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Taxation of discretionary trusts

Gifts into discretionary trusts are treated as Chargeable Lifetime Transfers (CLTs) and if the amount gifted exceeds the donor’s available Nil Rate Band, 20% tax is immediately due on the excess. Whilst IHT is liable at the rate of 40%, any lifetime IHT already paid will be taken into account as a credit, but this cannot result in a refund.

As with absolute trusts, taper relief can be applied  if the CLT exceeds the available nil rate band and death occurs after 3 years but before 7 years from the date the gift was made.

Care needs to be taken on the impact making an immediate CLT has on any previous CLTs. We have to look back retrospectively to take into account all CLTs made in the preceding seven years so they can be deducted from the available nil rate band.

Unlike absolute trusts, the beneficiaries’ share of trust property held in a discretionary trust does not fall into their estate for inheritance tax purposes unless advances of capital have been made to them by the trustees.

Periodic Charges for Discretionary Trusts

Investment bonds held within discretionary trusts may be subject to periodic IHT charges every 10 years. This will be the value of the investment bond less the available Nil Rate Band at the 10 year anniversary and the maximum charge is capped at 6%.

Exit Charges for Discretionary Trusts

An investment bond held within a discretionary trust may also be subject to an exit charge when the trustees distribute capital, regular income or ad hoc amounts to the beneficiaries.

Exit charges are calculated by reference to the time the trust was first established or, if more recent, from the date of the last 10­year periodic charge.

If the exit charge applies prior to a 10-year periodic charge, an “effective rate” is applied by multiplying each complete quarter of a calendar year the investment bond has been held for by 1/40th. This figure is then multiplied by an “appropriate fraction” of 30%. Any previous Chargeable Lifetime Transfers made in the previous 7 years have to be taken into account. The current available Nil Rate Band can be deducted from the amount distributed to the beneficiaries plus the original value of the investment bond to give a “taxable amount” which suffers a hypothetical Chargeable Lifetime Transfer tax charge at 20%. This figure is then divided by the current value of the investment bond and multiplied by 100 to give us the “Effective Rate”. 30% of this effective rate is then applied to the value of the distribution amount to give the tax payable.

Where an exit charge applies after a 10 year periodic charge, we take the effective rate from the last periodic charge and work out how many complete quarters have passed since the last periodic charge. The number of complete quarters is divided by 40 and multiplied by 30% to give the appropriate fraction which is then applied to the amount to be distributed.