The Ins and Outs of Interest in Possession Trust Taxation

We’ve talked many a time about how a discretionary trust is taxed, but anyone sitting the J02, AF1 and potentially the R06 and AF5 exams will also need to know the ins and outs of how an interest in possession (IIP) trust is also taxed.

This article is relevant to examinable tax year 2017/18.

The first thing to say is that trustees of IIP trusts are only charged to the basic rate of income tax so interest and rental income (after allowable expenses such as repairs etc) suffer 20% and dividends are taxed at 7.5%. Trustees don’t receive a personal allowance to set against income and nor do they receive a dividend allowance. Also, expenses cannot be used to reduce the trustee’s taxable income. They can, however, be taken into account when working out the income due to the life tenants.

When a Distribution is Made to an IIP Beneficiary

When a distribution is made to a beneficiary, the payment is made with a tax credit, which the beneficiary can then use to offset against his own liability.  Unlike a discretionary trust, the income stays the same once distributed and does not become ‘trust income’.  This has the advantage that a dividend retains its status as a dividend and is paid with a 7.5% tax credit.  If the beneficiary has not used his dividend allowance, he can receive a refund of the tax suffered at source.  If he has used up his dividend allowance, then further income tax will be due if he is a higher rate or additional rate taxpayer.

What is clear from this, is that trustees should distribute dividend income to the life tenant who has spare dividend allowance and can reclaim the tax.  Even better, income can be mandated directly to the beneficiary, which means it bypasses the trust altogether; the beneficiary reports the income on his tax return and again uses his own dividend allowance.

Discretionary trusts are treated differently

Just to make it clear, beneficiaries of discretionary trusts cannot use their dividend allowance in this way; once distributed, the income from a discretionary trust becomes ‘trust income’ and loses its original identity.  Income is paid out with a 45% tax credit, and it depends on the tax status of that beneficiary whether they can reclaim any of this or not.  In these circumstances, there could be a case for changing the investment strategy or even, if possible, changing the nature of the trust.

Other Taxes Paid in an IIP Trust

As for the other taxes paid in an IIP trust, capital gains are taxed at 20% or 28% if the asset disposed of is residential property with an exempt amount of half the normal CGT exempt amount.

Grab the resources you need!

If you’re studying for your CII J02 exam, and you want to make sure you are feeling confident on exam day, grab our free taster to try out one of Brand Financial Training’s resources for yourself.  Click the link to download the J02 mock paper taster now!

Alternatively, you can download taster resources for R06, AF1 or AF5 if one of those exams is causing you some anxiety.