purposes is still postponed by section 80.

Inserting sufficient powers to establish a debt or charge scheme will no doubt continue. However, given the amendment to section 49 of the IHTA 1984, the personal representatives should take advice after the death of the testator as to whether to implement a debt/charge scheme where it is necessary to resort to the testator’s share in the matrimonial home in order to populate a nil-rate-band trust fund.

Summary

The simplest tax-efficient wills, which incorporate an absolute gift of the nil-rate band to children and the residue passes to the testator’s spouse, absolutely continue to be a sensible and prudent option. Similarly, the final form of the Finance Act 2006 means that life interests can still be established for a spouse of a second marriage and attract spouse exemption on the death of the first to die. However, advising those testators who wish to benefit their grandchildren has become more complicated and the solution for each testator may depend on what their paramount objective is – tax saving, control or flexibility. Additionally, lifetime planning should not be disregarded. Although this article does not consider the establishment of lifetime settlements, the Finance Act also impacts on lifetime options (including the late introduction of section 89A of the Inheritance Tax Act 1984, which permits self-settlement on trusts for disabled persons) and testators with surplus capital and income may indeed wish to consider making lifetime disposals, while it still remains possible to make PETs!

Disclaimer

The author is a barrister at 5 Stone Buildings. The views expressed in this article are the author’s alone and are intended to prompt discussion only. Readers should take independent advice and the author cannot accept liability for any act or omission resulting from the contents of this article.

Karen Hepworth is a barrister at 5 Stone Buildings. She can be contacted at khepworth@5sblaw.com