What is an interest in possession trust?

If you are considering setting up a trust, there are various types of trust to choose from. In the case of an interest in possession trust, the beneficiary has right to receive the income from the trust at any time they choose, without having a right to assets themselves.

So what is an interest in possession trust, and when might you choose to use one?

What is an interest in possession trust?

An Interest in Possession Trust is one which grants the beneficiary (the person who benefits from the trust) an immediate and automatic right to receive income from the trust. As with other trusts, there are trustees assigned to manage the trust on behalf of the beneficiary, so that the beneficiary does not have legal control over the assets. However, unlike in a discretionary trust, the trustees of an interest in possession trust are obliged to pay out all income immediately to the beneficiary, aside from any trust expenses that they need to deduct.

There are two different types of beneficiary in an Interest in Possession trust:

1. The “life tenant” or “income beneficiary”

This is the beneficiary who has a right to the income or enjoyment of the trust throughout their lifetime, or until certain conditions, set out by the creator of the trust, are met. In some cases the benefit of the trust may not be financial – for example, it may be the right to continue living in a house for the rest of their life. However, whilst income beneficiaries are entitled to the benefits of the trust, they have no rights to the capital or assets themselves. There can be more than one income beneficiary, but all of the income during the lifetime tenancy is paid to the income beneficiaries alone, excluding any other beneficiaries (i.e. capital beneficiaries).

2. The “remainderman” or “capital beneficiary”

The second beneficiary is the one who will eventually receive the asset or capital in the trust, once the “interest in possession” has ended. They have no rights to any of the income from the trust until after the “interest in possession” has concluded.

For example:

Simon is married to Emily, but has two daughters from a previous marriage.

In his will, he establishes a trust fund containing all of his shares.

Emily is the life tenant of the trust, so she will receive all dividends from the shares during her lifetime.

After Emily’s death, the trust ends and ownership of the shares will pass to Simon’s daughters, who are the capital beneficiaries

Why use an interest in possession trust?

There are many reasons why you may choose to set up a trust, and interest in possession trusts offer some flexibility in how you pass on your estate.

In particular, interest in possession trusts are helpful for those who wish their children to inherit their estate, but want to allow their spouse or civil partner to continue living in the family home until they pass. The children still inherit the property through the trust, but not until after the death of the surviving spouse.

What are the tax implications of an interest in possession trust?

It is the responsibility of the trustees to declare and pay any Income Tax annually through a Trust and Estate Tax return. That said, trustees sometimes “mandate” income to the beneficiary, meaning income goes directly to the beneficiary rather than via the trustees. In this case, the beneficiary must include it on their own self-assessment tax return. The income tax rates for interest in possession trusts are as follows[1]:

Dividend-type income = 7.5%

All other income = 20%

Capital Gains Tax is due on any profits made through a sale or transfer of assets – such as shares, possessions or property – when those assets have increased in value. It is only paid on any gain over the trust’s Annual Exempt Amount. However, Capital Gains Tax is not payable when assets are passed to the remainderman at the end of the “interest in possession”.[2] The beneficiaries of an interest in possession trust are not taxed on the trust gains.

It is worth noting that, depending on the date at which assets were transferred into the trust, inheritance tax may be payable. This could be charged when assets are transferred into the trust, when the trust reaches its 10 year anniversary, or when the assets are distributed from the trust.

The contents of this article do not constitute legal advice and are provided for general information purposes only.

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[1] https://www.gov.uk/trusts-taxes/trusts-and-income-tax

[2] https://www.gov.uk/trusts-taxes/trusts-and-capital-gains-tax

Difference between Assignment & Novation of Contract

If you have entered into a contract with a client and wish to transfer your interests to a third party, of contract you may be wondering about the difference between assignment and novation. Both methods involve the transfer of an interest in a contract to a third party, although it is important to understand how each approach differs to be sure you have chosen the correct one.

Contractual obligations of a contract

The purpose of a contract between a buyer and supplier is to ensure that both parties receive what they want. Each party is legally bound to uphold their end of the agreement, whether it relates to the provision of a product or services, or the agreed payment for those goods or services.

Because the very nature of a contract is to bind each party to account, it can be complicated for either party extricate itself from that contract.

What is Assignment?

Assignment transfers to a third party your rights to the benefits of the contract, without transferring the obligations of the contract. So assigning your interests to another party could mean that payment is to be made directly to that third party, instead of to you, but you would remain legally-bound to fulfil your end of the contract to the original co-party. You also cannot assign the obligation of payment to a third party if you are the buyer in a contract.

For example, if you are contracted to build a wall for a client, you may ask the client to directly pay a company that you owe money to, thereby assigning your interest to that company. However, you cannot assign the burden under the contract. So in this scenario you would still be responsible for building the wall – and would be liable if there was a fault with the finished product – even though the third party would receive the benefits of your end of the contract – i.e. the payment.

What is Novation?

Novation, on the other hand, is an agreement made with your co-party whereby you reassign your entire interest in a contract over to a third-party. This would mean that any subsequent services or payment required would pass directly between the other two parties, without you being in any way connected. It effectively allows one or more original parties to ‘drop out’ of the contract, and for replacement parties to be substituted in.

So, to use the example above, if you were contracted to build a wall for a client, but were unable to complete the job, you could agree with the client to novate the contract to a different contractor. That new contractor would from then on assume all your responsibilities for ensuring the job is completed, and would be held liable for any problems. They would also receive the full payment, whilst you would walk away with no further ties to the original contract.  

The difference between Assignment & Novation of Contract

In the case of assignment, the agreement of the co-party is not necessarily required. Most contracts include an assignment clause as standard, allowing transfer of rights to receive payment to a third party, without the buyer’s express consent. This is because service that the buyer receives has not changed: the original supplier is still obliged to fulfil their end of the contract as agreed at the outset. It is only the supplier whose interests in the contract will change – through opting to transfer payment on to someone else. So they are allowed to make this decision independently.

In contrast, novation must be agreed by all parties. The original co-party must be happy to receive the agreed service or product from a new party, the transferor must be happy to pass on all their interests in the contract, and the transferee must be happy to take on the burden of the contract, as well as the benefits.

Whilst the transferor and transferee may be happy with the arrangement, novation can be complicated by the original co-party. This party is likely to need assurances that there will be no change to what they are receiving and may need convincing that it is in their best interest to transfer the contract. Otherwise there is the risk they will use the situation to their advantage to secure a better deal in the new contract. In addition, the original party may still be required by the other parties to retain some liability under the original contract.

Novation of contracts during the sale of a company

During the sale of a business (an asset or business sale) novation would be used to transfer all the existing contracts of the business over to the buyer. The buyer would then be responsible for fulfilling those contracts going forward, and the clients would be bound to pay the new business owner.

Since the sale of a business involves numerous contracts and clients, there is a risk that not all customers will agree to the novation. Whist there are various means to try to resolve this, it is a risk that the buyer must take on, since existing clients are not legally bound to novate their contracts to the new owner. This should be carefully managed during negotiations for the sale of the business.  

Summary: choosing the right course of action

Assignment transfers only the rights to payment to the third party, whilst the original party remains responsible for meeting the terms of the contract. In the case of novation, a third party essentially replaces the original party in the contract, assuming both their benefits and obligations.

Whichever route you are considering, it is important to seek expert legal advice to ensure you are choosing the right course of action in your circumstances.

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