HMRC Inheritance Tax: Customer Guide

How is inheritance tax charged on relevant property trusts?

When is inheritance tax charged on relevant property?

There are two types of tax charge on relevant property. They are

What is the ten-yearly charge?

The amount on which tax is charged at each ten-year anniversary is the value, after allowing for any business or agricultural relief due, of any relevant property in the trust immediately before that anniversary.

The tax is calculated on the assumption that a chargeable transfer has been made.

The calculation of tax on a chargeable transfer takes account of

  • the amount of the current transfer, and
  • the total of all chargeable transfers made by the transferor within the previous seven years (the transferor's cumulative total).

For this calculation, the amount of the current transfer is assumed to be the total value of

  • the relevant property in the trust, immediately before the anniversary, on the ten-year anniversary
  • any other trusts set up by the settlor on the same day as the trust on which tax is being charged, valued at the time they were set up, and
  • any other property at the time it was put into the trust and which has not at any time been relevant property.

The calculation of tax also takes into account an assumed 'cumulative total' of

  • all the transfers chargeable to inheritance tax made by the settlor in the seven years before the creation of the trust (the settlor's cumulative total), and
  • the amounts on which any proportionate charges arose in the ten years before the present charge.

These rules are slightly different if the trust was set up before 27 March 1974 and if there have been distributions from the trust before 9 March 1982.

What is the rate of the ten-yearly charge?

It is 30% of the rate for lifetime gifts. If the charge arose on 6 April 1996, the rate would be 30% of 20% of the amount by which the total exceeds £200,000 (the inheritance tax threshold at 6 April 1996).

Example 1

Ali has made taxable gifts totalling £200,000 in the seven years ending in 1990. In 1991 Ali transfers £400,000 into a discretionary trust. The first ten-yearly charge is due in 2001 when the value of the trust property is £600,000. £80,000 was paid out to beneficiaries in 1997. (This gave rise to a proportionate charge.)

In 2001, the inheritance tax threshold is £242,000. Tax is charged on the £600,000 relevant property then in settlement, as follows.

Stage 1 The cumulative total is £280,000 (£200,000 + £80,000). Add the relevant property in the current transfer, £600,000, to get £880,000.

Stage 2 The rate will be 20% of £638,000 (£880,000 - £242,000).

This makes £127,600.

Stage 3 Tax at the same rate on the cumulative total of £280,000 is deducted.

That is £7,600 (20% of £280,000 - £242,000). This gives £120,000.

Stage 4 The tax payable is 30% of £120,000 = £36,000.

Does the cumulative total include potentially exempt transfers (PETs) made by the settlor?

While the settlor is alive, the cumulative total does not include the amount of any PETs, and tax charges on the trust are calculated without taking them into account.

If the settlor's cumulative total is later adjusted to include PETs which become chargeable as a result of the settlor's death, the charges on the trust will be revised, and extra tax may become payable.

What if the settled property has not been relevant property for the full ten years?

The rate of the ten-yearly charge is reduced on any part of the relevant property that has not been relevant property for the full ten years. This might be because there was an interest in possession in part of the settled property, which came to an end during that period.

In Example 1, if one-third of the trust property valued in 1996 at £180,000 (that is, £60,000) has only been relevant property since 1994, that is for one-fifth of the ten-year period, the rate charged on that £60,000 will be reduced by four-fifths.

How is the tax calculated if there have been additions to the trust?

There are special rules for calculating the rate of tax if, after 8 March 1982, the settlor adds property (or value) to the trust. Then the amount described as the settlor's cumulative total may be replaced by the total of the settlor's chargeable transfers in the seven years before the settlor made the addition, if this is greater.

What is the proportionate charge?

There are two types of proportionate charge (or exit charge).

The first applies when property in a discretionary trust ceases to be relevant property. The main examples are when

The second type of charge only applies when the first does not. This occurs when the trustees make a disposition which reduces the value of the relevant property in the trust. For example, if the trustees hold shares in a close company and the value of the relevant property in the trust is affected by the actions of the company.

Are there any exceptions to the proportionate charge?

Yes. Inheritance tax is not charged

  • on payments by trustees of costs or expenses, which are attributable to relevant property
  • on payments that are subject to income tax in the hands of the recipient
  • when the event giving rise to the charge occurs within three months of the setting-up of a trust or within the three months following a ten-year anniversary
  • if property settled by a person domiciled outside the UK becomes excluded property and is no longer relevant property
  • on a decrease of value resulting from a bad bargain made by the trustees, if there was no intention to benefit by the disposition
  • on a decrease of value resulting from the grant for full consideration of an agricultural tenancy.

In addition to these exceptions, there is no proportionate charge when property ceases to be relevant property if it is then

What happens when distributions are made from property settled by a Will?

If a person's Will creates a discretionary trust and within two years of his or her death an event occurs which would usually give rise to a proportionate charge, a relief may be available. These events are treated as if they had occurred on the death. So any appropriate exemptions or reliefs, for example, for transfers between spouses and civil partners will be available.

But, this does not apply to events occurring within three months of the death. This is because, as explained above, these are not taxable.

How is the proportionate charge calculated?

The amount of the proportionate charge is the amount by which the value of the relevant property in the trust is decreased as a result of the event giving rise to the charge, that is, the loss to the trust.

If the tax payable is paid out of any relevant property remaining in the trust the loss will be grossed up so that the amount chargeable includes the tax. An example of settlement grossing can be found in the section on age 18 to 25 trusts.

What is the rate of the proportionate charge?

The rate of the proportionate charge is a fraction of the last ten-year anniversary. The fraction is calculated as one-fortieth for each complete quarter that has passed since that anniversary.

Example 2

At the last ten-year anniversary, tax of £1,800 (30% of £6,000) was charged on the £30,000 relevant property in the trust. Four years (that is, sixteen quarters) later, £20,000 is given to a beneficiary. Assuming no changes in the general rates of tax since the last ten-yearly charge, the £20,000 will be taxed at the fraction of 16/40 of the rate of 1,800/30,000.

16/40 x £20,000 = £8,000

1,800/30,000 x £8,000 = £480

So £480 inheritance tax will be payable.

What if, since the last ten-year anniversary, property has been added to the trust, or property already in the trust has become relevant property?

The property is treated as if it had been relevant property in the trust at the last ten-year anniversary. The rate of tax at that anniversary is re-calculated as if the value of the property at that time had been its value when you added it to the trust or when it became relevant property. This re-calculated rate is then used for the proportionate charge.

What is the rate of the proportionate charge before the first ten-year anniversary?

There are special rules when the proportionate charge occurs before the first ten-year anniversary of a trust set up after 26 March 1974.

The rate of tax is a fraction of a rate calculated on the value of

  • all the property in the trust at the time of its creation
  • any property subsequently added to the trust, and
  • any other property in any other trust made by the settlor on the same day.

The cumulative total of the settlor's chargeable transfers in the seven years before the setting up of the trust is also added to the calculation. This rate is worked out in the same way as the rate of the ten-yearly charge.

Example 3

In June 1994 Bert, who has made chargeable transfers of £110,000 in the previous seven years, hands £500,000 to trustees to set up a discretionary trust. Bert pays the tax. In May 2001 the trustees give £20,000 to a beneficiary. The property has been relevant property throughout. The tax on the £20,000 will be calculated as follows.

Stage 1 Add the lifetime transfers, £110,000, to the value of property in the trust at its creation, £500,000, to get £610,000.

Stage 2 The initial calculation will be 20% of £368,000 (£610,000 - £242,000).

This makes £73,600.

Stage 3 The final rate will be £73,600/£500,000 x 100% = 14.72

27/40 x 30% x 14.72 = 2.98%

Stage 4 The tax payable is £20,000 x 2.98% = £596.

The tax is calculated on the basis of 30% of one-half of the death rate applying at the time of the distribution.

The fraction is calculated as one-fortieth for each complete quarter that has passed since the creation of the trust. In this example, the fraction is twenty seven fortieths. The fraction is reduced if the property was not relevant property for the whole period since the start of the trust.