We often are asked to explain what a ‘carve-out trust is. This is a trust which separates out different interests (or rights), some of which are generally held absolutely for the settlor of the trust and some of which are held on settlement for the beneficiaries (where the settlor is excluded from benefitting).
The interests or rights held for the settlor are not regarded as ‘settled property’ under the IHT definition [IHTA 1984 s43] and therefore are not subject to the relevant property regime, where exit charges and 10 year charges would apply.
Under a carve-out trust the gift with reservation of benefit rules do not apply to the settlement, because the settlor is specifically excluded from benefiting.
Carve-out trusts are not new, and HMRC are fully aware of the mechanics of these types of trust. The existence of carve-outs have been challenged in court, an example being Ingram v Inland Revenue where the executors of Lady Ingram successfully argued the existence of a carve-out (a lease) which avoided the reservation of benefit rules applying [Finance Act 1986 s102].
When the Pre-owned asset tax was introduced in 2005, the fact the mechanics of a carve-out trust exclude the settlor from benefiting from the settlement – meant the POAT charge did not apply to these types of trust. Also in more recent developments, the Disclosure of Tax Avoidance Schemes (DOTAS) consultation lists such schemes as excepted from disclosure.
The Lifestyle Trust
The Lifestyle Trust, launched early 2016, is written as a ‘carve-out trust’ where the trust ‘carves-out’ the right for the settlor to access ‘Policy Funds’ at certain dates in the future.
We are often asked whether the Lifestyle Trust is a Reversionary Interest Trust. A reversionary Interest is defined in legislation under IHTA 1984 s47 - it is an interest that reverts back to the settlor of the trust once a beneficiary's (or a group of beneficiaries’) interest has come to an end. A carve-out trust operates differently, however, in that it excludes certain rights from the gift made from outset.
Both reversionary interest trusts and carve-out trusts rely on the valuation principles under IHTA 1984 s160 – ‘the price which the property might reasonably be expected to fetch if sold in the open market at that time’ - to value what is subject to IHT on death of the settlor.
The initial gift, is there a discount?
As described above, the Lifestyle Trust allows the settlor to specify access to certain Policy Funds (groups of individual policies within an investment bond) at future dates. The rest of the trust fund is held on discretionary trust for certain classes of beneficiaries including spouse, children, grandchildren etc.
The value of the gift into the discretionary trust is the premium paid to the investment bond (net of any adviser fees) minus the value of the benefit carved out. The value of the right to the Policy Funds is based on what a purchaser would pay on the open market if sold. So the question is ‘what would you pay for access to Policy Funds at a future date?’ If we look at two key considerations here:
- Is the settlor going to survive until the future date (known as the vesting date)?
- Will the trustees appoint policies to a discretionary beneficiary prior to the vesting date?
The first one is in effect the position of a DGT however, as the trustees have the overriding power to appoint benefits out of the trust fund then the value of that entitlement is negligible as this appointment could defeat the benefit carved out.
What about Gift with Reservation (GWR) rules?
As the Policy Funds are carved out absolutely at commencement they are not included within the settlement (the discretionary trust) for Inheritance Tax purposes and are therefore outside the scope of the GWR provisions. HMRC manuals confirm this approach under ihtm44112.
What happens when a policy fund reaches a vesting date?
The Policy Fund carved out for the vesting date in question now has a value (that of the policies contained within the Policy Fund). This value is now in the estate of the settlor as it is held on trust for them absolutely (a bare trust). This is not an exit from the discretionary trust as the carved out access to the trust fund never formed part of the settlement (as described above) so no exit charge will apply.
The trustees can then:
- Surrender the policies in the Policy Fund
- Leave them invested
- Assign them to the settlor (who can in turn surrender or assign)
What if a vesting date is postponed?
The settlor can defer the date they can access a Policy Fund as long as this is done prior to the vesting date outlined in the original trust deed (or a date changed in a previous deferral).
The deferral is a loss to the estate. However, the same valuation principle applies as at inception. As the Policy Fund has no market value prior to a vesting date the loss to the estate and therefore transfer of value is negligible.
Trustees have a duty of care to beneficiaries to act fairly between them, to consider their interests and needs, to ensure trustees interests do not conflict with those of the beneficiaries and to provide information and accounts to them upon request.
The settlor has an absolute right to the Policy Funds under the trust once the vesting date is met – this is the purpose of the carve-out. Therefore, at outset when the trustees are appointed the Trust Fund consists of the trust property less the carved out property. The settlor is not a beneficiary under the discretionary trust.
The trustees should give consideration to the settlor’s rights, and examples of this are that the settlor’s consent should be received by the trustees before surrendering the bond, or before income tax is paid from the bond – as that could fetter the settlor’s rights.
Carve-out trusts appear in numerous forms; this includes DGTs, flexible reversionary trusts and split trusts for critical illness and life assurance policies. There is a long history associated with these so advisers should feel confident in their acceptance by HMRC.
Date Created: September 2016