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What is an interest in possession trust?

Interest in possession (IIP) trusts give a named beneficiary (or beneficiaries) the right to any trust income. This beneficiary is often referred to as the life tenant of the trust (or life renter in Scotland). The right to income could also be satisfied by allowing the life tenant to benefit from the trust property without actually owning it. For example, it may allow them to live rent free in a residential property owned by the trust. Importantly, trustees cannot accumulate income.

The beneficiaries of the trust capital will be determined by the trust deed and the decision making powers given to the trustees. It is not normal for the life tenant to be one of those beneficiaries, but the trust may allow trustees to appoint capital to them.

When making investments, the trustees have responsibilities to both the life tenant and the beneficiaries entitled to capital, and must take account of the interests of both when choosing where to invest, unless the trust says otherwise.

Reasons for using an IIP trust

IIP trusts may be created during lifetime or on death.

IIP trusts are quite common in wills. Typically, the surviving spouse is given the right to trust income for their lifetime (or the right to occupy the marital home) with the capital passing on death to designated children. These are usually referred to as life interest trusts (or life rent in Scotland).

Prior to the IHT changes to trusts on 22 March 2006, it was common practice to use a form of IIP trust with life policies, including investment bonds. These are known as 'flexible' or 'power of appointment' trusts. The settlor names 'default' beneficiaries who are entitled to any trust income, and ultimately to capital when the trust ends unless the trustees exercise their powers to appoint capital during the life of the trust, or change the default beneficiaries. But unlike a trust with a life tenant, they do not have to provide an income for these beneficiaries. This allows the trustees to invest in life policies, such as investment bonds.

Gifts to flexible trusts were potentially exempt transfers (PETs) and the trust was not subject to periodic or exit charges. However, new trusts are now subject to the same IHT regime as discretionary trusts and their use has declined.

Rights to the trust fund

The life tenant only has an automatic entitlement to trust income and not capital. The trustees may have discretion over where and when to pay capital or it may pass automatically to named beneficiaries when the life interest ends. These beneficiaries are referred to as the remaindermen.

Administration issues

Once the trust is created the trustees will be the legal owners of any trust assets and investments. It is likely they will also have wide investment powers, but these must be used in the best interests of the beneficiaries. In the case of life interest trusts where different beneficiaries are entitled to income or capital they will need to act fairly between the different classes. They will normally need to strike a balance between a reasonable yield for the life tenant whilst giving the opportunity for capital growth for the remaindermen.

Investment bonds should not be used to provide an income to a life tenant (e.g. by taking up to the 5% tax deferred withdrawal allowance) as all payments from a bond are capital in nature. Bonds may be used, however, as part of an overall investment strategy to maintain capital for the remaindermen, using other investments to provide income for the life tenant.

IIP trusts will need to be entered on the HMRC trust register if they have income that is not mandated directly to the life tenant, or capital gains from disposals.

Inheritance tax

The IHT treatment of an IIP trust depends on whether it is created during lifetime or on death. For lifetime trusts the main issue is whether the trust was created before or after 22 March 2006.

Trusts created on death

An IIP trust can be created on death either by the terms of the deceased's Will, the laws of intestacy or a deed of variation. This type of IIP is known as an immediate post death interest or IPDI. There is a chargeable transfer by the deceased unless the IIP is for the spouse or civil partner in which case it is an exempt transfer.

IIP trusts created on death are not treated as 'relevant property' and so the trust will not be subject to periodic or exit charges. Instead, the value of the trust will form part of the life tenant's taxable estate on their death.

Lifetime trusts created after 21 March 2006

These have the same IHT treatment as discretionary trusts. There is an exception for disabled person's trusts.

Lifetime gifts into IIP trusts are now chargeable lifetime transfers (CLTs) that are subject to IHT at 20% if they exceed the settlor's nil rate band. The tax is grossed-up if it is paid by the settlor which makes the effective rate 25%. This is because by paying the tax which is primarily the responsibility of the trustees as 'donees', there is a further loss to the settlor's estate.

The trust is classed as a relevant property trust which means that periodic charges apply every 10 years and exit charges when capital is paid out to beneficiaries. The maximum rate of IHT for these charges will be 6% but in practice is often zero if the value of the trust remains below the available nil rate band.

The trust does not fall into the taxable estate of any beneficiary and beneficiaries can be varied without IHT consequence.

Lifetime trusts created before 22 March 2006

Gifts into these trusts were potentially exempt transfers (PETs) rather than CLTs. This meant that there was never an immediate charge to IHT whatever the value of the gift, but there could retrospectively be a charge should the settlor die within seven years of making the gift. The trusts were not subject to the relevant property regime of periodic and exit charges. The value of the trust formed part of the estate of the IIP beneficiary. This remains the case provided there is no change to the IIP beneficiary.

Since 6 October 2008, changing a beneficiary of one of these trusts will normally bring it into the relevant property regime and taxed in the same way as a discretionary trust.

Any change to an IIP beneficiary of a pre-22 March 2006 trust will affect the IHT position of the trust as follows:

How is the income of an interest in possession trust taxed?

Income tax on the trust

The income tax treatment will depend on whether the trust income is mandated directly to the beneficiary(ies) or is paid to them via the trust.

If the trustees choose to mandate the income directly to the beneficiary they will not need to report it on the trust tax return, which reduces their administrative costs. However, trustees will not be able to deduct any expenses from mandated income.

If investment income is not mandated to the beneficiary then the trustees are liable for income tax at the basic rate regardless of how much or how little income arises. The personal allowance, personal savings allowance and the dividend allowance are not available to the trustees. It should be remembered that dividends and interest are now paid gross with no tax credits available to meet the liability.

Trustees will pay tax on income at the following rates:

• Dividend income - 8.75%
• All other income - 20%

From 6 April 2024, trusts will total income of less than £500 will pay no income tax.

Income tax on the beneficiary

The life tenant (life renter in Scotland) is entitled to the net income after tax and expenses. The income, when distributed to them, retains its source nature, for example, dividend or interest. Beneficiaries who are taxed at less than basic rate can reclaim any tax paid by the trustees.

Beneficiaries can use their personal allowance, savings rate band, personal savings allowance and dividend allowance where available against trust income. Basic rate taxpayers will have to pay basic rate on mandated income but otherwise the tax paid by the trustees will satisfy their liability. Higher and additional rate taxpayers will always have tax to pay but any tax paid by the trustees will meet part of their liability.

Settlor interested trusts

Income tax anti-avoidance measures treat the trust income as that of the settlor if they and/or their spouse/civil partner can benefit from the trust. This does not include the former spouse/civil partner and so trusts set up for a widow(er) will not be affected. Most trusts offered by product providers are not settlor interested.

Parental settlements

Special rules also exist where a parent sets up a trust for their minor (under 18) unmarried child. If income paid to or for the benefit of the child exceeds £100 per annum, all trust income will be assessed on the settlor. The £100 annual limit is per parent and per child.

Investment bonds

Investment bonds do not produce an income and there is no income tax charge unless money is withdrawn from the policy and a chargeable event occurs. Each policy year, for a maximum of 20 years, 5% of the original investment (including any increments) in a bond can be withdrawn without triggering any immediate income tax liability.

The trustees should generally avoid paying bond withdrawals to a beneficiary who only has the right to receive income, as they are capital payments.

When a chargeable event occurs any gain will be assessed to income tax on:

• The settlor, if alive* and UK resident;
• Otherwise the trustees if the trust is UK resident.

* The liability remains with the settlor throughout the tax year of their death.

The settlor will be taxed in the same way as an individual. Top-slicing relief is available. Where there is more than one settlor, each will be assessed proportionately on any bond gain based on their contribution to the trust.

The settlor has the right to reclaim any tax they suffer from the trustees, and while they have this right it will be included in their estate for IHT. If the settlor does not wish to reclaim the tax from the trustees this could be seen as a further gift. This would be a chargeable lifetime transfer, and they should notify the trustees who may need to account for any IHT.

Where the liability falls on the trustees, the trust rate applies. Top-slicing relief is not available for trustees.

What is the CGT treatment of an interest in possession trust?

On creation of the trust

Trusts can be created by either the transfer of cash to the trustees, or by the transfer of an actual asset, such as an existing insurance bond or portfolio of shares/mutual funds.

There are no capital gains tax consequences for lifetime gifts involving cash or existing bonds. Other assets transferred into trust while the settlor is still alive will be a disposal for CGT with any gain being assessed on the settlor.

However, CGT can be postponed, or 'held over', at the time of transfer if it is also a chargeable lifetime transfer for IHT. As gifts into trust since 21 March 2006 will be CLTs, settlors may elect for 'holdover' relief. The relief can also be claimed if the gift is of business assets. Holdover relief is not available where the settlor, their spouse/civil partner or their minor (under 18) unmarried child can benefit from the trust (these are known as 'settlor interested' trusts).

Assets transferred to trust on the settlor's death will not normally result in a CGT charge. The trustees will acquire assets at their market value at the date of death.

During the life of the trust

If the trustees dispose of trust assets (for example, if they sell a mutual fund or a property) the gains are calculated in the same way as for an individual and taxed at the trust rate of CGT. The trustees are only entitled to half the individual annual CGT exempt amount. However, this exemption is shared equally between all trusts created by the same settlor, subject to a minimum of one fifth of the trust exemption.

Trustees can also claim principal private residence (PPR) relief on the disposal of residential property that has been occupied by a beneficiary of the trust as their only or main residence.

Transfer out of trust

There will be a CGT disposal if the trustees transfer chargeable assets to a beneficiary. This could happen either because they have the authority to make discretionary distributions of capital or where a beneficiary becomes entitled to the trust capital (e.g. on attaining a specified age or event).

The trustees may be able to jointly elect with the relevant beneficiary for gains to be held over if the asset is either a 'qualifying business asset' or the trust 'qualifies' (mainly lifetime IIP trusts created after 21 March 2006). This postpones the gain until the beneficiary ultimately disposes of the asset. This can be advantageous as the beneficiary has the full annual exemption and may pay a lower rate of CGT.

Where trustees want to utilise holdover relief, they must take care not to pass assets to a beneficiary within the first three months of the trust being created, or within the first three months following a ten yearly IHT charge. Such transfers are not regarded as chargeable lifetime transfers for IHT, and consequently holdover relief won't apply unless the transfer is of business assets.

Interest in possession trusts created before 22 March 2006 will benefit from a tax free uplift on the death of the life tenant. This is because the trust is subject to IHT in their estate. In other words, any gains up to death are wiped out and the acquisition cost is reset to the asset value at death. However, if there were any gains held over on creation of the trust (which could only apply if the assets were business assets) their death will bring the held over amount into charge.

Trusts set up on the death of a parent for their minor children (known as 'bereaved minors trusts' and '18 - 25 trusts') will also benefit from holdover relief when the beneficiary attains the relevant age.