The Taxation of Trusts: A Review

Response to a consultation document published on 7 November 2018

27 February 2019

A Review

Contents

1. Introduction 1 1.1 Smith & Williamson 1 1.2 Objectives 1 1.3 Trust law 2 1.4 Trusts 2

2. Transparency 6

3. Fairness and neutrality 9 3.1 Inheritance tax 9 3.2 Capital gains and income tax 10

4. Simplicity 13 4.1 Vulnerable beneficiary trusts 13 4.2 Compliance costs 14

5. Summary of Consultation Questions and responses 16

Appendix 19

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1. Introduction We welcome the opportunity to comment on the consultation document published on 7 November 2018. Trusts have an important role to play in the ownership of property and the provision of professional trustee services provides a substantial contribution to the economy of the United Kingdom and the health of the financial sector.

We hope that the consultation document will stimulate a healthy and wide ranging debate on the taxation regime affecting trusts and promote consideration of new types of trust that reflect the changing needs and demands of society both within and outside the United Kingdom. In particular we welcome the opportunity to comment on the current tax barriers that exist to the creation of new trusts or the winding up of those that are no longer viable or appropriate.

1.1 Smith & Williamson Smith & Williamson is an independently owned financial and professional services group that has been looking after the financial affairs of individuals, families and businesses for more than 130 years.

With approximately 1,750 people working out of twelve offices in the UK, Republic of Ireland and Jersey, we are the eighth largest UK accountancy firm (Accountancy Age, 2017) as well as one of the largest independently owned investment managers in the UK with around £21bn of funds under management and advice.

1.2 Objectives At Autumn Budget 2017, the government announced its intention to publish a consultation on how to make the taxation of trusts simpler, fairer and more transparent. Consistency should be added to these goals.

1.2.1 Simplicity Simplicity cannot be achieved by adding to existing complex legislation and we hope that in implementing any conclusions reached, the temptation to do so will be resisted. The plethora of taxes to which trusts are subject and their complexity means that it is at best unwise and at worst impossible for trustees to meet their compliance obligations without recourse to professional advisers.

In particular we would highlight the complexity added by the changes to the Inheritance Tax (IHT) regime affecting trusts introduced by Finance Act 2006 and the frequent changes made to the taxation of dividends.

1.2.2 Fairness Fairness is a subjective judgment and opinions on what is fair will differ between individuals and change with time. It is a matter best left to the courts. A better goal might be reasonable in all the circumstances.

We prefer fiscal neutrality as an objective. By neutrality we mean that transactions should broadly generate the same tax liability whether property is held personally, in trust or via an alternative holding vehicle. There can never be complete neutrality. It can at best be only an aspiration.

1.2.3 Transparency A distinction needs to be drawn between fiscal and public transparency. The public right to know is not the same as the public interest. Families and individuals have a legitimate right to privacy and

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confidentiality. This is currently the subject of separate discussion in the context of the implementation of the 5th Anti Money Laundering Directive (AMLD).

During the course of this response, we explore the idea of complete fiscal transparency, where the existence of the trust is ignored for all tax purposes, with the settlor continuing to be treated as owning the assets and income produced; an arrangement similar to the taxation of grantor trusts in the USA.

1.2.4 Consistency We have already referred to the challenges caused by complexity. Frequent changes to the rates and basis on which capital and income are charged to tax impose additional challenges. It takes time for trustees and their advisers to become familiar with how the trust is to be taxed. They also need certainty so that they can compute levels of income that will be available for distribution and ensure that they have adequate liquidity to cover both distributions and foreseeable liabilities.

1.3 Trust law The tax regime should accommodate the law of trusts rather than seeking to circumvent it. In recent years the Law Commission has addressed many of the difficult issues affecting trusts, consulting widely and promoting new legislation. In particular the classification and apportionment of capital and income in trusts was addressed by the Trusts (Capital and Income) Act 2013.

1.4 Trusts Trusts, whether constructive or express pervade all aspects of the ownership of property in England and Wales. They provide a framework for among others:

• Succession planning;

• Joint property ownership;

• Provision for minors;

• Pension provision;

• Life assurance;

• Sovereign and commercial debt;

• Unified management of land and private company shares;

• Charitable giving.

The attraction of the trust lies in its flexibility and comparative simplicity. It is, for example, the ideal vehicle for assisting in wider share ownership, with the trust providing a market for otherwise illiquid investments.

1.4.1 Family or private trusts Although some commercial trusts will be referred to in this response, its primary purpose will be to look at those set up as vehicles for managing private wealth and succession.

Because of advances in medicine and living standards people are living to a greater age, however with that comes greater vulnerability, often caused by a loss of capacity. Whilst the Court of Protection has oversight of attorneys and deputies, including the power of removal, a trust may provide better protection against financial abuse or exploitation. Trustees, particularly independent professional trustees, have long established duties, powers and obligations, which can be easily enforced through the courts.

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Traditional family models are subject to considerable change. Many long-standing relationships do not become formal marriages or civil partnerships, and the rights of unmarried partners and children can often only be determined by recourse to the courts. Under the law as it currently stands in England and Wales subsequent marriage will normally invalidate any prior will.

In many states of the USA, onerous probate formalities have led to the widespread use of the revocable lifetime grantor trust as an alternative to the will. The lifetime settlor interested trust may increasingly find favour in England and Wales.

Tax should not create an artificial barrier to the use of trusts as vehicles for managing the assets of the vulnerable or securing family succession.

1.4.2 The decline of the family lifetime settlement Whilst trusts continue to be created by will, in our experience very few new lifetime private trusts are being set up by settlors who are resident and domiciled in England and Wales. Already in decline, the FA 2006 changes significantly discouraged trusts. This is demonstrated by the statistics published on 14 February 2019 by HMRC KAI Personal Tax. In 2003-04 there were approximately 225,000 trusts and estates. In 2016-17 there were 156,500, a fall of just over 30%.

Taxation is just one of the costs that forms a barrier to their creation and should not be viewed in isolation. Other costs include:

• Compliance with international regulatory measures including: MIFID II, FATCA, CRS, GDPR, DAC6 and the 4th and shortly 5th AMLD. The need to keep up to date and comply with regulatory and legislative developments acts as a disincentive for lay trustees to act and increases reliance on the professional sector;

• Trustees are often caught in the middle of family disputes, which may culminate in litigation. The trustee without professional indemnity cover can find himself in a very difficult and potentially disastrous personal position. Lay trustees need to be indemnified for the costs of insurance;

• Professional trustees are increasingly taking active steps to contain and manage risk. Typically this includes incorporating a trust company or corporation and only taking on appointments via this corporate vehicle. Trust companies are expensive to manage and the costs inevitably must be passed on to the trust in the form of higher trustee fees.

The ongoing management costs are such that no-one sets up a trust in order to obtain a nugatory tax advantage.

1.4.3 Barriers to winding up redundant trusts Conversely tax costs may also be a barrier to winding up trusts that have outlived their purpose. Inheritance or capital gains tax may be too high, with the recipient beneficiaries unable to obtain comparable investment returns once the tax has been paid. Responsible trustees must determine how the immediate tax charge compares to any saving in trustees’ and professional advisers’ fees over the next seven to ten years.

1.4.4 Non-resident trusts Although there may be concerns about the use of non-resident trusts, those concerns should not prejudice attitudes towards wholly domestic trusts (those with UK resident and domiciled settlors, trustees and beneficiaries).

Measures taken over the last thirty years have curtailed the creation and use of trusts with non-resident trustees by settlors who are resident and domiciled in the United Kingdom. Many have been wound up or repatriated by the appointment of UK resident trustees.

Internationally mobile families continue to create and use trusts as vehicles to hold and manage assets for a number of reasons. Key among such reasons are:

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• Planning for family succession; • Centralisation of wealth management; • Tax minimisation. This could be characterised as tax avoidance, but is in fact legitimate and

sensible tax planning to choose a vehicle, which itself adds the least additional tax burden, whilst allowing the greatest flexibility in making distributions to provide for the needs of beneficiaries in a multiplicity of jurisdictions with very different tax concerns; and

• To avoid conflicts of law on death. Succession law may impose conflicting inheritance rights and its application can be dictated by a combination of any of the following factors:

– Nationality;

– Residence;

– Domicile;

– Religion;

– Situs of assets, particularly immovable property.

1.4.5 Tax evasion and money-laundering We find the regular conflation of tax evasion and avoidance unhelpful. They are two very different issues.

The use of trusts will always involve a loss of control by the settlor. Partnerships and companies do not involve this and as such are seen as a greater risk for criminal activity. Recent concerns about the misuse of Scottish limited partnerships have led to a review of partnership law.

Consideration of the fight against money-laundering and corruption is outside the scope of this consultation, however, client due diligence by reputable professional advisers and trustees will always involve consideration of the following:

• Source of funds;

• Complexity of ownership structures;

• Jurisdictions used and their international standing;

• The reputational and other risks assumed in taking on the client.

Although the publication of the Panama and Paradise Papers garnered considerable press coverage, much of what was revealed was of historic interest and not reflective of current behaviour.

International measures, including in particular Common Reporting Standards and Mutual Assistance Treaties, will both encourage and secure better standards of tax compliance. Professional standards have risen significantly since the period to which these papers related.

HMRC is to be congratulated on the work that they have done in fighting criminality at home and abroad and in altering public attitudes to tax evasion.

Public perception, regulation, peer pressure and derisking by banks and other financial institutions will continue to improve the standards operated by trust and company service providers based in international financial centres.

Unfortunately legislation will have little effect on those who are intent on criminal behaviour. Success is more likely to be achieved by better targeting of investigations, working more closely with other investigating agencies and regular review of Suspicious Activity Reports, which are currently the only way of reporting suspected tax evasion that protects the professional adviser from a breach of confidentiality claim.

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1.4.6 Trusts usage and policy principles We are pleased to note that the consultation document recognises the valuable role that trusts frequently play. We agree that the separation between the legal and beneficial ownership of assets should not prevent HMRC from being able to assess tax liabilities for which Parliament has legislated. We also agree that successive legislative changes have been successful in preventing avoidance across a wide range of taxes, however the plethora of measures involved and their interaction has added a layer of complexity far greater than the problems they seek to address.

We would also argue that domestic trusts (those with UK resident and domiciled settlors, trustees and beneficiaries) should be considered separately from those with an international dimension.

Question 1: The government seeks views on whether the principles of transparency, fairness and neutrality, and simplicity constitute a reasonable approach to ensure an effective trust taxation system; including views on how to balance fairness with simplicity where the two principles could lead to different outcomes.

Response: We feel that fairness is too vague and subjective an epithet to use.

We agree that the principles of fiscal transparency, neutrality and simplicity constitute a reasonable approach, but it must be recognised that in an imperfect world they can only represent objectives that are unlikely to be achieved. Trustees also need certainty and stability in order to manage their finances.

We believe that simplicity, fiscal transparency and neutrality can go hand in hand. The introduction of something similar to the US grantor trust regime would go some way to achieving this. Detailed proposals are included in our response to question 8.

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2. Transparency Offshore tax evasion and avoidance are two different issues and the remedies are not the same.

Tax evasion is often symptomatic of other criminal behaviour. As stated in our introduction, it can never be prevented completely; however, barriers can be erected that make it more difficult and dissuade financial institutions and advisers from involvement with known or suspected criminal activity.

As stated earlier in this response, it is too early to draw any conclusions on the effectiveness of Common Reporting Standards, to which 97 countries have now signed up. It is only one of a number of major initiatives promoting the exchange of information and better governance. These include blacklisting jurisdictions with a poor compliance record and increased regulation of the financial services sector. Anecdotal evidence suggests that these initiatives have had a major effect in changing attitudes within many of the international financial centres.

The EU Fourth Anti-Money Laundering Directive introduced the Trusts Registration Service. It is widely recognised that its implementation was not a success. The EU Fifth Anti-Money Laundering Directive will apply to all express trusts. Implementing the changes required will be a huge exercise. It is essential that those responsible within government departments consult widely with the private sector and in particular those firms and professional bodies with a known expertise in the administration and management of trusts.

Question 2: There is already significant activity under way in relation to trust transparency. However, government seeks views and evidence on whether there are other measures it could take to enhance transparency still further.

This should be carried out as a wholly separate exercise. It is also too early to assess the effectiveness of major international initiatives, including, but not restricted to, Common Reporting Standards.

Trustees and beneficiaries need certainty in the rules and principles governing how they are taxed. Death, retirement or family trustees moving between the UK and other countries may inadvertently give rise to changes in the trust’s residence.

Example 1: A US citizen moves to London to take up a senior role with a financial institution. After five years he is transferred back to New York. Many years previously, he had created a revocable life interest trust over all of his US assets as an alternative to writing a will. The trustees are him and his wife.

In the USA, such a trust is a grantor trust and completely disregarded for tax purposes. As it is revocable, the settlor may not even recognise that it exists. When he moves to the UK, the trust will have become resident in this country for income and capital gains tax purposes and will cease to be resident when he returns to New York.

There will be a mismatch between who is regarded as taxable, the settlor or the trustees, between the USA and UK, while he is resident here and there will be an exit charge when the trustees return to live in New York.

Example 2: Two brothers are trustees of a will trust created by their late father, which owns valuable family heirlooms and other illiquid assets. The younger brother works for an international oil company and is transferred to work in the UAE. While he is abroad, his elder brother dies. As the assets held by the trust are illiquid and there is no intention to sell them, he does not appoint a successor and the trust ceases to be resident in the UK.

The trustees should be able to elect for the trusts to be regarded as either non-resident (Example 1) or resident (Example 2) in the UK. In the case of Example 1, this would treat the settlor/beneficiary

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as potentially taxable on income and capital gains, aligning the UK and US treatment. In Example 2, the trust, which is essentially dormant, would remain UK resident.

Whilst it may be possible for UK resident individuals to set up non-resident trusts for income and capital gains tax purposes during their lifetimes, there is little evidence that many do so. This is in contrast to company share schemes.

Employee share ownership trusts are specifically exempt from the anti-avoidance measures applying to the trustees and beneficiaries of non-resident trusts. As a result shares can be held within a tax-free environment. The effect of this is that all of the expertise in managing share ownership trusts resides in offshore centres, specifically the Channel Islands and Isle of Man. Such trusts are routinely set up and managed within those jurisdictions.

The UK should be the natural home for UK employee share ownership trusts. This should be encouraged by ensuring that the same tax incentives apply to both resident and non-resident trusts.

International families want to use trust and company service providers established in well-regulated jurisdictions, with a high reputation. They also need them to be in accessible locations with a good court system and established law in the event of disputes. The tax system should encourage the use of the UK, specifically London, as one of the world’s leading financial and legal centre, rather than preventing it.

Professional trustees should be able to elect for a trust to be regarded as not resident in the UK, where the settlor is not domiciled or resident in the UK, the governing law and forum for disputes is within the UK and all trustees are professional/corporate trustees registered as Trust and Company Service Providers for the purpose of Anti-Money Laundering Regulation.

Question 3: The government seeks views and evidence on the benefits and disadvantages of the UK’s current approach to defining the territorial scope of trusts and any other potential options.

We favour an elective approach that prevents inadvertent changes in residence taking place. We also favour the introduction of an elective system that enables international families to take advantage of the UK’s pre-eminence as a financial and legal centre and for incentives to be created for employee share ownership trusts to be managed in the UK.

Tax evasion and financial crime is by its very nature secretive. The abuse of trusts for criminal purposes only comes to light when the crime is discovered and relies on trustees and professional advisers being either deliberately complicit, or lax/negligent in their application of professional standards and compliance with Customer Due Diligence requirements.

We find the link between paragraphs 4.13, which refers to criminal behaviour and 4.14 dealing with obtaining a tax advantage inappropriate and unhelpful.

In our response to Question 3, we have referred to the establishment and management of non-resident employee share ownership trusts.

At paragraph 1.4.4 of this response we have referred to the tax planning reasons why internationally mobile families might use trusts established outside the UK. There may be other compelling factors, including local law, that determine the choice of jurisdiction. They include:

• Longer perpetuities periods, including indefinite life; • Purpose trusts; • Asset protection measures; • Wider choice of corporate trustees; and • More expert administration.

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Question 4: The government seeks views and evidence on the reasons a UK resident and/or domiciled person might have for choosing to use a non-resident trust rather than a UK resident trust.

Employee share ownership trusts are routinely established in the Channel Islands and Isle of Man, because that is where the management and administrative expertise lies. UK resident trust and company service providers cannot establish a similar level of expertise unless the same tax incentives are brought to the UK.

For internationally mobile families, there may be a number of reasons why the choice of a non-resident trust may be appropriate. Tax may be only one of a number of factors, including both local trust law and a highly developed local trust industry.

Question 5: The government seeks views and evidence on any current uses of non-resident trusts for avoidance and evasion and on the options for measures to address this in future.

We are unable to comment on the use of trusts for the purposes of tax evasion, which can only take place with the assistance of trustees and professional advisers. The possibilities for evasion by non-compliant beneficiaries have been widely reduced by CRS and other related measures.

Criminality can never be completely eradicated, but international measures aimed at combatting money-laundering, increasingly powerful data analysis tools, the blacklisting of non-compliant jurisdictions and peer pressure from the industry are all playing their part in controlling it.

Non-resident trusts are generally used by internationally mobile families to avoid double taxation and conflicts in succession law, rather than the avoidance of tax as such. It is of no benefit to the global economy for wealth to be frozen within holding structures in offshore jurisdictions because punitive levels of taxation make it impossible to access.

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3. Fairness and neutrality We agree that the policy principle underlying the taxation of trusts should be neutrality and that tax should neither encourage nor discourage their use and only deviate from this principle where there are clear policy reasons to do so.

3.1 Inheritance tax Finance Act 2006 made significant changes to the regime affecting most trusts, aligning the treatment of life interest and accumulation and maintenance trusts with that of discretionary trusts. The previous regime had been in place for over forty years, dating back to the introduction of Capital Transfer Tax in 1975 (backdated to 1974).

The previous system had worked well, was logical and widely understood. The principle was that trust property should pay an equivalent amount of tax irrespective of whether it was held in trust or continued to be owned by an individual, whether settlor or beneficiary depending on the type of trust. The discretionary trust regime used the settlor as a comparator to create a broadly equivalent tax regime, whilst life interest trusts tied the trust property to the life tenant.

The 2006 changes turned things on their head and brought most trusts within the discretionary trust regime, removing the IHT link to real persons and replacing it with an artificial construct based on equivalence. Even after twelve years it is hard to see the rationale behind this decision.

The result was to add an unnecessary level of complexity to the tax treatment of many trusts, to influence trustees in the manner in which they exercise their dispositive powers and to dissuade settlors from passing down family wealth to the next generation, save by outright gift, which may be inappropriate when dealing with minors or young adults and lead to the fragmentation of businesses and estates.

The link between trusts and individual taxpayers should be restored, ideally by reverting to the system that prevailed prior to the 2006 changes.

At paragraphs 1.4.1 and 4.1 of this response we discuss the protection of vulnerable persons against financial abuse. The tax system must also recognise that many vulnerable persons, including in particular the elderly, those with degenerative medical conditions, mental illness and addictions, wish to settle their assets on trust for themselves, and should be able to do so without it being regarded as a disposal for the purposes of IHT or any other tax.

At 5.5.1, mention is made of settlors creating nil-rate band trusts every seven years. We do not regard this practice as being widespread and in particular draw your attention to the comments made earlier by us on the increasing burden of administrative and compliance costs which have to be incurred by trusts, which can far outweigh any modest tax advantage.

At 5.5.2 an attempt is made to draw a comparison between the amount of tax suffered by trusts and individuals. It uses thirty years as the yardstick for a generation, but in so doing ignores the practice of grandparents skipping a generation by passing assets down to their grandchildren, or legatees doing the same via deeds of family arrangement. It completely ignores the opportunity cost of having to pay tax earlier, either on a chargeable lifetime transfer or intermediate charge on relevant property rather than on death.

When drawing a comparison, it is necessary to look beyond the IHT liability. Paying it requires the trustees to raise funds, which in turn incurs costs, including capital gains and income tax. The tax liabilities on liquidating assets can themselves be substantial.

Further, there is no CGT uplift in the base cost of assets on the termination and distribution of a relevant property trust, as there is on the death of an individual.

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The appendix to this response demonstrates all of these points, comparing the tax payable on both an absolute gift (PET) and a trust, using compound asset growth of 3% per annum, which is regarded as a realistic investment return.

Question 6: The government seeks views and evidence on the case for and against targeted reform to the Inheritance Tax regime as it applies to trusts; and broad suggestions as to what reform should look like and how it meets the fairness and neutrality principle.

No system can ever be perfect and it must be accepted that it is impossible to achieve complete equality. We favour a restoration of the link between trusts and taxpayers that prevailed prior to 2006, with life interest trusts being treated as though owned by the life tenant and gifts to both those and accumulation and maintenance trusts as Potentially Exempt Transfers.

We would also like to see a regime that recognises the desire of many elderly and vulnerable persons to set up trusts for their protection against financial exploitation, by regarding such trusts as wholly transparent for all tax purposes.

3.2 Capital gains and income tax

3.2.1 Capital gains tax – holdover claims Prior to 14 March 1989 capital gains could be held over on gifts into trust and on capital appointments. Relief is now only available on gifts that are either immediately chargeable to inheritance tax or property that qualifies for business asset relief.

This deters trustees from winding up trusts that no longer serve a useful purpose, or are too expensive to manage, and settlors from transferring assets that are pregnant with gain.

A holdover claim does not avoid tax, merely defer it until a gain is realised on sale. The inability to hold over gains results in behaviour being distorted, driven by tax rather than investment considerations.

Whilst we favour the re-introduction of holdover relief on gifts and appointments out of trust, we recognise that such a measure, whilst producing tax equivalence, might have a modest effect on tax revenues.

3.2.2 Capital gains tax – Private residence relief At 5.6.1, the capital gains tax private residence exemption is discussed. The final sentence states, “However, under the terms of a trust, the proceeds from a dwelling’s disposal might be applied for the benefit of a different beneficiary, or indeed the settlor. This can result in an outcome that is not neutral.” We do not agree with this analysis. Firstly it ignores any IHT, but secondly, the exemption applies to the gain, not the proceeds. It is not dependent on the proceeds being reinvested in replacement residential property.

It is becoming common practice for many elderly individuals to downsize and gift a significant portion of the sale proceeds of their home to children or grandchildren or otherwise. Those situations would appear to be directly analogous and accordingly there is tax equivalence.

3.2.3 Trust management expenses We do not agree that the treatment of expenses is more generous than that for individuals who incur costs in managing their affairs. Individuals engaged in business, including the receipt of rental income are entitled to a deduction for expenditure wholly and necessarily incurred in the course of that business. Further, collective investment schemes such as OEICs and investment trusts obtain a deduction for similar expenditure.

Beneficiaries with an interest in possession are not entitled to the gross income of the trust, but the net income after deducting expenses that are properly chargeable against income. Case law has

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long established that only expenses that are exclusively and identifiably of an income nature may be charged against income. All other costs must be charged against capital.

This was considered extensively by the Law Commission in their paper Capital and Income in Trusts: Classification and Apportionment, which was published on 7 May 2009. The report can be found at https://s3-eu-west-2.amazonaws.com/lawcom-prod-storage-11jsxou24uy7q/uploads/2015/03/lc315_Capital_and_Income_in_Trusts.pdf

The treatment of expenses therefore reflects trust law and to treat them otherwise would result in beneficiaries of interest in possession trusts being taxed on income which they would never receive.

As far as discretionary trusts are concerned, the deduction is only against higher rates of tax, it cannot generate a repayment of tax suffered or paid at the basic rate.

No relief is given in the case of trusts where the settlor has retained an interest. Whilst at first sight this might appear inequitable, such trusts are not directly comparable, since the settlor has in effect alienated himself from an income source, while retaining the right to it.

3.2.4 Income and capital receipts in trust law The Law Commission’s report Capital and Income in Trusts: Classification and Apportionment, to which reference has been made above, discussed the issues of capital and income distributions at considerable length and the challenges caused by company law in this area. These issues were addressed by the subsequent Trusts (Capital and Income) Act 2013.

Capital receipts are not generally available for distribution as income and may well give rise to a liability to IHT. Regular receipts of capital by a beneficiary may however be treated as income and taxed accordingly.

We would also point out the unfairness of the surcharge imposed on distributions of dividend income to discretionary beneficiaries. By treating all income distributions as having suffered income tax at the trustees’ rate and charging a surcharge to achieve this, an element of double taxation has been introduced.

3.2.5 Trusts and transactions declared void by the courts The Supreme Court judgment in the cases of Futter and another v HMRC and Pitt and another v HMRC [2013] UKSC 26 restricted the ability of trustees to correct mistakes and have steps set aside. Rectification can only be obtained if the court is satisfied that the trustees have made a fundamental mistake, rather than simply omitting to consider the legal, including tax, consequences.

Whilst a number of jurisdictions have enacted legislation permitting rectification on the wider grounds that pertained prior to Futter and Pitt, that is not the case in England and Wales, where the bar is set very high.

By declaring a transaction void, the trust property must be restored to what it would have been had the transaction never taken place. This may require beneficiaries to repay distributions that have been made to them in error. Consequently there can be no unfair tax outcome.

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Question 7: The government seeks views and evidence on:

a) The case for and against targeted reform in relation to any of the possible exceptions to the principle of fairness and neutrality detailed at paragraph 5.6; b) Any other areas of trust taxation not mentioned there that would benefit from reform in line with the fairness and neutrality principle.

Response: We do not accept that any of the issues raised (private residence relief, trust management expenses, income and capital receipts or transactions declared void by the courts) give rise to a breach of the principles of fairness and neutrality, indeed changing the law by, for example, restricting the reliefs currently given, would itself result in unfairness and tax outcomes that were not neutral. Taxation should as far as possible reflect legal and financial reality.

Whilst we favour the reintroduction of holdover claims on transfers into and appointments out of trust, we recognise that such a measure is likely to have a modest effect on tax revenues and would therefore not find favour.

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4. Simplicity Tax legislation in the UK has become too complex and would benefit from radical overhaul. Simplicity is not something that can be added, but only achieved by returning to first principles and cutting away large swathes of complex legislation.

Complexity has a number of adverse results:

• Compliance is expensive and wholly reliant on professional agents, who themselves must implement review processes to manage risk, the costs of which are passed on to the taxpayer;

• Compliance standards deteriorate;

• People are inhibited from taking decisions that are in the best interests of their dependants because of the tax consequences;

• Inconsistency and uncertainty hinder the financial management of the trust, particularly in planning for distributions and liabilities.

4.1 Vulnerable beneficiary trusts The tax definition of vulnerable beneficiary is largely restricted to bereaved minors and those who have particular medical conditions or are entitled to certain state benefits. Vulnerability however covers a very wide spectrum and the prevalence of press reports on the financial exploitation particularly of the elderly suggests that society has not got things right.

At the heart of this lies the principle enshrined in mental capacity legislation that people should have the right to make decisions that others might find incomprehensible or foolish.

There are three issues that we need to consider:

• Bereaved minors;

• Disabled persons; and

• Vulnerable or potentially vulnerable people who do not fit within the current definitions.

4.1.1 Bereaved minors Trusts for bereaved minors are created by will or on intestacy. They are held for minor children who have lost one or both parents, who must become entitled to capital on or before their eighteenth birthday.

As a matter of public policy it does not seem appropriate for tax rules to promote the passing of large sums of capital to young adults who may lack parental or adult guidance in how to manage money.

In our response to the inheritance tax section of chapter 5 Fairness and Neutrality we expressed our regret at the changes brought in by Finance Act 2006. We recommend that the vesting age for qualifying bereaved minors’ trusts should be increased from 18 to 25, although we would prefer to see the restoration of the life interest regime that existed prior to 2006 with IHT being related to the life tenancy and no entry charge to IHT at any age. This is discussed in paragraphs 3.1 of this report.

4.1.2 Disabled persons Vulnerable person’s trusts have their roots in what used to be called disabled person’s trusts held for those who by reason of a mental or physical condition are incapable of managing their affairs. The trustees in effect stand in the shoes of the beneficiary and are entitled to many of the reliefs and allowances that apply to an individual.

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Such trusts and the legal precedents used to create them are well understood. A number of charities are active in helping families to create qualifying trusts and offer trustee services through their own trust companies. Charities involved include Rethink which supports those suffering from schizophrenia, their families and carers.

Before any changes are undertaken, it is essential that open and active discussions are held with representatives of charities that represent the interests of those suffering from mental and physical disability or ill-health.

4.1.3 Non-qualifying vulnerable persons We believe that there is a strong case for adopting a regime similar to that applying in the USA to grantor trusts. Such trusts would be treated as entirely transparent for all tax purposes. Although the trustees would submit an annual return for income tax purposes, all tax liabilities would fall on the settlor, who would have an automatic right to reimbursement from trust property. Treatment as a settlor trust would be dependent on a joint election made by the settlor and trustees.

Such trusts would have some or all of the following features:

• Income could only be distributed to the settlor or accumulated during his lifetime; • The trustees would have the power to distribute capital to the settlor. Unlike a bare trust,

the settlor would not have the right to capital; • Transfers to the trust by the settlor would be disregarded for IHT purposes, as he would still

be regarded as owning the trust property; • Periodic and exit charges would not apply to the trust property during the settlor’s lifetime; • Distributions of capital to other beneficiaries during the settlor’s lifetime would be

Potentially Exempt Transfers; • The trust would be aggregated with the personal estate on death.

Such trusts could also be used for the receipt of damages obtained following medical negligence or personal injury claims. They should be available to all irrespective of their medical state.

Although the primary purpose would be to provide a vehicle for the management of assets owned by those who were concerned at the prospect of vulnerability caused by age or infirmity, they might also provide an alternative to wills for estate planning purposes, as they are in the USA. The advantage of such trusts is that on death assets can pass or be made available to beneficiaries immediately without having to wait for the completion of probate formalities.

4.2 Compliance costs We agree that the compliance costs of trusts can often outweigh the tax at stake. As stated in our introduction, tax compliance is just one of many regulatory and other costs to which trustees are subject.

We would also repeat our assertion that simplification will only be achieved by a wholesale revision of the taxation of trusts based on very clear and consistent principles that apply across all relevant taxes.

The introduction of look-through settlor trusts as set out in paragraph 4.1.3 above would create a new simplified model that was wholly tax neutral.

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Question 8: The government seeks views and evidence on options for the simplification of Vulnerable Beneficiary Trusts, including their interaction with ’18 to 25’ trusts.

Response: We believe that there is a strong case for introducing a tax regime similar to that applying to grantor trusts in the USA.

Changes should not be made to the regime affecting trusts for the disabled without discussing them with interested health and disability charities.

The vesting age for bereaved minors’ trusts should be changed to 25.

Question 9: The government seeks views and evidence on any other ways in which HMRC’s approach to trust taxation would benefit from simplification and/or alignment, where that would not have disproportionate additional consequences.

Response: Simplification will only be achieved by a wholesale revision of the taxation of trusts based on very clear and consistent principles that apply across all relevant taxes.

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5. Summary of Consultation Questions and responses Question 1: The government seeks views on whether the principles of transparency, fairness and neutrality, and simplicity constitute a reasonable approach to ensure an effective trust taxation system; including views on how to balance fairness with simplicity where the two principles could lead to different outcomes.

Response: Response: We feel that fairness is too vague and subjective an epithet to use.

We agree that the principles of fiscal transparency, neutrality and simplicity constitute a reasonable approach, but it must be recognised that in an imperfect world they can only represent objectives that are unlikely to be achieved. Trustees also need certainty and stability in order to manage their finances.

We believe that simplicity, fiscal transparency and neutrality can go hand in hand. The introduction of something similar to the US grantor trust regime would go some way to achieving this. Detailed proposals are included in our response to question 8.

Question 2: There is already significant activity under way in relation to trust transparency. However, government seeks views and evidence on whether there are other measures it could take to enhance transparency still further.

This should be carried out as a wholly separate exercise. It is also too early to assess the effectiveness of major international initiatives, including, but not restricted to, Common Reporting Standards.

Question 3: The government seeks views and evidence on the benefits and disadvantages of the UK’s current approach to defining the territorial scope of trusts and any other potential options.

We favour an elective approach that prevents inadvertent changes in residence taking place. We also favour the introduction of an elective system that enables international families to take advantage of the UK’s pre-eminence as a financial and legal centre and for incentives to be created for employee share ownership trusts to be managed in the UK.

Question 4: The government seeks views and evidence on the reasons a UK resident and/or domiciled person might have for choosing to use a non-resident trust rather than a UK resident trust.

Employee share ownership trusts are routinely established in the Channel Islands and Isle of Man, because that is where the management and administrative expertise lies. UK resident trust and company service providers cannot establish a similar level of expertise unless the same tax incentives are brought to the UK.

For internationally mobile families, there may be a number of reasons why the choice of a non-resident trust may be appropriate. Tax may be only one of a number of factors, including both local trust law and a highly developed local trust industry.

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Question 5: The government seeks views and evidence on any current uses of non-resident trusts for avoidance and evasion and on the options for measures to address this in future.

We are unable to comment on the use of trusts for the purposes of tax evasion, which can only take place with the assistance of trustees and professional advisers. The possibilities for evasion by non-compliant beneficiaries have been widely reduced by CRS and other related measures.

Criminality can never be completely eradicated, but international measures aimed at combatting money-laundering, increasingly powerful data analysis tools, the blacklisting of non-compliant jurisdictions and peer pressure from the industry are all playing their part in controlling it.

Non-resident trusts are generally used by internationally mobile families to avoid double taxation and conflicts in succession law, rather than the avoidance of tax as such. It is of no benefit to the global economy for wealth to be frozen within holding structures in offshore jurisdictions because punitive levels of taxation make it impossible to access.

Question 6: The government seeks views and evidence on the case for and against targeted reform to the Inheritance Tax regime as it applies to trusts; and broad suggestions as to what reform should look like and how it meets the fairness and neutrality principle.

No system can ever be perfect and it must be accepted that it is impossible to achieve complete equality. We favour a restoration of the link between trusts and taxpayers that prevailed prior to 2006, with life interest trusts being treated as though owned by the life tenant and gifts to both those and accumulation and maintenance trusts as Potentially Exempt Transfers.

We would also like to see a regime that recognises the desire of many elderly and vulnerable persons to set up trusts for their protection against financial exploitation, by regarding such trusts as wholly transparent for all tax purposes.

Question 7: The government seeks views and evidence on:

a) The case for and against targeted reform in relation to any of the possible exceptions to the principle of fairness and neutrality detailed at paragraph 5.6;

b) Any other areas of trust taxation not mentioned there that would benefit from reform in line with the fairness and neutrality principle.

Response: We do not accept that any of the issues raised (private residence relief, trust management expenses, income and capital receipts or transactions declared void by the courts) give rise to a breach of the principles of fairness and neutrality, indeed changing the law by, for example, restricting the reliefs currently given, would itself result in unfairness and tax outcomes that were not neutral. Taxation should as far as possible reflect legal and financial reality.

Whilst we favour the reintroduction of holdover claims on transfers into and appointments out of trust, we recognise that such a measure is likely to have a modest effect on tax revenues and would therefore not find favour.

Question 8: The government seeks views and evidence on options for the simplification of Vulnerable Beneficiary Trusts, including their interaction with ’18 to 25’ trusts.

Response: We believe that there is a strong case for introducing a tax regime similar to that applying to grantor trusts in the USA. Changes should not be made to the regime affecting trusts for the disabled without discussing them with interested health and disability charities. The vesting age for bereaved minors’ trusts should be changed to 25.

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Question 9: The government seeks views and evidence on any other ways in which HMRC’s approach to trust taxation would benefit from simplification and/or alignment, where that would not have disproportionate additional consequences.

Response: Simplification will only be achieved by a wholesale revision of the taxation of trusts based on very clear and consistent principles that apply across all relevant taxes.

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Appendix

The following table compares the effect of the current rates of IHT and CGT on the transfer of £5m passed down two generations, from grandfather to grandson. Two options have been considered: the grandfather acquires an asset and may either:

• make a PET, which is subsequently transferred to the grandson through the father’s death estate; or

• transfer the asset into a relevant property trust for the father’s life then absolutely for the benefit of his grandson. In this case, disposals are made to fund the IHT charges over the life of the trust (and the corresponding CGT incurred on those disposals).

The value of the liquidated asset on the father’s death has been calculated for both scenarios. The total tax cost has also been aggregated and is displayed as a column chart to illustrate the various tax costs that comprise the whole. As shown, the value of the liquidated asset to the grandson is approximately £1.1m greater when the asset is transferred as a PET. Although the total tax burden is £1.98m higher than if the asset is transferred into a relevant property trust, the asset’s value is not eroded over time by disposals to fund the principal charges.

These figures illustrate the substantial disincentive to transferring property via a trust. HMRC also receives a higher revenue, but the tax is paid later, which creates an opportunity cost not factored into this analysis.

This analysis does not consider the father’s option to make a PET to the son. In this case, the IHT charge in the death estate would be replaced by a CGT charge on the gift from the father to the son. The total CGT liability would be approximately £1.7m, and the value of the liquidated asset would be approximately £14.2m.

Please note the following assumptions in relation to this analysis:

• each person lives to the age of 85 and there are 33 years between generations; • the asset, which is not residential property, grows in value at an annually compounded rate

of 3% per annum; • the NRB is available; • the IHT annual exemption, CGT annual exempt amount and basic rate band have been fully

utilised; • no BR or other reliefs are available; and • no other CLTs or PETs are made.

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PETGift into relevant

property trust

GRANDFATHER IHT on gift to parent/trust 0 935,000

First principal charge 308,281

CGT on sale of asset to pay IHT and CGT 16,629

Second principal charge 394,811

CGT on sale of asset to pay IHT and CGT 38,697

Third principal charge 502,344

CGT on sale of asset to pay IHT and CGT 66,951

Tax in death estate 6,394,076

Fourth principal charge 635,910

CGT on sale of asset to pay IHT and CGT 102,394

Exit charge 0

CGT on distribution 1,412,570

Total tax cost 6,394,076 4,413,587

Difference: +1,980,489

Value of liquidated asset 9,916,113 8,772,618

Difference: +1,143,495

FATHER

GRANDSON

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