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Author: Jo Summers (firstname.lastname@example.org) - 16/11/2010
Are trusts dead?
Finance Act 2006 started the 'attack' by aligning the inheritance tax ('IHT') treatment of trusts. Gone was the old IHT distinction between discretionary trusts (bad) and life interest/accumulation & maintenance trusts (good). Since 22 March 2006 a lifetime transfer into any type of trust (with limited exceptions for disabled trusts) is a chargeable transfer.
This means an upfront 20% inheritance tax charge for the settlor on any value settled above the nil-rate threshold (unless the assets are exempt from IHT). This may be a problem for even more clients now the nil-rate band has been frozen for next tax year at £325,000. If the settlor is careless enough to die within 7 years of making the settlement, up to a further 20% IHT will become due.
Then there are the IHT charges that apply to trustees on every tenth anniversary and every time capital 'exits' from the trust. Although the maximum rate is currently only 6%, many clients and practitioners are convinced this will increase as the UK struggles to plug the deficit gap.
As if that wasn't enough, from 6 April 2010 many UK trusts will find themselves paying income tax at the new higher rate of 50%. Although, for individuals, this tax rate only hits high earners (£150,000+ per annum) there is no such threshold for trusts. Many smaller trusts may have to consider appointing life interests to avoid paying 50% tax on the trust income.
December's Pre-Budget Report continued the theme that trusts should be stamped out. PBR Note 21 targeted two specific trust structures:
• the purchase of someone else's interest in a trust (usually an excluded property trust so outside the scope of IHT); and
• using reversionary interests to reduce the value chargeable at 20% on settling funds into trust.
The speed at which HMRC acted in plugging these so-called loopholes shows that trusts are perceived as a serious threat to the Exchequer. The following statement in press release PBR 09/03 confirmed this view:
"The Government announces it is also examining wider solutions to the problem of trusts being used to avoid inheritance tax."
The implication appears to be that trusts are a 'problem' and are only used to avoid IHT. Indeed, there is now a wider issue in that tax avoidance (rather than illegal evasion) is no longer seen as being acceptable. Alistair Darling managed to fit the following comment into his pre-budget report speech:
"I am determined to tackle activities, such as avoidance and evasion, which undermine tax receipts."
No doubt this sentiment comes from an urgent need to balance UK plc's books. But it seems clear that trusts are seen as being unacceptable and designed solely to 'undermine tax receipts'. In light of this opposition, trusts hardly seem an attractive proposal currently.
Partnerships to the rescue?
Of course the problem with all this 'trust-bashing' is that it ignores the many non-tax reasons for settlements being created. Wealthy families are increasingly concerned about asset protection, hoping to ensure that the family's money lasts longer than just one or two generations. Most trust practitioners have stories of beneficiaries who need protecting from themselves: who would drink/smoke/spend/crash any money given to them without the protection of a trust.
Recent high profile divorce cases have shown that trusts do not provide total protection against avaricious ex-spouses, but they're definitely better than nothing. If wealthy parents give funds outright to their children, no matter how much they trust their own offspring, there is always a concern about current or future other halves.
So whilst UK trusts may be unattractive from a tax-perspective, families are still looking for ways to replicate the asset protection advantages of trusts. Enter family partnerships, which are being mooted as the next best thing.
In fact, the use of a partnership as an estate-planning vehicle is not new. It is a common structure in US succession planning. In the UK, it is most commonly used as a means of gradually transferring the ownership and ultimately the control of a family trading business (such as a farm) to the next generation but in a controlled manner. This is done by:
• The senior partners (usually parents) introducing junior partners (their children) and transferring (to their capital accounts) a proportion of the value of the business.
• The senior partners retaining voting control until the junior partners are ready to take on more responsibility.
There is no reason why this model could not be used where the business is not, say, a farm but investing family assets with a view to generating income and capital growth.
Partnerships as the ‘new trust’
Partnerships are a creature of contract. The partnership deed (presuming there is one) is a contractual arrangement between the partners. Practitioners have long been used to persuading partners to record their contractual arrangement in writing, not least to prevent the trust terminating on the death of one partner. Partnership deeds can take time to prepare since the draftsman will have to obtain details of every agreement between the partners, no matter how informal.
The partnership deed can cover every aspect of the partnership: who has control, who gets income or capital, when the partnership terminates, who is liable for the partnership’s debts, what happens if a partner wants to leave, dies or becomes bankrupt and so on.
It is quite possible to structure a partnership to replicate trust relationships, both in relation to control of partnership assets and access to income/profits. For example, the role of trustees in controlling and administering the trust assets can be given to the senior partners. However, those senior partners may only have a restricted interest in the partnership income and profits. Indeed, there is nothing preventing a partnership appointing a managing partner who receives a fixed salary but, like a trustee, has no other financial interest in the partnership. On the other hand, those partners with the financial interest may, like beneficiaries of a trust, have little or no control.
In some respects partnerships can be more attractive than trusts, particularly to settlors who don't like to lose control. A partnership does not have to terminate within the perpetuity period applicable to trusts. Even with the extension of the statutory trust period to 125 years, some clients are desperate to rule their family from beyond the grave for as long as possible. A partnership can continue without any fixed termination date, but instead allow the partners to vote to bring the partnership to an end.
Another potential draw back with trusts is that the settlor has no rights once the trust has been created, unless s/he is also a beneficiary. This can frustrate settlors who wish to control the trustees, leading to concepts such as the reserved powers trust. With a partnership, the ‘settlor’ can retain control as one of the senior partners, for example reserving ultimate voting control over ‘big’ decisions such as termination of the partnership and distribution of capital.
Partnerships have another potential advantage over trusts. Frequently trusts are seen as being old fashioned and inflexible. Once the trust deed has been signed, it may be difficult to change its terms or add to the trustees’ powers without an expensive application to court. Because partnerships are contractual, the partners can agree to change the terms of the partnership if circumstances change. This could be used to pass more control to the ‘junior partners’ as and when they show they are financially responsible.
There is one potential downside to this contractual flexibility. Trusts are frequently created to benefit minor or even unborn children. Minors cannot however contract and cannot be bound by any contractual arrangement signed on their behalf. There is a great deal of uncertainty as to what this means in practice to partnerships. Can a child repudiate his or her partnership interest upon reaching age 18? Or could it be even worse, could the child disclaim any interest in the partnership’s debts but still retain the funds in his/her capital account?
Partnerships also struggle to deal with unborn children. Whereas a trust can cater for future children being born, who would automatically be included within the class of beneficiaries (as long as they are born before the class closes), a partnership would need to be altered to include new partners. The tax consequences of adding new partners would have to be considered carefully.
Tax treatment of family partnerships
The main attraction of partnerships is their IHT treatment. Unless the partnership falls within the definition of ‘settlement’ for IHT purposes, there will be no chargeable transfer when funds are put into the partnership. This means no 20% upfront IHT charge for the partners and no ten-yearly or exit charges for the partnership.
Fortunately, the definition of settlement for IHT is clearly set out in s43 of the Inheritance Tax Act 1984. This states that a ‘settlement’ is any ‘disposition or dispositions of property..."whereby property is for the time being:
a) held on trust for persons in succession or for any person subject to a contingency;
b) held by trustees on trust to accumulate the whole or any part of any income of the property or with power to make payments out of that income at the discretion of the trustees or some other person, with or without power to accumulate surplus income; or
c) charged or burdened (otherwise than for full consideration in money or money’s worth paid for his own use or benefit to the person making the disposition) with the payment of any annuity or other periodical payment for a life or any other limited or terminable period."
It should be relatively straightforward to draft the partnership deed to ensure that the partnership is not a ‘settlement’ under s43 IHTA 1984. The result is that a transfer from one partner’s capital account (e.g. the parent’s) to another’s (e.g. the child’s) will be a potentially exempt transfer. Provided the donor partner survives that gift by 7 years, there will be no IHT to pay, with the IHT bill reducing after 3 years. Term assurance can also be taken out to cover the potential IHT charge.
Another advantage of partnerships, from a taxation point of view, is that they are transparent for income tax and capital gains tax purposes. The partnership itself is not taxed. Instead, its income and capital gains are taxed on the partners individually, pro rata to their respective financial interests. That means the new 50% rate of income tax will not necessarily apply to all the partnership income, only to those partners who are ‘high earners’. It also means there is no separate tax filing for the partnership, since the partners simply include their share of partnership income and capital gains on their own self-assessment tax returns.
It should be borne in mind, however, that a partnership could be a settlement for income tax purposes. The definition of settlement is in s620 of the Income Tax (Trading and Other Income) Act 2005. This contains an inclusive rather than an exhaustive definition. A settlement includes any disposition, trust, covenant, agreement, arrangement or transfer of assets. A settlor is defined as anyone who has provided funds, directly or indirectly, to the ‘settlement’.
HMRC clearly consider that a partnership can be a settlement under this definition. Their Trusts, Settlements & Estates Manual contains this statement at TSEM 4125:
“The creation of a partnership may be regarded as an arrangement for transferring income from a settlor to members of his or her immediate family. ??Where the incoming partner receives a share of profits out of all proportion to the contribution made to the partnership, the arrangement would include an element of bounty.”
Therefore, if a parent puts funds into a partnership for their minor child, effectively as a gift to that child, the parent will be taxed under s629 ITTOIA on any income paid to the minor child from the partnership. Similar rules to tax settlors to capital gains tax, under s77 of the Taxation of Chargeable Gains Act 1992, were abolished by Finance Act 2008. The rationale was that since all taxpayers pay CGT at the same rate, currently 18%, there was no need for these anti-avoidance provisions.
Limited vs unlimited partnerships
One potential drawback with a ‘standard’ or general partnership, as in one created under the Partnership Act 1890, is that the partners are jointly and severally liable for the debts of the partnership. Where the family partnership is to contain non-trading assets, this may not be an issue. A general partnership may then be the simplest and most cost-effective result.
However where there are trading assets, or just general concerns about liability, there are two options. First, the family could set up a Limited Partnership, in accordance with the Limited Partnership Act 1907. This requires a General Partner to take responsibility for all the partnership debts. Often a limited company is set up to act as the General Partner.
A more modern alternative is the Limited Liability Partnership, created by statute in 2000. An LLP does not require a General Partner, but instead each partner’s liabilities are limited as set out in the LLP deed. An LLP has to file publicly certain information, including limited accounts, which may put off the most secretive of families. There may however be foreign partnership structures that have similar limited liability without such disclosure requirements.
Financial Services issues
One point that concerns advisers is whether a family partnership falls within the definition of a ‘collective investment’. This is a complex area, but the general view seems to be that whenever you have partners (e.g. the minor/junior partners) who are not actively involved in the running of the partnership then you may have a collective investment.
In practice, the solution seems to be for the partnership to contract out, to a suitably authorised body (such as the investment advisors), the role of operating the collective investment scheme. Investment advisors would have been required anyway by a trust with non-trading assets. Hopefully this means there shouldn’t be any increase in costs involved in running a family partnership even if it is a collective investment.
With no apparent let up in the continued attack on UK trust planning, family partnerships may be a suitable alternative. It should be easy to ensure the partnership is not a settlement for IHT, so that it is not caught by the 20% upfront charge on the settlor or ten yearly and exit charges on the trustees. It may still however be a settlement for income tax purposes.
There are some additional issues to consider, such as whether the partners wish to limit their potential liabilities and whether the partnership could be a collective investment. The contractual nature of the partnership is extremely flexible, so that it may be more attractive than a trust to some families, particularly as there is no perpetuity period for partnerships. The position of minor and unborn children is however less certain than with a trust.
These articles were based on the legislation in force at the date of publication. The laws may well have changed since. These articles should not be taken as being or replacing proper legal advice.
This case is important on two levels. From a practical perspective, it is a stark reminder to all trustees of the importance of keeping accurate and up-to-date records of their beneficiaries. Equally the case shows how vital it can be to take out insurance on the winding-up of a trust.
From a technical perspective, the case is important because it confirms, for the first time, that the protection afforded by section 27 of the Trustee Act 1925 can be extended to trustees of pension schemes. However, trustees cannot rely on the s27 protection when they have already had ‘notice’ of a claim. The judgment examines what constitutes notice for these purposes.