Consider a client who wishes to create a trust of £325,000 for his grandchildren. He is concerned about giving them absolute access to these funds, so a discretionary trust provides the required flexibility and caters for any new family members that he may want the trustees to add to the list of beneficiaries. The trust falls within the current available nil-rate band (NRB) of £325,000 for 2010/2011 and as it is a discretionary trust, it falls under the chargeable lifetime transfer (CLT) rules, with an entry charge of £0.

Additionally, he wishes to make an outright gift of £325,000 to his adult children via bare trusts. These gifts would be considered potentially exempt transfers (PETs), so entry, 10-year periodic and exit charges are not applicable. Combining both bare and discretionary trusts means that he can give away £650,000 without any immediate liability to tax.

£325,000 discretionary trust (for his grandchildren), subject to CLT rules £0 entry charge.

£325,000 bare trust (for his adult children), subject to PET rules.

£325,000 + £325,000 = £650,000.
He can give away this amount without any immediate liability to IHT.

At this point all the client’s objectives seem to have been addressed. But, supposing the client dies eighteen months later, how will this impact IHT? The key question now is ‘in what order were the trusts created?’, as this will determine which trust benefits from the NRB.

The scenarios on the following pages assume that the residual estate has been passed to the spouse under the spouse exemption, annual exemptions have been utilised and the spouse has utilised their NRB should they predecease them.

The PET would be allocated to the current available NRB (assume £340,000 in the tax year of death), minus £325,000. This would leave £15,000 of unused NRB which can be used against the CLT.

The CLT would be taxed as £325,000 minus £15,000 (£310,000) x 40%, minus any tax paid on entry (nil). This leaves £124,000 tax to pay.

There would be no taper relief available as the client did not survive for three years after making the gifts. The £124,000 tax can be paid by the trustees, leaving a trust fund of £201,000 (£325,000 - £124,000). Assuming there are no payments to the beneficiaries in the first ten years, and that the value of the discretionary trust has by then grown to £410,000, the calculation at the first 10-year periodic charge point will be:

The CLT would be allocated to the current available NRB (assume £340,000 in the tax year of death) which would leave the balance of the NRB to be set against the failed PET. The tax on the failed PET would now be £124,000. The 10-year periodic charge on the trust would be as follows:

In this example we have focused on the impact of the 10-yearly periodic charge. The same principles will also apply when calculating ongoing exit charges when the trustees look to distribute from the trust to the beneficiaries in the first and subsequent 10-year periods.

The entry, exit, and 10-yearly periodic charges which now apply to flexible and discretionary trusts means the order in which gifts are made into trust will impact immediate and future tax payable. Therefore, careful consideration is required. By executing the deeds at different times, future taxes can be reduced or even negated. There may be other factors which require consideration but the diagram below outlines, for the majority of multiple transactions, the order of events which is most effective in reducing tax liability.