Interest in Possession Settlements Print
This type of trust is normally created to provide for a beneficiary for a specific period, or during his lifetime, and for the capital to be distributed to him, or to other specified beneficiaries at the end of the trust period. For example, a parent may create a trust to provide an income stream to his child for life and on the death of the child, for the grandchildren to become absolutely entitled to the assets of the trust.
For 2016/17, interest in possession settlements are taxable at 7.5% in respect of dividend income, (trustees do not benefit from any exempt amount of dividend income) and at the basic rate of 20% on all other income. The lifetime beneficiary will be liable to pay any higher rate tax, if due, on the income as it arises. Gains are chargeable at 20%, and 28% in respect of gains on residential property.
There is no CGT payable by the beneficiary as any CGT is payable by the trustees. On the eventual vesting of the assets to the beneficiaries, a CGT liability may arise on the Trustees if the beneficiary receives any chargeable assets out of the trust at that time.
Prior to 22 March 2006, the creation of an interest in possession settlement was treated as a Potentially Exempt Transfer (“PET”), during the lifetime of the settlor, or as a chargeable transfer on death. On termination of the interest in possession, in life interest cases, IHT was chargeable on the estate of the life tenant where the assets pass to the remainder men on the death of the life tenant. In other cases, the transfer was likely to be a PET and an IHT charge would only arise if the disposal of the beneficial interest in possession occurred within 7 years of the death of the beneficiary.
Transitional provisions apply in respect of existing trusts at 22 March 2006, and these allow interest in possession trusts created before that date to retain their existing IHT treatment where the life-tenant retains his existing beneficial right to the income of the trust, or where a Transitional Serial Interest (TSI) was created during the period 22 March 2006 to 5 April 2008.
A TSI was created where, before 5 April 2008, a new beneficiary became entitled to a life interest in the trust assets on the termination of the life interest of the individual who was the life-tenant as at 22 March 2006. It has not been possible to create a TSI after 5 April 2008.
For IHT purposes, the inter-spousal exemption still applies where the life-tenant of a pre 22 March 2006 trust dies after 5 April 2008 and the surviving spouse becomes entitled to a Successive Life Interest. Accordingly the trust assets will form part of the surviving spouse’s estate.
For interest in possession settlements created during the lifetime of the settlor on or after 22 March 2006, IHT is charged on the settlor in accordance with the same rules as previously applied to Discretionary Settlements. This means that if the amount settled, together with gifts or settlements made by the settlor within the past 7 years exceed the nil rate band threshold (£325,000 for 2016/17), IHT will be payable at the lifetime rate of 20% on the excess. In the event that the Settlor dies within 7 years of making the transfer further IHT up to 20% may become due. It should be noted that there is no tapering of this additional charge as there is for other lifetime transfers.
In addition the Trustees will be liable to pay IHT on the value of the Trust assets every 10 years. The charge is equivalent to approximately 6% of the value of the trust at that time. A further IHT exit charge of up to 6% is likely to arise if the trust is wound-up and the assets distributed to the beneficiaries. This charge is time apportioned based on the fraction: the number of quarters that have elapsed since the settlement was created, or the last 10 year charge arose, divided by 40 (being the number of quarters in the 10-year period).
CGT hold-over relief may be claimed on the settlement of chargeable assets into an interest in possession settlement.
So far as the beneficiary is concerned, other than a beneficiary with a Successive Life Interest (see above) an interest in possession settlement no longer forms part of the beneficiary’s estate, so on the termination of an interest in possession on the death of the beneficiary the value of his interest in the settlement is not included in his estate for IHT purposes. Furthermore, there is no longer a PET on the beneficiary giving up a life interest during his lifetime.
There is an exception to these rules in respect of trusts created during the lifetime of the settlor relating to trusts for disabled beneficiaries, where the amount settled is still treated as a PET. Similarly the ten-year charge, and exit charge will not apply to these trusts.
To qualify for this treatment, the beneficiary must be:
- Incapable, by reason of mental disorder, of administering his property or managing his affairs, or
- In receipt of Attendance Allowance, or Personal Independence Payment by virtue of entitlement to the daily living component at either the standard or enhanced rate.
- Would have been in receipt of either of the above allowances, but for being provided with accommodation, or is living outside the UK.
For Will trusts created on or after 22 March 2006 the above rules also apply but with certain exceptions in the case of:
- Immediate Post Death Interest Trusts (IPDI)
- Trusts for Bereaved Minors (BMT)
- Age 18-25 Trusts.
An IPDI only applies to a trust arising under a Will, or intestacy, and can be for the benefit of a surviving spouse, or any other beneficiary. For IHT purposes, the termination of an IPDI during the lifetime of the life-tenant will be a PET where:
- An individual becomes absolutely entitled to the trust assets;
- Trust assets are gifted to a disabled person’s trust, or a life interest trust for a qualifying disabled person;
- The IPDI is terminated in favour of a bereaved minor’s interest where the original trust was created by the Will of a parent.
In all other cases, the transfer will be chargeable to IHT at the lifetime rate of 20% subject to any remaining nil-rate band, or reliefs. This could increase up to a maximum of 40% if the life-tenant dies within 7 years from the date of transfer.
If the life interest is not an IPDI, BMT, or 18-25 trust, then the rules outlined above will apply.
A trust for bereaved minors can only be created in the following circumstances:
- Under the Will, or intestacy of any person with parental responsibility including a deceased parent, step-parent, adopted parent, or legal guardian.
- Under a statutory trust created on the intestacy of a deceased relative;
- Under the Criminal Compensation Scheme.
The trust must stipulate that the bereaved minor will become absolutely entitled to the trust assets by the time he has become 18, including any income arising, or accumulated income.
Whilst the beneficiary is under 18 any assets advanced from the Trust are paid to, or for the benefit of the beneficiary, and no income is distributed for the benefit of any other person.
An age 18-25 trust is based on the BMT, and was introduced as a result of extensive lobbying of parliament to extend the age at which a young person would become absolutely entitled to the trust assets from the age of 18 as originally proposed. It was generally considered that 18 is a very young age at which the beneficiary could become absolutely entitled to considerable wealth. As a result of the representations made, the Age 18-25 regime was introduced, which goes some way to addressing this issue. It should be noted that as for BMTs these Age 18-25 Trusts only apply where the beneficiary has lost one of his parents.
The IHT position is as follows:
Whilst the beneficiary remains under 18, there is no 10-year charge, or exit charge.
There is no IHT charge where the beneficiary takes an absolute interest at the age of 18, or if he dies under the age of 18.
An exit charge arises where between the ages 18-25 the beneficiary:
Receives an advancement of capital from the trust;
Becomes absolutely entitled to the trust assets.
In these circumstances, the exit charge is calculated in the same way as the 10-year charge, but with a tax rate of 4.2% spread over a 7 year period of 28 quarters.
Main advantage: to provide a beneficiary with a right to income arising from specific assets without passing the ownership of those assets to the beneficiary.
By using any of the above Settlements, the settlor will divest himself of assets, which may increase substantially in value whilst in the hands of the trustees, and thereby avoid the increased IHT that would otherwise arise on his death.
With regard to all the above trusts there are certain common anti-avoidance provisions, in particular, the following should be noted:
If the Settlor retains an interest in the Trust, then for all income tax purposes the income of the trust is treated as the income of the settlor. In addition, any gains arising in the trust may also be assessable on the settlor. Furthermore, the settlor may also be liable to tax under the new pre-owned assets legislation.
The Settlor can no longer claim hold-over relief where the beneficiary is an unmarried minor child of the Settlor.
If, in any year, settlement income is paid for the benefit of an unmarried minor child including a stepchild or illegitimate child of the settlor, the income is treated as that of the settlor, subject to a de minimis limit of £100 per child.
There are many other applications in which Trusts may be used tax efficiently. As discussed above, the use of overseas trusts has been countered by specific anti-avoidance legislation, but there are still significant tax saving opportunities.
It is imperative that proper professional advice is sought from the outset, and that the settlements created are structured properly. It should also be noted that where overseas trustees are appointed, their fees are likely to be more expensive than trustees of a UK based Settlement, and this should be taken into account when considering the creation of a Settlement.