Gifts With Reservation, Settlor-Interested Trusts and Excluded Property

Most of what is sold to families as inheritance tax planning fails for one of three reasons: benefit reserved, interest retained, or property that was never excluded. All three rules are old, all three are well understood by HMRC, and all three are routinely misunderstood by those selling the arrangement.

Three Rules That Undo Most Amateur Planning

A great deal of what is presented to families as inheritance tax planning fails for one of three reasons: the settlor retained a benefit, the settlor retained an interest, or the property was never excluded property in the first place. Each rule is old, each is well understood by HMRC, and each is routinely misunderstood by those selling the arrangement.

Gifts With Reservation of Benefit

Where an individual gives property away but does not part with possession and enjoyment of it, or the property is not enjoyed to the entire or virtually entire exclusion of the donor and of any benefit to the donor, the property is treated as remaining part of their estate on death.

• The classic failure is the gift of the family home to children with the parents continuing to live in it. The seven-year clock never starts because the gift is ineffective for IHT purposes throughout.
• Paying a full market rent is a recognised route out, but it must be a genuine market rent, actually paid, reviewed over time, and evidenced. A nominal or historic rent does not work.
• Occupation by the donor after a change in circumstances can be within a statutory carve-out, but the conditions are narrow and specific.
• The double whammy. A gift can fail as a GWR and still have been a chargeable transfer when made, and the interaction needs working through rather than assuming one cancels the other.
• Pre-owned assets tax is the backstop: an income tax charge on the benefit of using property formerly owned, aimed at arrangements that escape the GWR rules. An election can be made to be treated as within GWR instead, and the choice needs modelling.

Settlor-Interested Trusts

Where the settlor or their spouse can benefit from a trust, the income tax and capital gains tax consequences are unattractive and often surprise the settlor:

• Trust income is treated as the settlor’s for income tax, taxed at their rates, whether or not it is distributed.
• The settlements legislation extends to arrangements involving minor unmarried children of the settlor, catching income paid to or for their benefit above a small limit.
• Holdover relief is denied on transfers into a settlor-interested settlement, so the very relief that made the transfer attractive is unavailable.
• The trust remains a relevant property trust for IHT, with entry, ten-year and exit charges, while the settlor still bears the income tax. It is frequently the worst of both worlds.

Whether the settlor can benefit is a question of the trust’s terms and any related arrangements, not of whether they in fact have. Widely drawn beneficial classes and unexcluded default beneficiaries are the usual culprits.

Excluded Property

Property situated outside the UK held in a settlement made by a settlor who was not UK domiciled (or, under the current framework, not long-term UK resident) at the time the settlement was made is generally excluded property and outside the IHT charge. The recurring issues are:

• Status at the date the settlement was made, which is a question of evidence about a historic period and frequently poorly documented.
• Additions to the settlement made after status changed, which do not share the excluded status of the original property.
• UK residential property held through offshore structures, which is expressly brought within the charge and is no longer excluded property however the structure is layered.
• The move from domicile to a residence-based test, which changed the analysis for many long-standing structures and requires each one to be re-examined rather than assumed to continue.

How HMRC Challenges

• On the IHT400, through the gifts and reservation questions, which are the standard entry point.
• Through the Trust Registration Service, which has given HMRC visibility of structures it previously could not see.
• Through information notices to trustees and advisers, noting that advice on the structuring is likely privileged, while the underlying transactional documents generally are not. See privilege in HMRC disputes.
• Through discovery, with extended time limits where offshore matters are involved, and the associated offshore penalty uplifts.
• On penalties, where reliance on advice about a genuinely technical structure is directly relevant to behaviour under the Auxilium test.

Practitioner Application

1. Review every home-gifting arrangement in the family’s history before an IHT400 is filed, not after HMRC asks.
2. Where rent is being paid, evidence it: market appraisal, bank payments, periodic review. Without those three, it will not hold.
3. Read the beneficial class to see whether the settlor or spouse can benefit, however remotely, before assuming the trust is not settlor-interested.
4. Establish and document the settlor’s status at the date of settlement, and treat every later addition as a separate question.
5. Re-examine long-standing offshore structures against the residence-based framework rather than assuming continuity.
6. Model the POAT election rather than defaulting to one treatment.

Frequently Asked Questions