Opportunity knocks

While interest in possession trusts are not widely used any more it is still important that advisers are aware of them says Bob Perkins

Until the Budget and Finance Act 2006, trusts where there was an interest in possession (IIP) were used extensively for inheritance tax (IHT) planning. Transfers (gifts) of assets into such trusts had enjoyed the status of a potentially exempt transfer (PET).

For trusts created since 22nd March 2006, that status ceased and they now fall under the regime for chargeable lifetime transfers. That makes them no different, in terms of IHT treatment, to discretionary trusts where no beneficiary has an automatic IIP.

What is an IIP?

The point of reference for the definition of an IIP used by HM Revenue & Customs (HMRC) is the House of Lords case Pearson v IRC -

A person has an interest in possession when they have 'a present right of present enjoyment' or an immediate right to the income or enjoyment of property (irrespective of whether the property produces income).

In terms of IHT planning it is the "right to income" that has been used successfully in packaged solutions involving trusts and life assurance contracts, which are of course non-income producing assets.

Previous advantages

The main advantage has been that because the transfers into trust have been treated as PETs, (as long as there was nothing in the trust to cause it to be a gift with reservation), there has been no limit to the size of the gift. If the donor outlives the gift by seven years, it would no longer be aggregated with their estate on death and the gift together with any future investment growth would be entirely free of IHT.

Furthermore, the flexibility of such a trust incorporating a power for the trustees to make appointments of interest to other potential beneficiaries during the lifetime of the trust has given significant freedom to donors to plan for their families.

Where the donor is a trustee they can effectively make the transfer yet still exercise control over what happens to the investment of the trust assets, who benefits from what and when.

The disadvantages seem fairly insignificant by comparison -

- The trustees must distribute any income arising within the trust to those who are entitled to it (generally, minor beneficiaries apart).

- The individuals who have the IIP are treated as the owners of the assets for IHT in the event of their deaths.

- Transfers of the IIP away from beneficiaries entitled to it, over which they would have no control, were treated as "gifts" by them and so could have an effect on their IHT planning.

Income tax and CGT

The changes brought about by the Finance Act 2006, did not alter the tax treatment of these trusts. Income arising from assets within the trust are assessed to tax on the beneficiaries with the interest in possession, not the trustees.

Beneficiaries can recover overpaid tax deducted at source, apart from withholding tax on UK dividend income.

Capital gains, after taper relief and the trustees' annual exemption, are taxable at 40%, the rate applicable to trustees.

Are they any use now?

It has been said that, given the extra flexibility afforded by discretionary trusts, those with an IIP are now largely defunct. That may be the case because it is possible to create an IIP under a discretionary trust at a future stage in any event, so why not have maximum flexibility at the outset?

For many donors where a new trust is being created, they may well choose to have the maximum flexibility as a primary objective.

Where a new trust is being established then depending upon the circumstances, an IIP could still be useful. Above all it does enable the donor to immediately give the right of income to specific individuals if that is what they wish to do, without giving an automatic right to capital as well. If this is something that is required at the outset or is likely to be required within a short time frame then perhaps this would be the best option rather than having to give an interest under a discretionary trust.

IIP's will still appear and be outside of the scope of "periodic" and "exit" charges to IHT, that would otherwise apply, in the following situations -

- Immediate post death IIP - where a beneficiary becomes entitled to it on the death of an individual through their Will or intestacy.

- Disabled person's IIP - where more than one half of the assets within the trust are applied to benefit a disabled person.

- Transitional serial IIP - where a change in an IIP arises between 22nd March 2006 and 5th April 2008 or where it arises after 5th April 2008 on the death of a previous holder and the recipient is the spouse or civil partner of the previous holder.

In the case of life assurance policies in an IIP Trust, where the trust existed prior to 22nd March 2006, the trustees have a "window", within which to create a transitional serial IIP, if they should consider that appropriate, prior to 5th April 2008. Any changes made after that date would result in the trust losing its previous status.

By special concession relating to life policies, where a life policy is subject to an IIP Trust created before 22nd March 2006, the rules relating to transitional serial IIP extend to the situation where an individual, whoever they may be, is granted an IIP on the death of the previous holder after 5th April 2008.

Where an IIP falls into one of these categories, although they escape the affects of "periodic" and "exit" charges for IHT, the assets are still treated as being in the beneficiary's estate for IHT on their death.

Summary

It is still important to understand what an IIP is and how it works as well as where they may crop up in years to come.

More importantly, it is crucial for trustees of IIP Trusts that were created prior to 22nd March 2006 to take the opportunity available to them to review the position under the transitional arrangements and take action, if necessary, as soon as possible. The window is closing!