Taxation of an Interest in Possession Trust under English Law 

Introduction: Facts and Legal Issue 

An interest in possession trust is one where a beneficiary (often called a life tenant) has the present right to the present enjoyment of trust income, such as receiving income as it arises from the trust assets. The core legal issue is the taxation of such trusts—specifically, how income tax, capital gains tax (CGT), and inheritance tax (IHT) apply to both the trustees and the beneficiaries. The answer below details each head of tax, drawing on current English law. 

1. General Principles: Definition and Structure 

• Definition: 
  An interest in possession is defined as a “present right to the present enjoyment of the income of a trust, such as an immediate right to trust income as it arises.” The trust is structured so that the beneficiary’s right is fixed, and although trustees may pay administrative expenses, this does not invalidate the interest in possession (“An interest in possession has been defined as a present right to the present enjoyment of the income of a trust, such as an immediate right to trust income as it arises. Pearson and others v IRC [1980] … Interest in possession trustees normally have the right to disburse administrative expenses from the trust, which does not invalidate the interest in possession of the beneficiary.” ) [1]. 

• Defeasible Interests: 
  The rights of a beneficiary may be defeasible, meaning they can be brought to an end, but until such an event occurs, the trust remains an interest in possession trust (“The rights of a beneficiary (or life tenant) under an interest in possession trust may be defeasible, which means that they can be brought to an end, but the trust will still be an interest in possession trust until that time.” )

2. Income Tax Treatment 

a. Liability and Mechanism 

• Beneficiary’s Taxation: 
  The beneficiary is taxed on the income of the trust as it arises, in the same tax year it is received by the trustees, even if the income is not actually paid out in that year. Each source of income retains its identity, and the beneficiary is taxed at rates applicable to each source (“The beneficiary is entitled to the income of the trust as it arises, and is therefore liable to tax on the income in the same tax year as it is received by the trustees, whether or not the beneficiary actually receives the income in that tax year. Each source of income retains its separate identity, and the beneficiary is taxed at the rates applicable to each source.” )

• Tax Deduction Certificate (Form R185): 
  Trustees must issue a tax deduction certificate showing the net income paid and tax deducted. The beneficiary is taxed on the gross amount, with credit for tax deducted by trustees (“The trustees must issue a tax deduction certificate (form R185) showing the net income paid to the beneficiary and any tax deducted. The beneficiary will be taxed on the gross amount, but credit will be given for the tax deducted by the trustees.” )

• Mandated Income: 
  If income is mandated directly to the beneficiary, it is taxed as if the beneficiary owned the source; this income is not included on the R185 certificate (“A source of income may be mandated directly to the beneficiary by the trustees. Such income will be taxed on the beneficiary as if they owned the source. This income will not be included on the tax deduction certificate.” )

• Reporting Requirements: 
  Income received by the beneficiary must be included in the trust pages of their self-assessment return, except for scrip dividends (main pages) and foreign income (foreign pages). Income received gross is entered on the page for that source (“Income received by the beneficiary of an interest in possession trust must be included in the trust pages of the beneficiary’s self-assessment return and entered in the boxes relating to the rate of tax deducted. The only exceptions are scrip dividends, which should be entered on the main pages, and income from foreign sources, which should be entered on the foreign pages. Any income received gross from the trust should be entered on the relevant pages for that source of income.” )

b. Trustees’ Tax Position 

• Trustees’ Rates and Allowances: 
  Trustees pay basic rate tax on non-dividend income and dividend rate tax on dividend income. Certain forms of income (e.g., offshore income gains, deeply discounted securities) are taxed at the trust rate. Trustees do not get the benefit of the dividend allowance or the personal savings allowance (“The normal rule for the trustees of an interest in possession trust is that they will be liable to: dividend rate tax on dividend income (including alternative receipts … ); and basic rate tax on all other income. … Neither the dividend allowance … nor the personal savings allowance … are available to trustees.” )

• Calculation Example: 
  If the trust receives property income, bank interest, and dividends, trustees deduct allowable expenses and calculate tax accordingly. For example, property income of £23,000 less expenses of £2,100 leaves £20,900 taxed at basic rate; £11,000 bank interest at basic rate; £15,000 dividends at the dividend rate. The total tax liability for the trustees is then calculated and subtracted from the gross income to arrive at the amount available for distribution (“… Expenses of £2,100 were incurred in respect of the rental property, and other expenses in connection with the trust were £950. Mr D’s tax liability as a trustee will be: … Tax thereon: Dividends: 15,000 @ 8.75% … Other income: 31,900 @ 20% … Tax liability 7,692 … Available for distribution 38,258…” )

• Personal Circumstances Ignored: 
  The personal tax circumstances of both the trustee and the beneficiary are ignored in calculating the trustees’ tax charge (“In calculating the charge to tax on the trustee of an interest in possession trust, the personal circumstances of both the trustee and the beneficiary are ignored.” )

3. Capital Gains Tax (CGT) 

• Trustees’ CGT Liability: 
  Trustees are liable to CGT on disposals of trust assets, subject to available reliefs. Where the trust property is occupied by a beneficiary as their main residence, the trustees can claim principal private residence relief (PPR), unless a specific type of holdover claim was made on the original gift into the trust (“If a trust property is occupied by a beneficiary as a main residence, the trustees can claim principal private residence relief (PPR) … However, PPR is not available to the trustees if a specific type of holdover claim (relating to a chargeable transfer for inheritance tax purposes) was made on the original gift into the trust … If the claim is revoked, PPR will become available to the trustees.” ) [6], (“Principal private residence relief (PPR) does not apply to residential property gains made by a company, including a company owned by a settlement, nor does it apply to residential property gains made by an overseas company that are apportioned to a UK shareholder. For the interaction of PPR and trusts, see ¶66405 and ¶68120+. Note that the relief will not be available to the trustees if a holdover claim (relating to a chargeable transfer for IHT) was made on the original gift into the trust.” )

• Holdover Relief: 
  If a settlor transfers assets into a trust and the transfer is a chargeable transfer for IHT purposes, holdover relief may be available to defer the gain, but this may restrict the availability of PPR for the trustees later (“If the disposal gives rise to a chargeable gain, in certain circumstances the settlor may be entitled to claim holdover relief … In addition, the availability of principal private residence relief ( ¶68120+ ) for the trustees may be adversely affected where the settlor makes a holdover claim on a transfer which is chargeable to inheritance tax.” )

• Transitional Provisions: 
  Where a holdover claim was made before 10 December 2003 and the property not disposed of before that date, PPR is only available on the gain up to 9 December 2003, calculated on a time-apportioned basis (“There are transitional provisions to restrict PPR where a holdover claim was made prior to 10 December 2003, and the property was not disposed of by the trustees before that date. In this case PPR is only available on the gain up to 9 December 2003, which is calculated on a time apportioned basis.” )

4. Inheritance Tax (IHT) 

a. Creation and Transfers 

• Pre-22 March 2006 Trusts: 
  Retention of an interest in possession in the whole fund is not a transfer of value for IHT purposes if created before 22 March 2006, or if it is an immediate post-death interest, transitional serial interest, or disabled trust created after that date (“The retention of an interest in possession in the whole fund is not a transfer of value for IHT purposes, and is not therefore relevant to these provisions, where the interest was created: before 22 March 2006; or on or after 22 March 2006, and where it was an immediate post-death interest, transitional serial interest …, or an interest in a disabled trust …” )

• Lifetime Transfers and PETs: 
  Creating an exempt interest in possession trust during the transferor’s lifetime increases the estate of the beneficiary and may be a potentially exempt transfer (PET). Since 22 March 2006, this only applies to interests for a disabled person, a transitional serial interest, or an immediate post-death interest (“The creation of an exempt interest in possession trust during the lifetime of the transferor increases the estate of the beneficiary, and may therefore be a potentially exempt transfer or PET … since 22 March 2006 this treatment only applies to: the creation of an interest for a disabled person …; a transitional serial interest …; or an immediate post-death interest …” ) [

Table: Summary of PET and CLT Rules 

(“Prior to 22 March 2006, the lifetime creation of an interest in possession trust, and a transfer into an accumulation and maintenance trust, were PETs … but any such transfers on or after this date are CLTs. Between 22 March 2006 and 5 October 2008 the lifetime creation of an interest in possession settlement was a PET if it was a transitional serial interest … Since 6 October 2008, where an interest in possession created before 22 March 2006 comes to an end and is replaced by another interest in possession, an IHT charge will arise. The lifetime termination of an interest in possession … is a PET if the interest was created: before 22 March 2006; or on or after 22 March 2006, and it is an immediate post-death interest or a transitional serial interest … In all other cases, the lifetime termination of an interest in possession on or after 22 March 2006 is not a transfer of value for the life tenant, because the life tenant is not considered to have the assets within their estate.” )  

• Anti-avoidance: 
  Specific anti-avoidance provisions prevent using a PET followed by termination of the interest in possession for IHT-planning purposes (“Provisions prevent the avoidance of tax where an exempt interest in possession settlement is created by a potentially exempt transfer, followed by the termination of the interest in possession in favour of a chargeable trust (a chargeable lifetime transfer).” )

b. On Death/Termination 

• Charge on Death: 
  If the life tenant dies and the trust was created before 22 March 2006 (or is a disabled, post-death, or transitional serial interest), the trust property is included in their estate for IHT. Otherwise, the relevant property regime applies. 

• Calculation Example: 
  If the transferor survives seven years from the PET date, no IHT arises; if not, the transfer is included in the cumulative total and taxed accordingly (“If the transferor lives for more than 7 years after the date of the transfer, no IHT will become due but the transfer will have used up the transferor’s annual exemption if it is available … If the transferor dies within 7 years from the date of the transfer, the transfer will become chargeable to IHT like any other PET. The transfer will be taxed at death rates, using the cumulative total brought forward in the normal way. It will also form part of the cumulative total for other transfers up to the date of death …” )

5. Application to the Question: Tax Implications for an Interest in Possession Trust 

In summary, under English law: 

• Income Tax: The beneficiary is taxable on trust income as it arises, at their marginal rates, with credit for tax already deducted by trustees. Trustees are liable to basic rate and dividend rate tax (without dividend or personal savings allowances), ignoring their own and the beneficiary’s personal circumstances . 

• Capital Gains Tax: Trustees pay CGT on gains from trust assets. PPR may be available if a beneficiary occupies the property as their main residence, unless a holdover relief claim relating to an IHT chargeable transfer was made. If so, PPR is not available ([6], [7], [8]). 

• Inheritance Tax: The creation, termination, or retention of interests in possession is subject to complex IHT rules, with the treatment depending on the date and nature of the trust/interest (PET, CLT, or relevant property regime). Anti-avoidance rules apply to prevent manipulation of these structures . 

Conclusion 

The taxation of an interest in possession trust in England involves separate regimes for income tax, capital gains tax, and inheritance tax. Each area has its own complexities, with careful attention required regarding the timing of the creation and termination of the interest, the nature of the trust, and the precise structure of the rights conferred. Trustees and beneficiaries alike should ensure compliance with the reporting and calculation rules outlined above, and seek professional advice on planning or restructuring such trusts. 

Would you like to explore specific scenarios, such as the treatment of accumulated income, the interaction with overseas beneficiaries, or the tax implications of terminating an interest in possession? If you have a particular trust arrangement or transaction in mind, please provide further details so we can examine the relevant rules more closely and address any uncertainties.