Lifetime termination of an interest in possession
W here a beneficiary has a life interest in the income of a trust fund, any inheritance tax consequences of a lifetime termination of that interest will depend (ignoring any possible reliefs) both on the nature of the life interest being terminated and on the nature of the new interest being created.
With regard to the existing life interest, the crucial factor is whether it is:
- a so-called ‘qualifying interest in possession’ (within section 59), so that the life tenant is attributed with beneficial ownership of the property underlying the income interest; or
- a ‘new-style’ life interest, i.e. an income interest in possession within the relevant property regime in Chapter III IHTA 1984.
Looking at these in more detail:
Because a life tenant with a qualifying interest in possession is treated as being beneficially entitled to the property ‘in which the interest subsists’ (section 49(1)), its termination results in a loss to the life tenant’s inheritance tax estate and is a transfer of value (section 52). Qualifying interests in possession include an interest in possession created before 22 March 2006, an immediate post-death interest, a disabled person’s interest and a transitional serial interest (TSI, within section 49C or 49D).
Tom has been the life tenant of the Tiptop family trust for more than 10 years. In 2009 the trustees are considering various possibilities for terminating his interest in favour of Tom’s son, Pete, absolutely. This will be a potentially exempt transfer (PET) by Tom in favour of a life interest for Pete, which will be an immediately chargeable transfer by Tom. Pete’s interest will be an income interest within the relevant property regime, in favour of a life interest for Tom’s wife, Jane. This will also be an immediately chargeable transfer and Jane’s income interest will be in the relevant property regime (contrast this with the termination of Tom’s interest in favour of Jane on death, which would be spouse exempt, with Jane taking a TSI).
Terminating an income interest in possession, which is within the relevant property regime, has no inheritance tax consequences provided the assets remain in trust. There is greater flexibility in the regime for the trustees to vary interests in income without incurring any tax charge, as such interests are not within the charge on termination by virtue of section 52(2A).
Sally is the life tenant of a trust of GBP3 million, created in 2007, so her life interest is within the relevant property regime. As Sally is now 25 and earning her own living, the trustees would like to consider benefiting other members of the family and terminating her life interest. This could be in favour of Sally’s cousin, who will have a revocable life interest. This would not be a PET by Sally as she has no beneficial entitlement to ‘the property in which the interest subsists’ and the trust fund does not leave the relevant property regime, so there is no exit charge. Or this could be carried out in favour of Sally’s cousin absolutely, which gives rise to an exit charge assessable on the trustees, as the assets in the trust fund are leaving the settlement (assuming no available reliefs).
Assume that the trustees opted to give Sally’s cousin a revocable life interest. However, Sally loses her job in early 2010 and the trustees want to reinstate her income interest (in part of the fund). They can do so, by terminating part of Sally’s cousin’s interest and appointing Sally a new life interest in that part of the trust fund. This can be done without incurring any inheritance tax charge because the assets remain in the relevant property regime throughout.
As time goes on, more trust interests will fall into the relevant property regime, with the flexibility for revoking and reinstating income interests in possession without any inheritance tax consequences (assuming the trustees have the powers to do so). In contrast, because of the inheritance tax charge that may arise on the lifetime termination of a qualifying interest in possession onto continuing trusts, even when in favour of a spouse/civil partner, trustees will need to think carefully before taking action. Increasingly, we are likely to see fewer lifetime terminations of qualifying interests in possession (in the absence of reliefs, such as business property relief and agricultural property relief). On the other hand, there will be greater scope (and incentive) to create revocable life interests where trusts are within the relevant property regime. This can be beneficial particularly where the intended life tenant’s marginal rate of tax is 40 per cent or lower, in contrast to the increased 50 per cent rate for trustees of discretionary trusts, which will apply after 6 April 2010.
* Statutory references are to Inheritance Tax Act 1984 unless otherwise stated.
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