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Cumulation principle for investment bonds in trust

Care needs to be taken when writing an investment bond in trust because of the impact the cumulation principle may have on pre-existing trusts. It is necessary to go back 14 years to look at the history of previously written trusts because of the way in which UK inheritance tax is calculated with regard to trusts. It is all too easy for trustees and settlors to be unaware of the inheritance tax consequences of establishing a new trust, particularly when previously written trusts attracted no immediate liability to inheritance tax.

The starting point for working out the impact a new trust can have on pre-existing trusts is to consider what type of gifts have been made into the previous trusts. HMRC will regard these gifts as either Chargeable Lifetime Transfers (CLT) or as Potentially Exempt Transfers (PET) and this is determined by whether the trust is a Bare, sometimes referred to as absolute, trust or a trust where the beneficiaries are not fixed from outset and can be changed in the future, which is regarded as being set up on a discretionary basis. Transfers into Bare trusts or absolute trusts are deemed to be Potentially Exempt Transfers whereas transfers into discretionary or Interest in Possession trusts are regarded as Chargeable Lifetime Transfers.

The next step is to work out the chronology of these trusts to see how they impact cumulatively on the available Nil Rate Band. As mentioned previously we need to go back 14 years to be certain that a proposed new trust does not inadvertently negate the IHT efficacy of other pre-existing trusts.

The cumulation principle amalgamates previous transfers and applies them in order to calculate the rate of tax applicable to the most recent transfer. Previous PETs and CLTs can inter-act because both become chargeable to Inheritance Tax if death occurs within 7 years of setting up the investment bond within an absolute, discretionary of interest in possession trust. We need to take into account all CLT’s made up to 7 years before each trust was established. So where a PET was made within 7 years of death it is necessary to check for CLTs established up to 7 years previously to work out any reduction this has on the available Nil Rate Band. Where there is an overlap it can have a dramatic and avoidable IHT consequence.

For example if an investment bond was written into a trust established on an absolute basis they have created a PET. If the settlor died one day before the 7 years required for this to fall outside of their estate, this is said to be a failed PET. If another investment bond was written into a trust set up on a discretionary basis within 7 years of the more recent trust, this would mean we have a CLT to take into account. The way this is calculated is to deduct the value of the CLT from the available Nil Rate Band and any remaining Nil Rate band can be offset against the failed PET which can also be reduced by Taper Relief.

Had a full seven years passed between the creation of the two trusts, the first CLT would have been taken out of the cumulative total. So careful planning and the application of due diligence could have prevented the overlapping of two trusts and the unnecessary creation of a tax charge.

To demonstrate the cumulation principle, HMRC have produced a worked example.