Practitioners of a certain vintage may remember fondly the strict settlement, a legal institution much beloved of the landed classes for much of the 20th century. While there have been no new strict settlements since 1 January 1997, settlements in existence before that date continue to subsist and will continue to do so until exhausted or brought to an end.¹ When the current generation of Tenants for Life passes on, the future of any continuing strict settlement may be in peril.

The reason strict settlements remain significant for private client practitioners is twofold:

• They are not encountered very often and have some quite unusual features, perhaps being a speciality of a generation of practitioners who have retired or are about to retire.
• The nature of the assets held in strict settlements usually point towards a family of considerable wealth.

• A change in the Tenant for Life – A generational shift may require advice as to how the settlement works and may be an important trigger for tax purposes.
• A question arises about the exercise of powers – The regime in the Settled Land Act 1925 (SLA) is highly prescriptive but the powers of a Tenant for Life are not equivalent to those of an absolute owner, which may require the giving of advice or an application to Court.
• Collapsing the settlement – There will inevitably be tax consequences when a strict settlement comes to an end

There are a number of tell-tale features of a strict settlement that make it quite distinct from what we would recognise as a Trust of Land post-1996. The following features must all be present for it to be a strict settlement:

• It must have been created before 1997 – All trusts that were not subsisting strict settlements before the Trust of Land and Appointment of Trustees Act 1996 (TOLATA) and all new trusts since are now ‘Trusts of Land’.
• The property in the trust must not be held on a ‘Trust for Sale’ – even a Trust for Sale with a power to postpone a sale indefinitely (as was often the case) remains outside the scope of the SLA.
• The trust must be capable of being governed by the SLA – as per TOLATA.

A strict settlement may additionally have some or all of the following features which should raise a red flag:

• The presence of vesting deeds – the Tenant for Life and not the trustees hold the legal title to the principle assets comprised in the trust under a strict settlement, which will have been conveyed with a vesting deed separate from the trust instrument.
• Specific reference to the powers conferred by the SLA – The SLA is a prescriptive regime with the powers of the respective parties to the settlement shared between the legislation and any trust instrument.
• The assets in the trust comprise wholly or primarily of land and heirlooms – typically there will be a landed estate associated with a house (sometimes referred to as the ‘mansion house’). Often collections of valuable chattels such as artworks will be included as heirlooms.
• The settlement is usually limited by way of a succession of life interests – strict settlements are frequently (but not exclusively) expressed to be in ‘tail male’ i.e. passing to the nearest male heir after the death of the Tenant for Life. Some settled land may also be charged with the payment of annuities, portions2 or jointure3 to a widow.

The person specified under the settlement that is of full age⁴ and entitled to immediate possession of the settled land is known as the Tenant for Life⁵. The strict settlement is an interest in possession (IIP) trust, which makes it a familiar beast for those familiar with the taxation of such trusts before 22 March 2006.

The Tenant for Life has an IIP and is entitled to all income arising from the settlement for his lifetime. This may be comprised of income from the settled land itself and also all income streams derived from ‘capital monies’ held by the trustees.

All income tax charges arising from the assets of the strict settlement must be met by the Tenant for Life on his personal tax return rather than by the trustees.

If there is a capital gain from the strict settlement – perhaps from the sale of a portion of the settled land – that will incur a capital gains charge. The next question is: who is taxed on the gain? The confusion arises because there are two people who could be described as ‘trustee’. The Tenant for Life holds the legal title to the land but there are also actual trustees of the settlement.

Section 69(3) Taxation of Chargeable Gains Act 1992 (TCGA) provides that where part of the settlement is vested in the Tenant for Life, he can be regarded as a trustee. That poses a difficulty for the Tenant for Life; as a trustee he is laden with the lower annual exemption for gains to trusts. As a trustee he will also pay capital gains tax (CGT) at 28 per cent – but given that the Tenant for Life is likely to be a higher-rate income tax payer anyway, it’s not likely to make a difference.

If the Tenant for Life became vested with his interest before 22 March 2006, this will have been a deemed disposal but there won’t have been a charge. The settlement will also benefit from the tax free uplift⁶.

However, where the Tenant for Life is vested with his interest after 22 March 2006, there will be no CGT event when the settlement devolves to a new Tenant for Life on his death, but there is also no uplift because the settlement will no longer be a qualifying interest in possession (QIIP). Given that the death of the life tenant is not relevant to the relevant property regime, this isn’t likely to be a problem. Instead, the charge will arise (if at all) when gains are made from the settlement or when the Tenant for Life becomes absolutely entitled as against the trustees by the settlement coming to an end.

The IHT position of a strict settlement prior to 22 March 2006 was straightforward. As an IIP, the value of the settlement was aggregated in the Tenant for Life’s estate upon death.

How the settlement is taxed on the death of the current Tenant for Life depends upon whether the settlement continues for another generation or whether it is terminated while the current tenant is still alive. If the settlement is terminated by barring the entail, the settlement will be aggregated with the Tenant for Life’s estate and will suffer IHT at the rate applicable to individuals. It is possible the property could be put back into trust as an immediate post-death interest (IPDI) QIIP, but such a structure would not be a strict settlement. Many older clients will be comfortable and familiar with potentially exempt transfers (PETs). Inter vivos dispositions from the settlement by the current Tenant for Life while the trust is still a QIIP can continue to be used.

But if the settlement continues beyond the death of the Tenant for Life, the settlement will not be aggregated with his estate in the usual way. Instead the death will constitute an immediately chargeable transfer incurring a 20 per cent entry charge and the settlement will be governed by the relevant property regime thereafter.

For all Tenants for Life assuming possession after 22 March 2006, the settlement must be taxed as a relevant property trust, with periodic (ten-yearly) and exit charges. While trust lawyers would still recognise the new Tenant for Life as a life interest, he will not hold a QIIP for IHT purposes.

The classic quandary suffered in strict settlements is one of cash flow. While generally land and asset rich, many Tenants for Life experience difficulty where the income from the settlement is outstripped by the cost of running the estate. Land is an expensive asset to maintain and setting aside the cost of insuring what are likely to be valuable heirlooms, there is also the ad hoc cost of repairs and improvements to the principal mansion house and estate buildings.

Being a prescriptive regime, there is little flexibility given to the Tenant for Life in order to raise income and capital. If, for example, he wishes to make improvement to the settled land, he must consult SLA Schedule III, which indicates from where (if at all) the improvements can be paid.

The focus for a Tenant for Life will often be to seek an injection of cash to meet the liabilities, which, in the absence of a comprehensive estate management strategy is only likely to be a temporary solution. It is very important that funds be not simply added to the settlement without seeking advice. Such an injection would constitute an immediately chargeable transfer, triggering a 20 per cent charge to IHT.⁷ The new funds will also create a parallel trust subject to the relevant property regime alongside the IIP of the strict settlement.

The focus for the current generation of Life Tenants will be to get the settlement into a position where it is able to mitigate the effect of IHT as far as possible. IHT relief for strict settlements is particularly important to preserve the purpose of the settlement – which is to keep assets in the family and also because the settlement devolves to non-IHT exempt beneficiaries.

Given the largely agricultural nature of most settled land, claiming Agricultural Property Relief (APR) will be the obvious solution. However, APR is designed only to reduce the agricultural value of the land. The fact that the land is largely agricultural is perhaps a cause of the classic asset rich but cash poor dilemma faced by many strict settlements.

Those advising a Tenant for Life should also consider the applicability of Business Property Relief (BPR) to the settlement⁸. Like APR, BPR will relieve the settlement from periodic and exit IHT charges, either at 100 per cent or 50 per cent. The following points should be noted:

• APR will only exempt the agricultural value of the land. If the market value per acre is more than the agricultural value, (for example there is development potential) BPR will be the appropriate way to make the most of the land while sheltering it from IHT.
• While APR is available for a passive owner of agricultural land who simply receives rent, to qualify for BPR requires a business activity distinct from the land holding as confirmed by recent Northern Irish authority9.
• The Upper Tribunal’s recent decision in HMRC v Brander10 is welcome confirmation that Tenants for Life can manage the settlement as a composite business of farming and estate management. An important feature of the case was the late Earl of Balfour’s hands-on involvement with all the activities.11 However, much can turn on the ability and willingness of the Tenant for Life to get ‘stuck in’.
• Being an all-or-nothing relief, Tenants for Life and their advisors must closely monitor a composite business to ensure no more than 49 per cent is a non-trading activity.
• BPR is particularly useful to Life Tenants of QIIP trusts, following the case of Finch v IRC12, where 100 per cent (rather than 50 per cent) relief is available on the death of the Tenant for Life on all assets comprised in the settlement used in the business, even if owned personally by the Tenant for Life as part of the settlement. Given that the current Tenant for Life of a strict settlement will be the last beneficiary taxed as a QIIP trust, this may be an extremely valuable opportunity to mitigate IHT before the inevitable transition to relevant property status.
• It is important to ensure that if the settlement is run as a business, excess unused capital is not left sitting on the balance sheet. From an IHT perspective this is value in the business not being used by the business and may be excluded from the BPR. Tenants for Life should be advised to earmark capital reserves for re-investment or to extract it from the business to avoid this happening.

Given the dynastic character of many strict settlements, it is not uncommon to find heirlooms settled along with the land, such as art and furniture collections, to be of significant artistic, historical or cultural value. Earl Spencer, for example, recently sold a number of pieces of art and furniture from Althorp House, including a Rubens, at Christies in July 2010 for GBP21.1 million.¹³

While some settlements are divesting themselves of such pieces in an attempt to diversify their asset portfolios and raise capital there will be plenty of others keen to preserve such collections. The problem with such pieces is that they swell the value of the settlement but don’t produce any income. Advisors should consider the dusty recesses of Part II Chapter II Inheritance Tax Act 1984. If Her Majesty’s Revenue and Customs (HMRC) agree that the property qualifies as ‘heritage property’, IHT can be postponed indefinitely on such objects, subject to continuing undertakings by the Tenant for Life, which include preserving the property and allowing public access to it.

There are various reasons why a strict settlement might be terminated.

• A significant factor following Finance Act 2006 is likely to be inheritance tax planning. Assuming the relevant property regime is here to stay, the next generation of Tenants for Life will could potentially pay more IHT during the lifetime of the trust. Collapsing the trust and gifting property absolutely as a PET now can avoid a charge on the death of the Tenant for Life.
• There are also practical reasons for dissolution. For example, a Tenant may wish to dispose of the settled land to escape the inflexibility of the SLA, which was designed for estates that now face different financial pressures.

The most common means of collapsing a strict settlement is for the Tenant for Life and Tenant in Tail to execute a disentailing deed. While there is no capital gains or inheritance tax charge on the disentailment itself¹⁴, any subsequent resettlement of the assets will be an immediately chargeable transfer, bringing the settlement within the relevant property regime for inheritance tax, incurring an immediate 20 per cent entry charge. The new trust will also be a Trust of Land rather than a strict settlement, which is a very different beast in terms of the powers conferred upon the Tenant for Life.

Following a disentailment, a trust might not be the appropriate vehicle for the estate. Any inter vivos disposition of an interest in formerly settled land will be a PET. If there is an absolute gift from a former Tenant for Life, consideration needs to be given to the practicalities of how and where he or she will now live in order not to trip the gifts with reservation of benefit rules.¹⁵

The current generation of Tenants for Life will be the last to be taxed under the pre-2006 regime for IHT. The settlement will thenceforth become a relevant property trust. That means decennial and exit charges for the next generation. The periodic charges in particular will be an additional drain on an institution long famed for its cash flow difficulties.

The focus for the current generation of Life Tenants will be to get the settlement into a position where it is able to mitigate the effect of IHT as far as possible for the next generation. Given the largely agricultural nature of most settled land, claiming APR will be the obvious solution but BPR should also be looked at. Developing the settled land into a diversified business may release more of its potential than keeping it for pure agriculture. Using the settlement as a business vehicle is also likely to generate more income for the settlement, which can go some way to alleviating the cost of preserving the land and heirlooms.

The high value of heirlooms within the trust may mark them out as being historically or culturally significant. Their value can be sheltered from IHT using the conditional exemptions, but any exemption will come with strings.

Whatever strategy is used, there is no avoiding the inevitable transition to the relevant property regime. Tenants for Life will be well-advised to plan ahead before the roof falls in.

James Sheedy is Legal Editor at CPDcast.com Ltd