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23 min read 28 Feb 22
The term IIP is not defined in tax legislation. Nevertheless, in its Capital Gains Manual HMRC state.
Broadly speaking, a person has an interest in possession in property if he or she has the immediate right to receive any income arising from it or to the use or enjoyment of the property.
Clearly therefore, it is not always necessary for the trust property to produce income. Indeed, an IIP frequently exist in assets that do not produce income. The most common example of enjoying property is the right to reside in a house.
The leading case for the definition of an IIP is the House of Lords case of Pearson v IRC  AC 753.
For the avoidance of doubt, if the trustees have discretion or power to withhold the income from the income beneficiary, which can be exercised after income arises, then there cannot be an IIP. Note however that an administrative power to withhold income to pay advice fees, or withhold income to pay for the upkeep and repair of a trust property would not affect the existence of an IIP.
The income beneficiary is often referred to as having a ‘life interest’ (life rent in Scotland) or being the ‘life tenant’ (life renter).
Example of a life interest
On trust for my wife Alison for life, thereafter to my children Brian, Catriona and David in equal shares absolutely.
Prior to 22 March 2006, insurance companies commonly offered ‘flexible’ or ‘power of appointment’ IIP trusts where the trustees have a power to appoint amongst, or to vary, beneficiaries. There are two classes of beneficiary – actual and potential - with the trustees having the power to replace an actual beneficiary with anyone from the list of potential beneficiaries.
Example of a ‘flexible’ IIP trust
On trust for such of my wife, children and remoter issue as the trustees shall from time to time by deed or deeds revocable or irrevocable at their absolute discretion appoint and in default of any appointment for my children Edward and Fiona in equal shares absolutely.
A flexible IIP trust offered by an insurance company therefore allowed the settlor to choose named individuals (i.e. Edward & Fiona) who were entitled to the income generated by the trust assets and allowed a discretionary class whereby the trustees could choose to allocate the capital to anyone in either class. Insurance company bonds were a common asset held within the trust due to the fact they do not produce income. A tax efficient flexible arrangement was therefore obtained.
22 March 2006 was the day of the 2006 Budget which made far reaching changes to the IHT treatment of trusts, many of which took immediate effect. As a consequence, new, flexible insurance company trusts (other than bare trust) created on or after 22 March 2006, even if expressed in terms of IIP trusts, are taxed under the relevant property regime. This is the regime which traditionally applied to discretionary trusts where there are potential, entry, exit, and periodic charges. This regime is explored here.
From 17 March 1987 to 21 March 2006, lifetime gifts into IIP trusts qualified as Potentially Exempt Transfers (PETs). The ‘relevant property’ regime did not apply meaning that there were no entry, exit, or periodic charges.
The trade-off for this tax treatment was that the income beneficiary was treated as beneficially entitled to the underlying capital. In other words, the trust fund fell inside that person’s estate for IHT purposes (S49(1) IHTA 1984). This continues to be the case for IIP trusts created before 22 March 2006 providing the income beneficiary is still in place – though see ‘ Transitional Serial Interests’ below.
If that IIP terminates during the beneficiary’s lifetime then tax is charged as if the beneficiary had made a transfer of value. Therefore, if the IIP terminates or the beneficiary disposes of his/her IIP then a PET arises if the property passes to another individual absolutely. If however the income beneficiary’s interest comes to an end on or after 22 March 2006 and the property remains in trust, then the outgoing beneficiary is treated as making a Chargeable Lifetime Transfer (CLT) based on the trust fund value at that time, and the trust will become subject to the relevant property regime.
Example of IHT arising on death of the income beneficiary
Gina has recently passed away. She was widowed twice and was left the right to live in her 2nd husband’s house on his death (i.e. she was given a life interest). The house will now pass to the nephews and nieces of her 2nd husband under the terms of his will trust.
The calculation of Gina’s estate will include the value of the capital underlying the IIP.
The IHT liability is split between Gina’s free estate and the IIP trustees as follows.
Step 1 – Free Estate
Assume Gina’s free estate simply comprised cash in the bank of £90,000
Step 2 – IIP value
Assume the house that Gina lived in under the IIP trust was valued at £2,500,000
Step 3 – there will be a double NRB but no RNRB as the house is not passing to direct descendants
1,940,000 @ 40%
Due by executors
90,000/2,590,000 x 776,000
Due be trustees
2,500,000 /2,590,000 x 776,000
The 2006 legislation introduced the concept of a TSI. There are 3 sets of circumstances when this may arise as covered in the next 3 sections.
These TSIs apply to IIP trusts commencing before 22 March 2006. Essentially, if the TSI rules apply in a given scenario, then the IIP that someone is becoming entitled to on or after 22 March 2006 will be taxed under pre 22 March 2006 rules. This means that the trust property will be treated as forming part of their estate for IHT purposes whereas otherwise the relevant property regime would have applied.
If prior to 6 October 2008, the pre 22 March 2006 IIP came to an end while the income beneficiary was still alive to be replaced by a new beneficiary, then that new beneficiary will be taxed under the pre 22 March 2006 rules. The new beneficiary will have a TSI. In other words, there was a window between 22 March 2006 and 5 October 2008 when a beneficiary of an IIP trust could pass on that interest to others such as children.
Example of Pre 22 March 2006 IIP replaced prior to 6 October 2008 giving rise to a TS
Gordon has had a life interest (the ‘prior interest’) under an IIP trust since 1 July 2000. On 1 October 2008 he terminated that interest in favour of his daughter Harriet (the ‘current interest’). She remains the current life tenant of the trust.
Gordon made a PET on 1 October 2008 subject to the 7 year rule.
The trust fund is within the IHT estate of Harriet. She has a TSI.
The trust is treated as pre 22 March 2006 and is not subject to the relevant property regime.
As noted above, the longstanding principle with an IIP is that trust fund falls inside the estate of the deceased beneficiary for IHT purposes.
If the death occurs on or after 6 October 2008 and a spouse or civil partner then becomes entitled to the IIP then the spouse's interest will be known as a TSI.
Example of a post 5 October 2008 death of spouse giving rise to a TSI
Ivan had a life interest (a “previous” interest) under an IIP trust from 1 August 2001. On 1 March 2009 he dies and his wife Jane becomes entitled to the IIP (a “successor” interest). She remains the current life tenant of the trust.
For tax purposes, the inter-spouse exemption applied on Ivan’s death. There would have been no spousal exemption if the transfer on 1 March 2009 had been made while Ivan was still alive (because the relevant property regime rules would have applied).
The trust fund is within the IHT estate of Jane. She has a TSI.
The trust is treated as pre 22 March 2006 and is not subject to the relevant property regime.
A TSI can also arise with life insurance trusts. This occurs where there is a pre 22 March 2006 IIP trust and the trust fund comprises an insurance policy. The person with the IIP has an ‘earlier interest’. If that person died on or after 6 October 2008 but before the life insured then a new beneficiary can acquire a ‘present interest’. Therefore, providing that changes in the holders of the IIP take place on death then these provisions allow all subsequent holders to be treated under the pre 22 March 2006 rules.
From 22 March 2006, new IIP trusts will fall under the relevant property regime unless the interest is
The relevant legislation is S49(1A) and S58(1) IHTA 1984.
In other words, for IIPs arising after 21 March 2006, other than the categories of TSIs described above, the income beneficiary will only have the trust fund inside their estate where the interest is
Essentially an IPDI is created when an individual becomes beneficially entitled to an IIP on or after 22 March 2006 under a will or intestacy where the bereaved minors provisions do not apply and neither do the disabled person’s interest rules. Even if the trustees have a power of appointment, and can terminate the original life tenant’s interest if they so desire, they will be outside the scope of the relevant property regime. The capital supporting the life interest will, of course, continue to form part of the estate of the life tenant in these circumstances.
Example of an IPDI
Kirsteen who is married to Lionel has three children from a previous relationship. In her will she includes a provision stating that her estate will pass to trustees where Lionel will have a life interest (entitled to income) and on his death the capital will pass absolutely to her three children.
In the above example, Kirsteen and Lionel were married, but for the avoidance of doubt, an IPDI does not have to be in favour of a surviving spouse or civil partner.
For completeness, note that a PET can arise on or after 22 March 2006, for lifetime gifts into a bereaved minor's trust on the coming to an end of an IPDI. This is a bit niche!
Trusts for vulnerable beneficiaries are explored here.
Summary of post 21 March 2006 trusts
All transfers into IIP trusts on or after 22 March 2006 are treated as chargeable transfers and are taxed in the same way as ’relevant property’ trusts. FA 2006 changed the definition of a ‘qualifying’ IIP so that it now excludes any settlement created on or after 22 March 2006, other than an IPDI, disabled person’s interest, or TSI.
There are special rules for life policy trusts set out later.
For non-life policy trust situations, it is possible that the trust fund comprises gifts both before and after 22 March 2006. The end result will be
In 2003 Stephen gifted “Moor Place” into an IIP trust for Linda
In 2008 Stephen added “Moor Place Lodge” to the same trust and instructed the trustees to administer the two properties as separate funds.
Moor Place? Linda is treated as beneficially entitled to it and IHT charged as though Linda owned it.
Moor Place Lodge? That’s relevant property.
The circumstances may not always be so straightforward. What if the facts had been similar but instead of two properties, the trust contained a number of stocks and shares to which more had been added.
The trustees might have maintained separate funds for the two additions of the stocks and shares with the values clear for each. If however the stocks and shares have been mixed, then an apportionment will be required.
Not to be confused with adding property!
Where value is added after 21 March 2006 this will not result in any of the trust fund becoming relevant property provided the addition is indeed solely of value and not and addition of property. This is because there needs to be a disposal of property to create a settlement (S43(2) IHTA 1984) and an addition of value doesn’t result from a disposal of property.
Consider Clara who created a pre 2006 IIP trust comprising shares for David. Assume the value of those shares increase through capital growth, post 2006. In that case, Clara is not making a post 2006 disposal and therefore none of the trust fund becomes relevant property.
For life insurance policies written into trust before 22 March 2006, there was a concern that regular premiums paid after that date would give rise to relevant property implications. As a result, S46A IHTA 1984 was introduced. This provides that the rights under the insurance contract are treated as pre 22 March 2006 and if the premium payment is a transfer of value then it will be a PET. Clients who exercise an option to increase payments into existing life insurance policies from 22 March 2006 will not create fresh relevant property trusts.
So, S46A applies to pre 22 March 2006 trusts where the life policy contract was entered into before that date. What else? Either a premium was paid on or after 22 March 2006 or an allowed variation is made to the contract on or after that day. An allowed variation is one that takes place via the exercise of pre 22 March 2006 rights under the contract. Note that a Capital Redemption policy is not a life insurance policy.
Note that the scope of S46A is not restricted to premiums paid that the individual was contractually bound to make before 22 March 2006. Instead, a single premium policy with the ability for the individual to make further premium payments (increments) would also be covered meaning that those premiums can continue to enjoy PET treatment.
Section 46A provides protection to not only the IIP that originally existed before 22 March 2006 but also extends to any TSI.
The trustees are initially be taxed on the trust income because they receive it (though see later section on ‘mandating’ income to the beneficiary).
Remember that personal allowances are available to individuals only and not to trustees. Also bear in mind that the rates below will apply to the trustees regardless of the level of income and therefore ‘tax bands’ do not apply.
Certain expenses will be deductible when calculating profits (e.g. allowable letting expenses in a property business). Trustees’ Management Expenses (TMEs) are however different. Allowable TMEs will reduce the beneficiary’s entitlement to income rather than being used to reducing the trustees’ tax liability.
Assuming no mandating procedure has been carried out then the trustees should make a Trust and Estate Tax Return
Again, assuming no mandating procedure is in place, the IIP beneficiary should receive a statement from the trustees of trust income. They will typically use R185
Different rules apply where the income of the IIP beneficiary is treated as that of the settlor under the settlements legislation. Examples of this are where the IIP beneficiary is a spouse, civil partner or minor child of the settlor. See later section on this subject
The IIP beneficiary is taxable on the trust income because he or she is entitled to it. Where the beneficiary has received income from the trustees net of tax, then to arrive at the correct measure of income, the net income is grossed up since the beneficiary is entitled to, and taxable on, the gross amount. The beneficiary should use SA107 Trusts etc
Example of income grossed up
A beneficiary who is entitled to the income is personally liable to tax on that income whether it is drawn or left in the trust fund. Beneficiaries receiving distributions from a trust are entitled to a tax credit for the rate tax paid (or effectively paid) by the trustees in respect of rental, savings income or dividend income. That income will retain its nature meaning that the tax due by the beneficiary will reflect the dividend nil rate ‘allowance’, the starting rate for savings income and the personal savings ‘allowance’ as appropriate.
As outlined below, it is possible for trustees to mandate trust income to a beneficiary. If so, it means that the beneficiary receives it and the trustees do not. In such a case there is no statutory basis for taxing the trustees as being in receipt of the income. The beneficiary both receives the income and is entitled to it. The trustees exclude the mandated income from the trust and estate tax return and the beneficiary (or, where the settlor has retained an interest, the settlor) includes the income on his/her tax return.
Sometimes there are instructions or arrangements for income to bypass the trustees of an IIP trust. If trust income passes directly or indirectly (for example, through an investment manager) to a beneficiary without going via the trustees the beneficiary needs to ensure that it is returned correctly on his/her tax return.
In correspondence with The Chartered Institute of Taxation, HMRC stated:
In simple terms the IIP trust income is mandated to the beneficiary when the beneficiary will receive that income directly from the source…In these circumstances there is no basis for taxing the trustees, because they are not in receipt of the income. The beneficiary is chargeable on the income because they are entitled to it.
The beneficiary should return all income on the relevant pages of their tax return, in addition to their direct personal income. For example, include:
However, if income bypasses the trustees and the trust:
then the settlor includes the income on his or her personal return. Other beneficiaries do not.
In essence this is an administrative shortcut. The tax paid remains the same but there is a time and costs saving for the trustees (and HMRC). The trustees will not have to supply all the income details on SA900 and may even request to be taken out of the Self-Assessment regime for future years.
As outlined above, the income of an IIP trust belongs to the beneficiary as it arises. Where the settlements legislation applies, the income is treated as that of the settlor and there will be no charge on the actual beneficiary. The settlor of a ‘settlor interested’ IIP gets no relief for TMEs.
Where the settlor has retained an interest in property in a settlement (i.e. a trust), the income arising is treated as the settlor’s income for all tax purposes. A settlor has retained an interest if the IIP beneficiary is the settlor, a spouse or civil partner. The legislation for this is S624 ITTOIA 2005.
Similarly, S629 ITTOIA 2005 applies to situations where the IIP beneficiary is a minor child or step child of the settlor (who is neither married nor in a civil partnership). A step child includes the child of a civil partner. S629 does not apply to a child’s trust income in any tax year if, in that year, the total amount of income does not exceed £100.
Example of IIP beneficiary being a minor child of the settlor
Victor creates an IIP trust where his three children are life tenants. Two of three children are minors. S629 applies to treat the income of the two minor children as that of Victor because the income belongs to the minor children.
Prior to the reform of CGT in 2008, capital gains arising to settlor interested trusts were charged on the settlor rather than the trustees. These rules were abolished as they were no longer considered necessary.
If an individual transfers property into a trust, that is a disposal by the settlor at market value even if the settlor retains an interest. Provided the relevant conditions are met it may be possible for the person making the disposal to claim hold-over relief.
As a result of IIP and Accumulation & Maintenance Trusts being brought into line with discretionary trusts for IHT purposes, any capital gains on the transfer of chargeable assets into these trusts from 22 March 2006 have become eligible for CGT holdover relief under s260(2)(a) of the Taxes and Chargeable Gains Act 1992 (Gifts on which IHT is chargeable etc.). This means that the crystallisation of capital gains can be deferred until the asset transferred is realised by the trustees (or following a further holdover claim realised by a beneficiary).
The main CGT rate for trustees and personal representatives is currently 20% though there is a 28% rate for gains on residential property not eligible for private residence relief. The annual exempt amount is generally half the exemption available to individuals. Where a number of trusts have been created since 6 June 1978 by the same settlor, the trustees exemption is divided equally between them, subject to a minimum exemption of one fifth of the available amount.
Where an individual becomes absolutely entitled to trust property during his or her Lifetime, the trustees will be treated as making a chargeable disposal for CGT. However, an election can be made to defer the CGT liability by claiming hold-over relief, regardless of the nature of the assets being distributed, provided that the beneficiary is becoming absolutely entitled to the trust assets without previously having been entitled to an IIP. Tax is then payable by the beneficiary when he or she finally disposes of the asset, and the acquisition cost is reduced by the amount of the held-over gain.
Prior to 22 March 2006 the value of trust assets was re-based for CGT purposes on the death of the beneficiary of an IIP trust. Consequently there was no CGT liability but the trustees were regarded as making a disposal of the trust assets at the then market value and the assets were deemed to have been acquired at their new base cost. This is still the position for IIP trusts which retain that IIP status. This re-basing facility ceased for most IIP trusts created on or after 22 March 2006 and consequently, as from that date, the death of a beneficiary will not give rise to any CGT re-basing. Note that the death uplift for CGT purposes would apply to an IIP in an IPDI. It can also apply to cases with a TSI.
Example of death uplift in a TSI case
Harry has been life tenant of a trust since 2005. He dies in 2020 and his wife Wendy then takes an IIP – her interest will be a TSI and because her estate is increased, spouse exemption is available. The CGT death uplift is available on Harry’s death and Wendy’s death.
Trustees need to be mindful that investments should be ‘suitable’. This encompasses not only the composition of portfolios, but also their tax-efficiency and associated administrative costs. This commends consideration of ‘tax wrappers’ such as investment bonds and OEICs which are at opposite ends of the investment spectrum. An OEIC generates income, albeit that with accumulation shares, income is not distributed but instead reinvested and added to capital. Even so, the distribution remains income for tax purposes. In contrast bonds are non-income producing investments and withdrawals are a return of capital not income. Regular withdrawals from a bond may erode the capital payable to the remaindermen on the life tenant’s death and withdrawals could be taxed as income by HMRC.
Accordingly, OEICs are often preferred to bonds for trustees of IIP trusts where one or more beneficiaries are entitled to income.
But, if there is a clause in the trust deed giving the trustees power to pay capital to the life tenant then an insurance bond would therefore be a potential investment if the trustees so choose. Also, in cases where one beneficiary is entitled to income and others entitled to capital, then the trustees could diversify the trust fund, perhaps by investing in a mixture of OEICs to suit the income needs of one beneficiary, and insurance bonds to provide capital for the others.
Trustees must hold the balance fairly between different categories of beneficiary. For example, where there is a life tenant entitled to income during their life and a second class (the remaindermen) entitled to capital on the death of the life tenant, then it would be unfair to the life tenant if the trustees were to invest in assets which produced little or no income, but offered the prospect of greater than usual capital growth. Equally, it would be unfair to the remaindermen if the trustees were to make investments which offered a high income but little or no capital growth, or which led to the value of the capital being eroded. The exception might be if the settlor made it clear that one class of beneficiary was to be preferred over another.
The requirement for the trustees to act ‘fairly’ in making investment decisions with different consequences for different classes of beneficiaries is regarded as preferable to the traditional image of holding scales equally between the income beneficiary and the remainderman. The image of scales suggests a weighing of known quantities whereas investment decisions are concerned with predictions of the future. More than that though, the image of the scales suggests a mechanical approach when in fact the trustees have discretion. For example, they can take into account the income needs of the life tenant or the fact that the tenant was a person known to the settlor and a primary object of the trust whereas the remainderman might be a remoter relative. There should not, for example, be a requirement for trustees to follow a mechanical rule for preserving the real value of the capital when the life tenant was the deceased’s widow who had fallen on hard times when the remainderman was young and well off.
Information as to whether trustees can buy a bond and who is assessed for the tax on a chargeable event gain on a bond in trust is contained in our important information about trusts document.
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