On 17 August 2012, the government set out their proposals on vulnerable beneficiary trusts in a new consultation. The consultation seeks views on (i) how best to define a vulnerable beneficiary for tax purposes and (ii) proposed changes to remove inconsistencies between different tax regimes in the qualifying conditions for vulnerable beneficiary trusts.
What are vulnerable beneficiary trusts?
Currently, vulnerable people in need of assistance are afforded certain tax advantages for assets held in trusts and the income from them. The qualifying conditions for these trusts are restrictive. If they qualify, however, there are three reliefs available to them:
- the trustees pay income tax and capital gains tax at the rate applicable to the beneficiary, instead of the usual inflated rate for trustees;
- the trustees’ annual exempt capital gains tax rate is increased to the normal rate for individuals; and
- the trust is exempt from the usual “relevant property” inheritance tax charges and the trust assets are treated as the beneficiary’s own property on death.
Section 34 of the Finance Act 2005 sets out the qualifying provisions for a vulnerable beneficiary trust. Those conditions are:
(a) that if any of the property is applied for the benefit of a beneficiary, it is applied for the benefit of the disabled person, and
(b) either that the disabled person is entitled to all the income (if there is any) arising from any of the property or that no such income may be applied for the benefit of any other person.
The definition of a “vulnerable person” is currently applied to two easily defined and recognisable groups:
- orphaned minors; and
- those with a severe physical or mental disability.
There are no plans currently to adjust the arrangements regarding orphaned minors.
Severe physical disabilities
Many trusts that qualify for special treatment rely on the Department for Work and Pensions’ assessment of the person’s disability – specifically, whether the person concerned is entitled to the highest or middle rate care component of Disability Living Allowance (DLA). However, DLA is being reformed by the Welfare Reform Act 2012 to create a new benefit called Personal Independence Payment (PIP). Initially, this will be introduced for people aged 16-64. This will mean that, without any amendment, some trust arrangements that would otherwise have qualified will not do so.
PIP will have two awardable components. One will be awarded on the basis of the individual’s ability to get around (the mobility component), the other on their ability to carry out other key activities (the daily living component). The proposed new definition will be based on the daily living component test for PIP entitlement which examines the person’s ability to perform key activities such as preparing food and drink, going to the toilet and making financial decisions. The Treasury feels this offers a sensible alternative to the care component of DLA in helping to define a vulnerable beneficiary trust, but is open to alternative approaches based on the use of the term “vulnerable adult” which is found in other legislation.
The Safeguarding Vulnerable Groups Act 2006 includes a list specifying when a person requires assistance in the conduct of his own affairs. The term also appears in regulations stating when people who look after “vulnerable adults” need to apply for enhanced criminal record certificates. The Treasury accept that either of these two options could also be considered if they are found to provide a more effective definition.
Severe mental disabilities
The consultation acknowledges that, following the withdrawal of DLA, a major route to qualifying as a vulnerable person (within the severely disabled group) may be via the ‘mental incapacity’ test which is not so widely used. The existing mental incapacity test is derived from what became section 94 of the Mental Health Act 1983, which was repealed when the Mental Capacity Act 2005 came into force. This means that, currently, a trust will qualify for tax relief if the person has a mental disorder which makes them incapable of administering his or her property or managing his or her affairs. The Treasury propose to limit the scope of this test to examine the person’s ability to manage or administer property and everyday financial affairs, and only where the mental incapacity is permanent.
It is worth noting that, currently, a “severe mental impairment” must be demonstrated for Council Tax discount purposes and this is only fulfilled by a registered medical practitioner certifying that the relevant person has such a condition. There is no equivalent for tax purposes.
Use of trust capital
As mentioned above, in order to qualify for the special tax treatment, the trust must be set up in such a way that limits how the trust property can be used by the trustees (s34 Finance Act 2005). In general, trustees can apply trust capital for the benefit of the beneficiaries. However, before the special tax treatment for vulnerable person trusts can be claimed, the terms of the trust must secure that the trust capital is only used in certain ways.
The Treasury deems the current rules as complex and confusing and proposes, instead, to adopt a single criterion, namely that the vulnerable beneficiary benefits from every application of the capital that is applied during their lifetime, therefore removing the trustees’ statutory power of advancement for such trusts. In order to secure that the vulnerable beneficiary benefits from every application of the capital, it will be necessary for the trust deed to include a clause preventing the trustees distributing half the trust capital to non-vulnerable beneficiaries during the vulnerable person’s lifetime.
Use of trust income
In addition to the proposed changes to the use of trust capital, the Government is also seeking to introduce a harmonised condition for the use of vulnerable beneficiary trust income. Under the new rules, this will also need to be met in order to qualify for the special tax treatment. The proposal requires that during the relevant person’s lifetime either the relevant person is entitled to all (if any) of the income arising from any property in the trust, or that no such income may be applied for the benefit of any other person.
Following the introduction of the new rules, some trusts will cease to qualify as vulnerable beneficiary trusts. In these cases, the qualifying status of the trust is determined for Inheritance Tax purposes at the time it was established and so “relevant property” trust charges will continue to not apply after the status changed, provided that no further funds are settled.
The consultation period started on 17 August 2012 and will end on 8 November 2012. Following the period of consultation, HMRC will publish a summary of the responses to the consultation. Subject to those responses, the Government intends to bring forward legislation in Budget 2013.
David Way, Partner, Fladgate LLP (email@example.com)
Sarah Sammons, Trainee Solicitor, Fladgate LLP (firstname.lastname@example.org)