Contents

• What is an interest in possession trust?
• Why use an interest in possession trust?
• Income Tax
• Capital Gains Tax
• Inheritance Tax
   

What is an interest in possession trust?

An interest in possession trust (IIP) will have a named beneficiary(ies), who will be entitled to income from the trust as and when it arises. Income is paid to the named beneficiary known as the “life tenant” or “life renter” in Scotland. The trustees cannot accumulate income within the trust fund.  

The trustees can decide who receives the capital from the trust fund from the class of beneficiaries. These beneficiaries are referred to as the remaindermen and the classes of beneficiary can be quite wide. They could include the settlor’s immediate family members (children, spouse, civil partner) or remoter descendants of the settlor and registered charities. The life tenant could also be included as a remainderman.

The trustees must have the best interests of both sets of beneficiaries, those entitled to the income and those entitled to the capital, when investing the trust fund.

New IIP trusts created on or after the 22 March 2006 are subject to the ‘relevant property regime’. This means they are taxed the same as discretionary trusts for IHT unless the trust is created for a disabled individual. Qualifying interest in possession trusts could no longer be created during the settlor’s lifetime from 22 March 2006, however they can still be created under the terms of an individual’s Will, or by the laws of intestacy or via a deed of variation. These are known as immediate post death interest trusts (IPDI). 
 

Why use an interest in possession trust?

They are commonly used where the surviving spouse/civil partner is given access to income during their lifetime or a right to live in the family home and on their death the children then benefit from the capital and receive the family home.

Where there are split families, an IIP trust could also be used to ensure children from first marriages are not left out of the Will whilst providing the surviving spouse/civil partner with income. 
 

 

Income Tax

The trustees are liable to income tax at the basic rate, no matter how much income is received.There are no personal or savings allowances available to trustees and there is no entitlement to the dividend nil rate.

Trustees pay 8.75% tax on dividend income and 20% on all other income, however, when they pay this out to the named beneficiary the income retains its nature. This means that the beneficiary can reclaim back the tax paid by the trustees up to the beneficiary’s marginal rates and utilise their own allowances such as their personal allowance the starting rate for savings and the personal savings allowance, in addition to the dividend nil rate. Where the beneficiary is a higher or additional rate tax-payer they will have further tax to pay.

To ease administration the trustees can arrange for the income to be paid (mandated) directly to the named beneficiary who will be assessed on that income at their marginal rates. The beneficiary can use all available allowances. Where income is mandated to the beneficiary the trustees will not have to report this on the trust tax return. This means that the trustees will not be able to deduct any expenses from the mandated income.

 

Capital Gains Tax

Where assets are transferred directly into the IIP trust the settlor is making a disposal and will therefore be taxed on any gains. If the transfer of assets is made following the death of the settlor there will be no gain realised. The trustees will have acquired the assets at the market value at the date of death.

All gains arising within the trust will be assessed on the trustees. Trustees have an annual exempt allowance, currently £1,500 (tax year 2024/2025) and is half of the individual allowance. This is split between the number of trusts the settlor created during their lifetime up to a maximum of 5 trusts (£300 each).

Gains within this allowance are not subject to tax, however gains above this allowance will be subject to the trustee rate of CGT. 

The trustee rate from 6 April 2024 to 29 October 2024 is 20% on chargeable assets and 24% for disposals of residential property. The tax rate from 30 October 2024 onwards is 24% on gains from chargeable assets and residential property.

However, 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 main residence.

On the death of the life tenant for pre-22 March 2006 IIP trusts, there is no capital gains tax liability, unless the settlor elected for holdover relief when transferring the assets into trust. The assets are revalued at the date of death.  

For trusts created on or after 22 March 2006 the position is the same, other than the assets are not revalued on death.

Inheritance Tax

The creation of an IIP trust trust before 22 March 2006 with a ‘qualifying interest in possession’ was a potentially exempt transfer (PET) and dropped out of the settlors IHT cumulation after 7 years. The named beneficiary, however, has the value of the trust fund included in their estate on death which is still the case for trusts created prior to 22 March 2006. Qualifying interest in possession trusts could no longer be created during the settlor’s lifetime from 22 March 2006.

Certain amendments, called Transitional Serial Interests, could be made to the trust before 6 October 2008, without bringing the trust into the relevant property regime and being taxed, from that date, as a discretionary trust. 

Gifts into an IIP trust created on or after 22 March 2006 is a chargeable lifetime transfer (CLT). If the settlor exceeds the value of the nil rate band, currently £325,000, in a 7-year rolling period there will be a charge when the trust is created. This charge is called the “entry” charge and is based on half of the death rates and is chargeable at 20% on the value over £325,000.

It is only CLTs that are included in the cumulation for the calculation of the entry charge. PETs are ignored. Where there are joint settlors the gift is deemed to be made half each unless there is evidence to show otherwise.

Sometimes the settlor may want to pay this charge on top of the transfer into trust in order not to reduce the funds for the beneficiaries. Where the settlor pays this charge it is classed as another CLT and is grossed up giving an effective rate of 25%.

If the settlor dies within 7 years of making the CLT the gift becomes chargeable and uses up some or all the settlor’s available nil rate band. Where the gift exceeds the nil rate band an additional charge of 20% applies. You cannot set CLTs against the residence nil rate band, only the normal nil rate band.

Where tax is payable taper relief may apply depending on the timing between the date of the gift and the date of death.

On each 10th anniversary of the creation of the trust, it may be subject to a charge which is called the “periodic” or “principal” charge. The basis of the charge is based on the value of the trust fund which exceeds the available the nil rate band for the trust and will be taxed at no more than 6%. 

There may also be exit charges applied when distributions are made to beneficiaries. These are called “exit” or “proportionate” charges. If there are no entry charges when the trust is initially set up generally there will be no exit charges within the first 10 years. If there are no periodic charges at the 10-year point there will generally be no exit charges for the following 10 years.

Calculating periodic and exit charges can be very complex and are normally carried out by accountants.