Don't believe in fairy tales

Trusts have long had a fairy tale press - the debutante's essential accessory. Why? Because Daddy is of the belief that a trust is a magical way to avoid paying tax. But be warned that this popular view of trusts is largely a fallacy. So why use them?

Trusts began in liberated Norman times when women could not hold property. This presented problems when the warriors went to the Crusades and wanted to see their wife well cared for in their (possibly permanent) absence. So they entrusted their worldly goods to the local priest while they were away with instructions that the wife was to get the benefit of them - that is, live in the house and receive any income.

It is essentially this distinction of legal and beneficial ownership that defines a trust. Mr Norman (the settlor) confers legal ownership on the priest (the trustee), but provides that Mrs Norman is the beneficiary. Thus there are always three parties involved.

Trusts come in many guises - the three main types are:

r Accumulation and maintenance trusts, which are designed for young relatives. They require that any income produced by the assets in the trust must be used for the maintenance, education or benefit of the children involved, or accumulated within the trust.

Equally, the children must become entitled to the right to income or capital from the trust by the age of 25 as the latest income generated in this type of trust is charged at 24 per cent for 1997/98 with an additional 11 per cent surcharge. Capital gains tax (CGT) on any gains arising is also charged at this rate after deduction of the annual exemption.

r Interest in possession trusts (IIP) - the income from this type of trust automatically belongs to the beneficiaries. This entitlement is usually for the lifetime of the beneficiary (the "life tenant").

The assets in the fund may then pass to another life tenant or a "remainderman" who would be a person or group of people entitled to the capital in the trust on the demise of the life tenant.

The income generated by an interest in possession trust is charged to income and CGT at 23 per cent for 1997/98. Equally, a charge to CGT will usually arise when capital leaves the trust.

r Discretionary trusts - here, the trustees have full discretion over the destination of income and capital within the class of beneficiaries specified in the trust deed. Some, if not all, can be kept within the trust and not distributed. The income and capital gains generated is charged at the 34 per cent rate for 1997/98.

In all cases, income payouts to beneficiaries are taxed in their hands, but with credit for income tax paid by the trust.

Inheritance tax (IHT) will always be a consideration on setting up a trust. A gift to an IIP trust ranks as a potentially exempt transfer and hence IHT is only payable should the settlor fail to survive seven years.

On the other hand, on a transfer to a discretionary trust IHT is immediately payable at 20 per cent to the extent that the transfer is above the settlor's nil-rate band of - from 6 April - pounds 215,000, with further tax possibly payable should the settlor not survive seven years.

If assets are being passed into a trust CGT may arise - but the quid pro quo of the IHT charge for the discretionary trust is that no CGT is payable.

Ostensibly, it is not easy to see where tax savings can be made when one takes into account the legal costs of setting up the trust and the annual compliance costs such as tax and trust return, trustees' remuneration etc. Another difficulty can be finding appropriate trustees.

There are tax savings to be made. Big CGT savings can be made through discretionary trusts using gifts relief, and the different rates that apply to IIP trusts will have been noted.

It comes down to trusts being ideal devices if family circumstances prohibit the making of outright gifts. Children may be financially immature or minors (under 18) or simply unsuitable to be the recipients of large amounts of wealth. Then control of the assets is retained in the hand of trustees whilst the benefits pass to the family. This often appeals when grandparents are thinking of benefiting grandchildren.

John Whiting is a tax partner, Cherry Reynard a tax specialist with Price Waterhouse.