Section 8: settled property
The Valuation Office Agency's (VOA) technical manual relating to Inheritance Tax.
Introduction
This Section outlines the rules for charging tax on settled property after property has been put into settlement. It does not deal with the transfer of property on the creation of a settlement, which is subject to the ordinary IHT rules for lifetime transfers and on death.
Meaning of Settled Property
Settled property for the purposes of IHT includes property held in trust for successive beneficiaries or for any person subject to a contingency such as the future birth of a further beneficiary. It also includes property held on trust under which the income of the property is payable at someone’s discretion or has to be accumulated (s.43(1)&(2) IHTA 1984). Not all property held in trust is settled property e.g. property held by trustees under a duty to distribute it immediately and, in certain circumstances, property which is not held in trust may nevertheless be regarded as settled property e.g. property which is subject to a lease for life if the lease was not granted for full consideration in money or money’s worth (see para 8.15 below).
How Settled Property is Taxed
The taxation of settled property essentially depends on the rights of the beneficiaries at the time in question. If there is an individual who is beneficially entitled to an interest in possession in the property, tax is charged when that interest comes to an end as if that person had transferred the property as absolute owner (s.49(1) IHTA 1984).
N.B. the number of settlements qualifying under section 49(1) IHTA 1984, has been severely reduced, under the provisions of Part 2 of Schedule 20 FA 2006, where a person becomes “beneficially entitled”, on or after 22nd March 2006. Briefly for people becoming beneficially entitled on or after that date, section 49(1) will only operate where it is either:
- 1) an immediate post-death interest (section 49A IHTA 1984)
- 2) a disabled person’s interest, or
- 3) a transitional serial interest (section 49B-E IHTA 1984).
If no individual has an interest in possession tax is charged under a different set of rules, which treat the settlement itself as a separate entity. It is important to realise that as the application of these rules depends on the rights of the beneficiaries at the relevant time, there can be no once-and-for-all classification of either the settlement or the property.
At any one point in time settled property will fall into one of two categories - see para 8.4 below.
The two categories of settlement are:
- settled property in which one or more beneficiaries enjoys an interest in possession; and
- settled property in which there is no interest in possession (commonly held in a discretionary trust).
Interest in possession is a concept of general law and there is no statutory definition of the term for the purposes of the tax except in relation to Scotland (see s.46 IHTA 1984). However, the House of Lords in the case of Pearson and Others v CIR (1981) AC 253 upheld the Board’s view that an individual has an interest in possession in settled property if that person has the immediate right to receive any income arising from it or to the use or enjoyment of the property. A life tenancy would be a typical example of an interest in possession in this context (however, see para 8,3 above for interests where an individual becomes beneficially entitled on or after 22nd March 2006).
Settlements With Interests in Possession
The most common interest in possession in settled property is a life interest, but the interest may be for a longer or shorter period. It may be for a fixed period or until some power is exercised or some other event occurs. The duration of the interest does not affect the basis on which tax is to be charged on the termination of the interest.
The general principle is that tax may be charged on the value of the settled property when an interest in possession comes to an end or is disposed of. On the death of the person entitled to the interest the property is taxed as part of the life tenant’s estate but the tax is normally payable by the trustees out of the settled property.
Prior to 22nd March 2006, if the interest disposed of came to an end (wholly or in part) in the lifetime of the person entitled to it, it is a potentially exempt transfer (PET) of the settled property (or appropriate part). There was, however, an exception. This is where the disposal was to a discretionary trust (see para. 8.35 below). In this type of cases the disposal was immediately chargeable to IHT at half death rates, with the normal IHT threshold.
If, on or after 22nd March 2006, an interest in possession comes to an end during the lifetime of the person entitled to it (provided the interest was created prior to 22nd March 2006), the interest disposed of does not become a PET, unless a beneficiary becomes entitled either outright, or to an interest in possession before 6th April 2008 (a “transitional serial interest”).
In all cases of disposal or the coming to an end of the life tenant’s interest the life tenant is the deemed transferor for IHT purposes.
The value of the property may be added to the cumulative total of previous immediately chargeable transfers (as described above). Previous PETs are never material unless the life tenant has actually died, thereby causing the PETs to fail. HMRC(IHT) will specify in their initial referral if any previous transfers are considered to be relevant.
When the interest of a life tenant is sold the consideration will reflect the value of the vendor’s interest in possession, which will almost necessarily be less than the value of the settled property. As the life tenant is deemed by s.49(1) to be the absolute owner of the property the loss to the estate is therefore the value of the settled property less the price paid for the life interest.
There are certain occasions when the termination or disposal of an interest in possession does not give rise to a tax charge (see ss.53-57 IHTA 1984 – as amended by Part 3 of Schedule 20 FA 2006) and these include property reverting to a living settlor or passing to a settlor’s spouse or civil partner (see para 8.24 below).
Leases for Life
Where a freeholder or head leaseholder grants a lease for life or one which is terminable on or by reference to a death then, by s.43(3) IHTA 1984, it is treated as a settlement and the property as settled property unless the lease was granted for full consideration. The life, lives or death to which the duration of a lease is related may refer to the lessor, lessee or any other person provided a lease becomes determinable on or by reference to a death. The lessee who is beneficially entitled to an interest in possession in settled property is treated, by s.49(1) IHTA 1984, as beneficially entitled to the property in which the interest subsists. The effect of s.49(1) is to treat the lessee as beneficially entitled to the interest in the property out of which the lease was granted and not to the lease itself.
The number of leases qualifying as interests in possession has been severely restricted by Part 2 of Schedule 20 FA 2006 (see para 8.3 above).
The lessee’s interest is, by s.50(6), taken to subsist in the whole of the property, less such part of it as corresponds to the proportion which the value of the lessor’s interest bears to the value of the property.
The value of the lessor’s interest is, by s.170, taken to be such part of the value of the property as bears to it the same proportion as the value of the consideration, at the time the lease was granted, bore to what would then have been the value of full consideration in money or money’s worth.
Thus if: a = the value of full consideration for the lease at the date it was granted, and
b = the value of the consideration paid by the lessee for the lease, and
c = the value of the property in which the lease subsisted at the date of the grant of the lease or at any other relevant time
| the value of the lessor's interest = | £b x c a |
| And | |
| the value of the lessee's interest = | £a-b x c a |
As the fractional values of the lessor’s and lessee’s interests add up to unity there is no question of an allowance for an “undivided share”. It will be appreciated that the value of the “consideration” in a. and b. above will be the aggregate of (1) any premium and (2) the rent reserved, appropriately capitalised.
If a lessor grants a lease for life (which qualifies as an interest in possession, as amended by Part 2 Schedule 20 FA 2006) at nil or part consideration a transfer of value takes place, by virtue of s.3(1) (as amended by Part 3 Schedule 20 FA 2006). This will normally be a potentially exempt transfer (a PET) initially and will only give rise to an actual charge if the PET fails on the death of the lessor within 7 years of the transfer.
Before the grant of the lease the lessor’s estate will include the property out of which the lease is granted, whereas after the grant the lessor’s estate will include the reversion expectant on it. This interest is specifically excepted from the general exclusion of “reversionary interests” from an estate for IHT purposes by s.48(1)(c) and its value is calculated as shown in para 8.17 above.
In all transfers of value involving leases for life (having regard to para 8.18 above) granted at more than nominal consideration (excluding PETs but including failed PETs where the transferor dies within 7 years) HMRC(IHT) will ask the DV for an opinion of both the capital and the rental value of the freehold or leasehold “settled” property in which the lease for life subsists. The practical effect of s.49(1) is to treat the lessee as owning the lessor’s interest in the “settled” property and the capital and net annual values should be assessed as unencumbered by the lease for life, including the benefit of vacant possession if the life tenant is in occupation. If the “settled” property is leasehold the liability of the lessor (the settlor) for the payment of rent and other outgoings under the terms of the head-lease should be taken into account when arriving at the capital and net annual values of the “settled” property.
The rental value to be reported by the DV is:
“the annual rent the property might reasonably be expected to fetch in the open market on the grant of the lease having regard to the provisions of the lease other than the rent, and reflecting any statutory restrictions which exist on the amount of rent obtainable.”
HMRC(IHT) will require these capital and rental values at the date of the grant of the lease for life in order that they may calculate:
i. the value of the lessee’s s.49(1) interest where the lessee gave only part consideration for the lease, in a proportion of the “settled” property. HMRC(IHT) will apply the formula set out at para 8.17 above;
ii. the value of the reversionary interest included in the lessor’s estate immediately after the transfer of value.
For any subsequent lifetime transfers of value by either the lessor or lessee, or on the death of either party, or on the termination of the lessee’s interest HMRC(IHT) may require the capital value of the “settled” property, but at the date of the relevant transfer.
HMRC(IHT) expect to be able to deal with the calculation of the reversionary interests and to calculate the values of a, b and c (see para 8.17 above) by using the capital and net annual values supplied by the DV, but they may sometimes ask the DV whether or not the consideration paid by the lessee represented the full consideration for the grant of the lease for life. Only in these cases will the DV be involved in the use of Life Tables in order to arrive at the required value. When making such references HMRC(IHT) will inform the DV of the age and sex of the person by reference to whose death the lease will determine.
If the lease is granted for full consideration or without gratuitous intent in the circumstances set out in s.10, the lease for life does not fall within the settled property rules of s.49(1) and there is no transfer of value on the granting of the lease. The reversionary interest will form part of the lessor’s estate in connection with any lifetime transfer of the reversion or on the lessor’s death. Similarly the lessee’s interest in the lease for life will form part of the lessee’s estate in connection with any lifetime transfer of the lease by the lessee or on the lessee’s death.
When the lease terminates (whether or not during the lessee’s lifetime), if it reverts to the settlor or to the settlor’s spouse/civil partner or to the widow/widower (as long as the settlor died less than two years earlier), IHT may not be chargeable (s.53(3) and (4) and s.54(1) and (2) IHTA 1984). HMRC(IHT) will not normally refer such a case to the DV, but if one is referred and the DV learns from the parties or has reason to believe that there has been a reversion to the settlor, the settlor’s spouse/civil partner or widow(er), the DV should advise HMRC(IHT) accordingly and await further instructions.
On first reference from HMRC(IHT), any valuations covered by these instructions should not be communicated to the parties. The DV may request further information and should carry out an inspection in the normal manner. The case should be registered as type 180, the report to HMRC(IHT) should be issued within 40 working days, endorsed “Not negotiated” and a credit type 01 should be taken.
HMRC(IHT) may refer the case back to the DV after they have discussed it with the parties, and request negotiations. The case should then be recorded as credit type 03. The DV should thereafter adopt the time limits and procedure contained in Section 27. It should not, however, be necessary to use Form VO 1101 or VO 1102 as HMRC(IHT) will have notified the DV’s valuations to the parties.
In no circumstances should the DV become involved in any legal argument with the parties or their advisers as to the validity of charge or approach. Any submission by the parties should be referred back to the caseworker at HMRC(IHT) and action on the case should be postponed pending further instructions.
Settlements Without Interests in Possession (Discretionary Trusts)
If no individual has an interest in possession, tax is charged under a different set of rules, which treat the trust as a separate entity. Trusts under which there is for the time being no individual entitled to an interest in possession are referred to as discretionary trusts. A common example is where the settled property is held on trust to accumulate the income or to apply the income at someone’s discretion. Such cases can be identified by their HMRC(IHT) reference number which will usually begin L9__/
For the purposes of the charge to tax, property held on discretionary trusts is effectively divided into two categories, namely:
- relevant property which is defined in, section 58 IHTA 1984 as “settled property in which no qualifying interest in possession subsists”. This section has now been amended by Part 3 of Schedule 20 FA 2006 to include interests in possession, where an individual became beneficially entitled, on or after 22nd March 2006, which is not:
i) an immediate post-death interest (section 49A IHTA 1984)
ii) a disabled person’s interest, or
iii) a transitional serial interest (section 49B-E IHTA 1984).
Section 58(1) also lists various exceptions, which do not constitute relevant property and these include property held on various special trusts and “excluded property” (see Section 4 para. 4.6).
- special trusts. These include:
i) accumulation and maintenance trusts (s.71 IHTA 1984); n.b. under Part 1 Schedule 20 FA 2006, no new accumulation and maintenance trusts can be created on or after 22nd March 2006 and existing trusts will be treated as relevant property, unless a beneficiary becomes absolutely entitled before 5th April 2008; or they are converted to either Bereaved Minor trusts or Age 18 to 25 trusts. Bereaved Minor trusts (section 71A) and Age 18 to 25 trusts (section 71D) continue to be special trusts.
ii) settled property held for charitable purposes only until the end of a period (s.70 IHTA 1984);
iii) employee or newspaper trusts (ss.86 and 87 IHTA 1984).
As well as incurring an entry charge (payable according to the normal IHT rules for chargeable transfers) when the property is first placed into the discretionary trust, there are two other types of charge on relevant property:
a) Ten year anniversary charge
The ten year charge arises on the tenth anniversary of the creation of the trust and then at the end of each subsequent ten year period during the life of the trust. The amount on which tax is charged is the value (after reliefs) of any relevant property in the trust immediately before the anniversary.
The tax is calculated on the assumption that a chargeable transfer has been made, i.e. taking account of the amount of the current transfer and of the total of all chargeable transfers made by the transferor within the previous seven years.
The important thing to bear in mind with the ten year anniversary charge is the rate of charge. It is 30% of the rate of charge for chargeable lifetime transfers. The current rate for such lifetime transfers is 20% i.e. half the death rate. This means, of course, that in relation to a ten yearly anniversary charge the rate would be 30% of 20% of any total that exceeds the IHT threshold. This is a maximum charge of 6%.
HMRC(IHT) will notify the DV of the maximum rate of charge on Form VOA 1 or VOA 2 and this should always be borne in mind in any subsequent negotiations (see Section 27 para. 27.7). For instance, even with an agreed increase of say £50,000 on realty the tax charge will be restricted to £3,000.
- exit or proportionate charge
Generally, the charge will arise when:
i) the trust comes to an end
ii) some of the property is distributed absolutely to beneficiaries
There are other occasions of charge and certain exceptions. The amount on which tax is charged 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. The rate of charge is a fraction of the rate, which was charged at the last ten year anniversary. The fraction is calculated as a one fortieth for each complete quarter which, has passed since the last anniversary.
The rate of charge can therefore be very low, for example, the charge on a distribution 2½ years after the trust was created (or after its last tenth anniversary) will be 25% (10/40) of the full ten-yearly charge.
Property held on special trusts is not liable to the ten-yearly and proportionate charges indicated above. Subject to any specific exemption, there is a tax charge when an existing discretionary trust is converted into a special trust.
In most circumstances there will also be a charge when property ceases to be held on special trust. In such circumstances, the tax payable is charged at a flat rate computed in accordance with the number of completed quarters that the taxable property has been held on the particular special trust (subject to a maximum rate of 30% where the property has been held in the trust for 50 years or more).
There is an age 18 to 25 exit charge when:
-
the beneficiary becomes absolutely entitled to the property in the trust between their 18th and 25th birthdays
-
some of the property in the trust is distributed to the beneficiary
-
the beneficiary dies aged over 18
The maximum rate of charge is 4.2% (28 fortieths of 6%).
In dealing with a discretionary trust, HMRC(IHT) will require valuation advice from the DV on the occasion of a ten year anniversary. This will normally involve a valuation of the relevant property immediately before the ten year anniversary, although in certain circumstances other property has to be taken into account also. Valuations may also be required of property ceasing to be relevant property on the occasion of an exit charge, or property ceasing to be held on special trusts.