Trust in the NRB

Mark Politz considers the advantages of nil-rate band discretionary trusts and their implementation on death in an article for Taxation Magazine

Key points

• After the transferable NRB was introduced, many testators with nil-rate band discretionary trusts in their wills decided to leave everything to the surviving spouse on the first death.
• If no other advantages exist, winding up the nil-rate band discretionary trust may be a suitable option.
• There are various reasons why it might be beneficial to retain the trust.
• If retaining the trust, it will be necessary to register with HMRC’s trust registration service.
• Dealing with a couple who have more than two nil-rate bands because of previous marriages.

Since the introduction of the transferable nil-rate band in 2007, nil-rate band discretionary trusts (NRBDTs) have become less popular. However, they can be advantageous for spouses in some circumstances and many wills still contain them. All references in this article to spouses also include civil partners.

Background

Before October 2007, the purpose of including a NRBDT in wills for spouses was to ensure that each inheritance tax allowance, known as the nil-rate band (NRB), would be used. If everything passed to the survivor on the first death, the NRB of the first-to-die would be wasted, as only one allowance would be available on the survivor’s death.

The simplest way of using the NRB on the first death was to leave an equivalent sum directly to children or other intended beneficiaries. The main drawback, however, was that the relevant amount would not be available to the surviving spouse. The solution was to provide in the two wills that, on the death of the first spouse, a legacy equal to their available NRB would be left to a discretionary trust. The potential beneficiaries would usually include the survivor and children. The couple would be advised to own their home as ‘tenants in common’, so that a share of the property could be used to satisfy the legacy to the trust, if other assets were insufficient.

Since 9 October 2007, the unused NRB on the first spouse’s death has been ‘transferable’ to the survivor. The change was more generous than that, as the NRB on the survivor’s death (which may be higher by that time) is increased by the proportion of the NRB that is not used on the first death. So, if on the first death the NRB is not used at all – perhaps there were no chargeable lifetime transfers and the whole estate passes to the UK-domiciled surviving spouse – the NRB on the survivor’s death would be doubled, at the level then applicable.

After the transferable NRB was introduced, many testators with NRBDTs in their wills – or other significant first-death legacies – decided to leave everything to the surviving spouse on the first death. It was expected that, in the normal course of events, the IHT threshold would have increased by the time of the survivor’s death, so that the overall allowances would be higher. Leaving everything to the survivor would also have the significant advantage of simplifying matters after the first death. Where protection is required, a life interest trust for the survivor would have the same effect for IHT purposes.

However, some testators with NRBDTs have chosen not to remove the trust provisions and others have simply not reviewed their wills since 2007. What are the options available to the trustees following the first death?

Terminating the trust

The trustees may decide, in consultation with the beneficiaries, that the best option would be for the assets to pass directly to the surviving spouse. This would be appropriate if none of the advantages of retaining the trust apply.

This is usually done by a deed of appointment in favour of the surviving spouse, although it will depend on the terms of the particular trust. Some trusts require a deed, whereas in other cases an advancement of capital, recorded in a trustees’ resolution, would be possible.

Under IHTA 1984, s 144 the termination of the trust within two years after the testator’s death would not be a chargeable event for IHT purposes, so there can be no exit charge. Instead, it will have retrospective effect, so if the termination is in favour of the testator’s UK-domiciled widow(er), the spouse exemption will apply.

There is no equivalent reading-back provision for capital gains tax. Hold-over relief under TCGA 1992, s 260 would not be available on a termination within the two-year period, although s 165 could be considered for qualifying business assets. However, CGT is not normally an issue in practice, as the trustees can simply appoint out their right to the NRB legacy, which would allow the executors to transfer the estate assets directly to the surviving spouse. The trustees would never receive the assets, so there would be no disposal by them when the trust is terminated. The survivor would take the assets as legatee and there would be no CGT liability.

The IHT position on the surviving spouse’s death should be relatively straightforward, as long as there is a record of the unused NRB on the first death. It would be useful to keep, with the survivor’s will, a copy of the relevant papers regarding the first-to-die, i.e. the death certificate, the marriage or civil partnership certificate, the grant of representation, the will and any codicil, any IHT form and the deed of appointment or resolution terminating the NRBDT.

Winding up the trust would avoid administration and tax compliance, and the associated costs. There would be no need for annual tax returns, tax deduction certificates for beneficiaries who receive income, trust accounts and management of the trust’s assets. If the trust is terminated within two years after the testator’s death, the trust will not have to be registered with HMRC’s trust registration service (TRS). Trusts have been subject to ever-increasing compliance rules in recent times, including the TRS and, in some cases, reporting requirements under the automatic exchange of information rules. This has deterred many people from creating trusts.

Retaining the trust

There are several situations where it would be advantageous to keep the NRBDT. These include the following.

• If either or both spouses have already been widowed, the NRBDT will avoid losing any transferable NRB from the estate of the previous spouse (see case study below).
• The NRBDT could have the advantage of keeping the survivor’s estate below the ‘taper threshold’ (currently £2m) for the residence nil-rate band. However, this could also be achieved by the survivor making lifetime gifts.
• If the surviving spouse is intending to leave their estate to a discretionary trust (or other relevant property trust) on death, there would be an IHT benefit in keeping the NRBDT on the first death. This would reduce the value passing into the survivor’s discretionary trust, and each trust would have its own NRB for the purposes of calculating ten-yearly and exit charges.
• It would be sensible to retain the trust if protection is required, for example, in the event of the divorce, bankruptcy or premature death of a beneficiary, or if means-testing for care fees may be an issue.
• There could be an advantage in using the NRBDT for business or agricultural assets that qualify for IHT relief, in order to secure the relief on the first death. However, it is normally preferable to have a specific legacy of those assets, which could be in addition to a NRB legacy.
• The trust could be beneficial if there are any assets in the first spouse’s estate that can be expected to increase in value significantly during the survivor’s lifetime, or at least at a greater rate than the NRB (for example, land with development potential). The NRB has been frozen at £325,000 since 6 April 2009 and will remain at this level until 5 April 2026 – and possibly beyond. The assets transferred to the trust in satisfaction of the legacy would not form part of the survivor’s estate. This could result in a substantial IHT saving, compared with relying on the transferable NRB.

Options for implementation

A case study best illustrates the options for implementing this type of trust.

Sybil died on 1 August 2021, having made no chargeable lifetime transfers. Her will included a NRBDT, with the remainder of the estate passing to her husband, Basil. The potential beneficiaries of the trust are Basil, their two adult children and remoter descendants. The executors and trustees are Basil and the two children. Sybil’s estate includes her half share in their home, Fawlty House, which she and Basil owned as tenants in common. The half share has been valued at around £500,000. Her other assets are individual savings account (ISA) investments worth £300,000 and cash savings of £100,000.

Basil’s first wife died in 1990. She left everything to Basil and made no chargeable lifetime transfers, so there is a full transferable NRB. There were no children of the marriage. Basil and Sybil therefore have three NRBs between them. If the NRBDT is terminated in favour of Basil, one NRB would be wasted. On Basil’s death, it will only be possible for a maximum of two NRBs to be claimed. The third NRB must be used on Sybil’s death, so the trustees decide to retain the NRBDT. They now need to consider the options for implementing the trust.

Option one

The simplest way of doing this would be for Sybil’s investments (£300,000) and some of her cash savings (£25,000) to be transferred to the trust. The investments would lose their ISA status, so income tax and CGT would have to be considered. This option would also involve additional administration during Basil’s lifetime, compared with the others mentioned below. The administration could be simplified by appointing an interest in possession to Basil after the second anniversary of Sybil’s death, which would not be an immediate post-death interest. In any event, Basil would prefer to inherit all of Sybil’s investments and cash savings.

Option two

An alternative would be for a share in Fawlty House worth £325,000 to be transferred to the trust. Basil wants to remain living there. The house could be held in the trustees’ names, with a declaration of trust confirming how the beneficial ownership is divided between Basil and the NRBDT.

If Basil remains living there alone for the rest of his life, HMRC could argue that Basil’s continued occupation amounts to an immediate post-death interest (statement of practice 10/79). If such an argument were successful, Basil would be treated for IHT purposes as owning the trust’s share, so the trust would not have achieved its purpose of preserving the third NRB.

If HMRC does not raise that point, the advantage of this option is that a co-ownership discount could be claimed on Basil’s death when valuing his own share in the house for IHT purposes. The discount could be up to 15%.

A potential disadvantage of this option is that there would be no CGT-free uplift for the trust’s share on Basil’s death. However, the trustees may be able to claim principal private residence relief when the house is sold.

Option three

Instead of any of Sybil’s assets passing into the trust, the legacy of £325,000 could be left outstanding, with an equitable charge being imposed on Sybil’s half share in Fawlty House. The amount due to the trust could be linked to retail prices or house prices, in order to preserve the value of the trust fund in real terms.

The half share would then be transferred by the executors to Basil, subject to the charge in favour of the trust. The house would be registered in Basil’s sole name, but a restriction could be entered at the Land Registry, to the effect that the house could not be sold without the consent of the trustees. The existing joint proprietors’ restriction would remain on the register, so Basil could not sell or mortgage the house without appointing at least one other person (who would usually be one or more of the trustees of the NRBDT) to act with him.

Until the house is sold, the trust administration would be straightforward. The trustees should meet regularly to review the arrangement and, if appropriate, confirm that they are happy for this to continue. All decisions made by the trustees should be recorded in writing and signed by them.

A variant of the equitable charge option is to have an unsecured debt or IOU. A detailed analysis is beyond the scope of this article, but a charge is usually preferable for stamp duty land tax reasons and also to avoid the operation of Finance Act 1986, s 103 in certain circumstances (as illustrated by the 2007 Special Commissioners’ decision in Phizackerley (SpC591)).

Further administration

Under each of the above options, the NRBDT would have to be registered with the TRS. In the case of option two (share of Fawlty House held in the NRBDT), the trust of land would also need to be registered.

The executors and trustees decide to implement the equitable charge arrangement, with the amount being linked to the house price index. Basil remains living at Fawlty House until his death in December 2026. Basil’s estate has a significant value and includes the house, subject to the equitable charge. In valuing his estate for IHT purposes, Basil’s executors claim a deduction for the amount due to the trust, which has increased to £425,000, ie the principal sum of £325,000 plus index-linking of £100,000. This must be paid to the trust out of Basil’s estate, otherwise it will not be deductible for IHT purposes – see IHTA 1984, s 175A(1)(a) and Inheritance Tax Manual, paras IHTM 28027 and IHTM 28029. The payment is made by Basil’s executors in November 2027, following the sale of the house.

The amount due to the trust has decreased the value of Basil’s estate for IHT purposes, but the index-linking has tax implications for the trust. It is arguable that the index-linked element of £100,000 is a capital return rather than income, but HMRC’s view is that this is interest (as confirmed in its Trusts and Estates Newsletter of April 2017). The trust’s income tax liability is around £45,000 at current rates.

From the net amount, the trustees decide to distribute £50,000 equally between Basil’s five grandchildren in December 2027, as his two children are higher rate taxpayers. The grandchildren are minors and have no other income. Each grandchild is given a tax deduction certificate showing gross income of £18,181 and a 45% tax credit of £8,181, ie a net amount of £10,000. Tax repayment claims can be made on behalf of the grandchildren and, depending on the level of the personal allowance in 2027-28, the tax credits could be repayable in full.

Alternatively, before the outstanding amount is paid to the trust, the trustees could appoint an interest in possession to the grandchildren, so that the trust would only pay 20% tax on the index-linking. The grandchildren would receive a credit for that 20% tax when the net amount is distributed to them. There may not be a significant difference between these two options, as the income will ultimately bear tax at the grandchildren’s rates.

There would be no point in the trustees demanding any index-linking for the period after Basil’s death, as this would not be deductible for IHT purposes and would result in an additional income tax charge on the trust. The trust fund and Basil’s estate are intended to pass in the same way. The trustees can sign a deed writing off the post-death index-linking.

Once all taxes have been settled and clearances obtained, the trust can be terminated in favour of the children and/or grandchildren. Alternatively, the trust could be kept running if required, eg for estate planning purposes if the children already have sufficient assets of their own, or for protection.

If the trust is terminated before 1 August 2031 (the tenth anniversary of Sybil’s death), there would be no IHT exit charge, because the initial value of the trust fund did not exceed Sybil’s NRB.

If the trust continues until 1 August 2031, there would be an IHT charge based on the value of the trust fund at that time. There would also be potential IHT charges every ten years thereafter and whenever capital distributions are made. However, without the NRBDT, the assets would have formed part of Basil’s own estate and been taxable at 40% on his death.

Conclusion

Nil-rate band discretionary trusts can have advantages in some circumstances, and trustees should consider these carefully in deciding whether to terminate or retain the trust. If they decide to keep the trust, there are a number of options for implementation. The initial administration of the trust can be straightforward in some cases, e.g. if an equitable charge is used, but there would be additional work after the survivor’s death.