Key takeaways
- Understand what an Interest in Possession trust is and their most common uses
- Setting up an Interest in Possession trust and their tax treatment post-2006
- Examples of situations where the Transitional Serial Interest arises
What is an Interest in Possession trust?
An Interest in Possession trust gives a named Beneficiary the right to receive an income from assets placed in the trust but they are not entitled to the trust assets. They are helpful in providing the Beneficiary with an income before the trust’s assets are passed to other Beneficiaries at some point in the future.
With Interest in Possession trusts, the Beneficiary is referred to as the ‘Life Tenant’ in England or the ‘Life Renter’ in Scotland, and ‘Remaindermen’ is the name given to those Beneficiaries who stand to inherit any remaining trust property after the Life Tenant’s interest comes to an end.
The Beneficiary’s status as the Life Tenant could include being allowed to live rent-free in a residential property owned by the trust.
When is an Interest in Possession trust used?
Most Interest in Possession trusts are arranged as part of a person’s will. Usually, the deceased’s will stipulates the surviving spouse is given the right to trust income (or the right to occupy the marital home) for the rest of their lifetime. Upon the death of the surviving spouse, the assets in the trust (such as the marital home) will pass to designated children or other beneficiaries.
The named Beneficiaries of the trust capital will be determined by the Trust Deed, as well as the decision-making powers given to the Trustee. It is not normal for the Life Tenant to also be named as one of those Beneficiaries, but the trust may allow Trustees to appoint capital to them. Trustees cannot accumulate income.
When making investments, the Trustee bears responsibilities both to the Life Tenant and the Beneficiaries entitled to capital. Therefore, they must take account of the interests of both when making investment decisions, unless the trust specifically states otherwise.
Interest in Possession trusts are increasingly commonplace in family situations where an individual has children from a first marriage, but lives in the family home with their second spouse. The Interest in Possession trust ensures the surviving spouse can continue to live in their home for the rest of their life, while the children from the first marriage will receive the property from the trust upon the second spouse’s death.
In trust terminology, the Beneficiary (Life Tenant) will never own the capital assets but will derive the benefit and enjoyment of their use, or any income generated from them. In other words, they are classed as having an ‘interest in possession’. This interest usually continues for the life of the Beneficiary unless they re-marry or enter into a civil partnership. On the Life Tenant’s death or other eventuality, the trust assets will pass absolutely to the Remaindermen.
Setting up an Interest in Possession trust
Once the Interest in Possession trust is created, the Trustee is the legal owner of any and all trust assets and investments. They are required to act in the best interests of Life Tenants and Remaindermen. This could include striking a balance between achieving a ‘reasonable’ yield for the life tenant whilst giving the opportunity for capital growth for the remaindermen.
After the Interest in Possession trust has been created, it should be entered onto the HMRC trust register if it has an income that is not mandated directly to the life tenant, or where capital gains from disposals are created.
Changes to the Inheritance Tax treatment of trusts in 2006
Before 22 March 2006, any lifetime transfers into Interest in Possession trusts were fully exempt from Inheritance Tax provided the Settlor survived seven years from the date of creation of the trust. This was because the transfers were treated for tax purposes as Potentially Exempt Transfers (PETs).
Interest in Possession trusts were also exempt from the ten-yearly periodic charge and the exit charge associated with Discretionary Trusts.
The Finance Act 2006 meant that transfers into most new trusts created on or after 22 March 2006 are no longer treated as PETs, unless the trust is a Bare Trust. This means that from 22 March 2006, all gifts into such trusts (including Interest in Possession trusts) are immediately chargeable to Inheritance Tax.
However, there is no immediate charge if the value of the transfer (including transfers in the previous seven years) is within the available Inheritance Tax nil-rate band (£325,000 for 2023/24).
As a result of the legislation, Interest in Possession trusts are also potentially subject to the ten-yearly periodic charge, the exit charge and the additional charge on death of the Settlor within seven years.
Transitional Serial Interest
The 2006 legislation introduced the concept of a ‘Transitional Serial Interest’. With a Transitional Serial Interest, the Interest in Possession trust is not taxed under the relevant property regime. Instead, the Life Tenant is treated as the owner of the assets for Inheritance Tax purposes.
There are three sets of circumstances when a Transitional Serial Interest may arise.
- The transitional period to 5 October 2008 (S49C IHTA 1984)
- Surviving spouse or civil partner trusts (S49D IHTA 1984)
- Life insurance trusts (S49E IHTA 1984)
These Transitional Serial Interests apply to Interest in Possession trusts that commenced before 22 March 2006. In these instances, an Interest in Possession trust that either the Life Tenant or Remaindermen would become entitled to after 22 March 2006 are taxed under pre-22 March 2006 rules.
This means the trust property will be treated as part of their estate for Inheritance Tax purposes whereas otherwise the relevant property regime would have applied.
Transitional Serial Interest Example 1: The transitional period to 5 October 2008
There was a window between 22 March 2006 and 5 October 2008 when a beneficiary of an Interest in Possession trust could pass on that interest to others, such as their children.
For example, Eddie had a life interest under an Interest in Possession trust since 1 April 2007. On 1 October 2008, Eddie terminated that interest in favour of his daughter Janet (the ‘current interest’). Janet remains the current Life Tenant of the trust.
Eddie made a PET on 1 October 2008, subject to the seven-year rule. The trust fund is within the IHT estate of Janet. As a result of the Transitional Serial Interest rules, the trust is treated as pre-22 March 2006 and is not subject to the relevant property regime.
Transitional Serial Interest Example 2. Surviving spouse or civil partner trusts
As noted above, the key principle with an Interest in Possession trust is that trust fund falls inside the estate of the deceased Beneficiary for Inheritance Tax purposes.
Should the death of the Beneficiary occur on or after 6 October 2008, then the spouse or civil partner becomes entitled to the Interest in Possession trust, and the spouse’s interest will be known as a Transitional Serial Interest.
For example, Andrew had a life interest (a ‘Previous’ interest) under an Interest in Possession trust from 1 November 2002. Andrew died on 1 May 2010, when his wife Susan became entitled to the trust (a ‘Successor’ interest). Susan remains the current Life Tenant of the trust.
For tax purposes, the inter-spouse exemption applied on Andrew’s death. There would have been no spousal exemption if the transfer had been made while Andrew was still alive (because the relevant property regime rules would have applied).
The trust fund is within the Susan’s taxable estate. As a result of the Transitional Serial Interest rules, the trust is treated as pre 22 March 2006 and is not subject to the relevant property regime.
Transitional Serial Interest Example 3. Life insurance trusts
A Transitional Serial Interest can also arise where a life insurance policies has been placed into the trust pre-22 March 2006. In these instances, the person with the Interest in Possession trust has an ‘Earlier Interest’.
If that person died on or after 6 October 2008, but before the life insured, a new Beneficiary can acquire a ‘Present Interest’. Provided that changes to the holder of the Interest in Possession trust take place on death, the provisions should allow all subsequent holders to be treated under the pre 22 March 2006 rules.
For example, Michelle is married to Victor, and has two children from a previous relationship. Michelle’s will includes a provision that her estate will pass to Trustees, and Victor shall have a life interest (entitled to income). On Victor’s death the capital will pass absolutely to Michelle’s children.
As a result, the spousal exemption will apply to those funds on Michelle’s death. Victor’s life interest will qualify as an Immediate Post-Death Interest. Upon Victor’s death, the trust fund will be inside his taxable estate. However, the trust is not subject to the relevant property regime.
Conclusion
Before the changes made to trusts on 22 March 2006, it was commonplace to use Interest in Possession trusts with life policies, including investment bonds. This allowed the Settlor to name ‘default’ Beneficiaries who were entitled to any trust income and capital at the end of the life of the trust, unless Trustees changed the default beneficiaries. Gifts into these trusts were PETs and the trust was not subject to periodic or exit charges.
However, in the post-2006 era, new Interest in Possession now fall into the same inheritance Tax treatment as discretionary trusts, including periodic and exit charges. As a result, the use of Interest in Possession trusts has declined, but they are still relevant for clients in certain situations.
