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Choice of reason

Last week, I took a look at the seemingly now unfashionable interest in possession trust. These trusts were very much in the news in the aftermath of the 2006 Budget when the inheritance tax relevant property provisions were extended to all lifetime trusts other than bare trusts and trusts for the disabled. From that point on, most new trusts developed by the financial services sector that are not bare trusts have been discretionary trusts – by definition, trusts without an interest in possession.

The view seems to have been taken, understandably, that if the IHT relevant property regime, also known as the discretionary trust regime, is to apply to flexible interest in possession trusts, then, as there are no other adverse tax implications where the trust asset is a life policy (protection or investment), the fully discretionary trust may as well be used.

As I said last week, that is not to say that a flexible interest in possession trust has no place in IHT planning with life policies. On non-tax grounds, the settlor may like the idea of actually specifying in the trust who will benefit in the absence of any appointment of benefits, other than at the end of the trust period. This is especially so for those who do not envisage wanting to change the beneficiaries and for whom the power of appointment in the trust is seen as a useful safety net rather than something to be frequently exercised in respect of trust income and capital.

Of course, this may be different where the trust asset is other than a life policy, for example, a collective investment. In this case, the complexity levels increase a bit.

As I explained last week, the income arising under a flexible interest in possession trust is likely to be assessed on the settlor under many family trusts.

However, this does not change who is beneficially entitled to the income. This will be the person (the beneficiary) with the interest in possession (the current right to current income). The income tax consequence is not a huge issue to deal with but it must be appreciated that the trust income actually belongs to the beneficiary entitled to it. It has to be paid out or if kept in the trust, separately identified and held for the benefit of the beneficiary who is entitled to it. This is regardless of who the income is assessed on.

This is feasible if the income buys separate identifiable units or shares but even here there is the difficulty of monitoring and managing this and, of course, the income and gains that these separate units and shares produce. So, complicated but possible.

What about the position where the income does not buy new units or shares but feeds back into the original units or shares? Well, that is where it all breaks down. The income loses its identity when it increases the value of the original units or shares. This means that collectives with this kind of mechanism for reinvesting income will be inappropriate for interest in possession trusts.

For those who want to hold collectives in other than a bare trust, a discretionary trust is the more likely choice. The IHT effect will be the same as that for the interest in possession trust but the problems associated with the right to income and the need to identify the income will not exist.

Of course, if the settlor, regardless of tax, wants a beneficiary or beneficiaries to have the right to income, then the interest in possession trust with income distributed is likely to be chosen.

Capital gains under trusts where the settlor, settlor’s spouse or minor unmarried children not in a civil partnership can benefit will be assessed on the settlor, regardless of whether the trust is a flexible interest in possession trust or a discretionary trust.

Where this anti-avoidance rule does not apply, the gains will be taxed in the same way under the flexible interest in possession trust and the discretionary trust, that is, at 18 per cent after the application of the annual capital gains tax exemption available to trusts, which is normally 50 per cent of that available to individuals but split between the trusts created by the same settlor (another anti-avoidance provision) but with a minimum exemption per trust of one-tenth of the full annual CGT exemption of £9,600, that is, £960 as a minimum.

In closing, I would reiterate that for life policy trusts, decisions on trust appropriateness can be made without worrying about income tax and CGT complications.

However, this does not mean that flexible interest in possession trusts will never be chosen. As I said earlier, with IHT neutrality and CGT and income tax irrelevance while the trust asset is a life policy, some may like the fact that default beneficiaries exist that have to be changed rather than there being no default beneficiary and the trustees having to appoint beneficiaries, with a “long-stop” default beneficiary clause which specifies bene- ficiaries at the end of the discretionary period if no other appointment has been made.

Regardless of the choices available now, there is a massive stock of pre-March 22, 2006 flexible interest in possession trusts and it will be worthwhile reviewing these ahead of October 5. I will look at this next week.


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