This is one of a number of explanatory articles, part of a set copied under licence from H M Revenue & Customs website:
Introduction – Is Inheritance Tax due?
Calculating Inheritance Tax
Valuing assets
Responsibilities of personal representatives
Business relief and businesses
Discretionary trusts
Deceased left no will
Pensions
Agricultural relief
Deceased's liabilities
Foreign aspects
Joint property
Penalties
Settled property
Woodlands
Probate
Alter Inheritance tax
Gifts
Excepted estates
Paying IHT
Thresholds and Interest
Introduction
This guide is designed to help our customers to obtain a grant of representation, complete an account of the deceased's estate, and pay any inheritance tax (IHT) which may be due.
It also gives advice about lifetime gifts and the taxation of discretionary trusts. This article in particular deals with settled proerty.
The proposals in the Finance Bill 2006 affect the meaning in this article regarding:
- gifts into certain kinds of trusts
- the tax treatment of trusts, known as interest in possession trusts, in which the beneficiaries have a right to benefits
- the ending of an interest in possession during a beneficiary's lifetime
- the treatment of funds in alternatively secured pensions on death.
This article will be updated as necessary when the Finance Bill is enacted.
What is settled property?
For inheritance tax, settled property includes property held in trust:
- for successive beneficiaries;
- for any individual, but subject to a contingency (such as attaining a specified age);
- under which the income is payable at someone's discretion or has to be accumulated.
Property that is held under arrangements governed by the laws of another country, which have the same effect, is also settled property.
What is the difference between legal and beneficial ownership?
In general law, a distinction is made between 'legal ownership' on the one hand and beneficial' or 'equitable' ownership on the other. If you are the absolute owner of an asset you have both a legal and a beneficial interest in it. You are not only the registered owner of the asset (e.g. in the case of land, your name is on the title deeds), but you can also benefit from any gain it produces.
The absolute interest (the combined legal and beneficial interest) can be split. So while you retain the legal interest, you can let someone else have any benefit gained from the property.
Alternatively, you can pass the legal interest to one person and the beneficial interest to another. If you wish to make this division, whether during your lifetime or under your will when you die, you create a trust. You create an interest in the property for the benefit of a person, or people, without giving them the legal interest.
Is all property held in trust settled property?
No, property that is held by trustees who must distribute it to specified people is not settled property.
Is all settled property held in trust?
No, some settled property is not held in trust. For instance, property that is subject to a lease for life may be regarded as settled property.
How is settled property taxed?
The taxation of settled property depends on the rights of the beneficiaries at the time in question.
For example, if an individual is the beneficially entitled to an interest in possession in the trust assets, tax is charged when the interest comes to an end on or within seven years before the individual's death as if they had transferred the assets as absolute owner. There are some exceptions.
If no individual has an interest in possession, tax is charged by treating the trust itself as a separate entity. Trusts that don't have an individual who is entitled to an interest in possession are called discretionary trusts.
Since these rules depend on the rights of the beneficiaries at the time in question, there is no final classification of either:
- the trust, or;
- the property in it.
Both sets of rules may apply to the same property at different times or to different parts of the trust at the same time. We deal with the taxation of discretionary trusts separately.
What form does an interest in possession in settled property take?
The most common form of interest in possession is when a person has a life interest. An interest in possession may also be:
- for a fixed period;
- until some power is exercised, or;
- until some other event occurs e.g. ceasing to enjoy a right to occupy a house.
The duration of the interest does not affect the basis on which tax is charged when the interest comes to an end.
What about Scottish trusts?
A right under a Scottish trust to enjoy property is treated as an interest in possession in settled property. For this purpose, a deed creating or reserving a proper life rent in any property is treated as a trust.
What happens when a company rather than an individual holds the interest in possession?
There is a tax charge when an interest in possession comes to an end only if an individual had a right to the interest. For this purpose, individual participators in a close company are treated as having a right to an interest held by the company. Special rules apply where the participators are trustees of a trust.
If an individual or close company does not hold the interest in possession, for example, if it is held by a charity, the property is subject to a charge to tax as if there is no interest in possession.
The exception is when the interest has been purchased for full consideration by a company whose main business is dealing in interests in settled property. Then the property is treated as an interest in possession.
How is tax charged when there is an interest in possession?
Inheritance tax (IHT) is charged if an interest in possession comes to an end, or is disposed of, on or within seven years before the death of the individual entitled to it.
When the interest comes to an end on the death of that individual, the property is taxed as part of the estate as though he or she had transferred the property as absolute owner.
The tax is charged on the value of the property and is normally payable by the trustees out of the settled property. If the value is greater when valued together with other property of the deceased, the deceased’s spouse or the deceased’s civil partner, then the higher value is taxed.
What happens if the interest is disposed of or comes to an end in the lifetime of the person entitled to it?
The individual is treated as having made a transfer of the settled property, which is valued in isolation.
This will usually be a potentially exempt transfer (PET). PETs are not immediately chargeable to tax but become taxable if the person making the gift dies within seven years. See our guidance on gifts for further information on PETs.
If the interest in the settled property is disposed of or comes to an end in part only, there is usually a PET of that part.
Depending on the circumstances, a PET may also arise if the trustees make a transaction with a beneficiary, or anyone connected with a beneficiary, which reduces the value of the settled property. Tax will be charged if that person dies within seven years of the transfer. The position is similar where the interest is sold, but the amount of the transfer is usually reduced by the price received for the interest.
Not every lifetime disposal or termination of an interest in possession is treated as a PET. For example, there may be an immediate charge to inheritance tax if the property goes into a discretionary trust.
The tax due on settled property in these circumstances will be payable by either:
- the trustees, or;
- the transferee.
What happens if several beneficiaries share the property equally or in defined shares?
Each beneficiary is treated as having an interest in possession in a proportionate share of the property.
How are annuities treated when calculating a beneficiary's share?
One beneficiary may be entitled to a fixed amount payable out of the income of settled property, and another beneficiary to the rest of the income. For example, where an annuity is charged on the income of a fund the beneficiaries are treated as having interests in possession in shares of the settled property, proportionate to their shares of the income.
There are special rules for deciding the amount of income that can be taken into account in calculating these shares. If the tax charge is on:
- the part of the fund that produces the annuity, the property must be treated as yielding not more than an amount calculated at the higher of two prescribed rates;
- the remainder of the fund, it must be treated as yielding not less than an amount calculated at the lower of those rates.
Are there any exemptions or reliefs affecting interests in possession?
Yes. Transfers are exempt if they are:
- between husband and wife or civil partners when an interest in possession in settled property is disposed of or comes to an end, and the interest or the property passes to the spouse or civil partner;
- to charities and political parties;
- gifts for national purposes or the public benefit.
A disposal by way of gift of an interest in possession is exempt for:
- the maintenance of a spouse or civil partner;
- children in full-time education or training, and;
- dependent relatives.
There is no exemption if the interest in possession comes to an end.
Annual exemption and gifts in consideration of marriage or civil partnership exemption are available for interests coming to an end or disposed of.
For these last exemptions to apply, the person whose interest has ended must give the trustees a notice stating how much of the relevant exemption the trustees can set against the amount treated as transferred on the termination.
Relief for business property and agricultural property may also be available. See the guidance on businesses, farms and woodlands for further details.
Is inheritance tax charged when settled property reverts to the settlor?
No. In certain circumstances, there is no tax charge if the property passes to the settlor's spouse, civil partner, widow or widower or surviving civil partner.
There are several restrictions on this exemption. It does not apply if, for example, a reversionary interest in the property has been purchased by the person to whom the property reverts.
Are there any other occasions when no charge arises?
There are four occasions when no inheritance tax is charged.
1) There is no charge when the property in which the interest in possession has come to an end is excluded property.
2) Under the estate duty provisions, where duty was paid on the death of one spouse on property in which the other was given a limited interest, for example, for life or until remarriage, the property was usually exempt when the survivor died. Similarly, there will not be a charge to IHT on settled property if estate duty was paid on it on the death of one spouse and the survivor dies and it would have been exempt from estate duty on the survivor's death. The same rule applies if the survivor's interest comes to an end or is disposed of.
3) If the trustee is given an annuity or the income of particular property and this represents no more than reasonable remuneration for services, there is no tax charge when the interest comes to an end on or within seven years of the death.
4) Relief from tax on settled property is available when a survivorship clause provides that a gift by Will or under a settlement will take effect only if the beneficiary survives a specified person, for example, the testator, for a short specified period. The relief only applies where the specified period is up to six months. Trusts applying during the specified period are disregarded and the gifts that actually take effect at the end of the specified period are treated as having done so on the death.
4)
What is the threshold for an excepted estate?
For an excepted estate, the inheritance tax (IHT) threshold means the amount above which IHT is payable. If the death was between 6 August and 5 April in any one tax year, you should use the threshold that applied at the date of death.
If the deceased died after 5 April but before 6 August in any one tax year and the grant of representation is applied for before 6 August of that year, the threshold which applies for an excepted estate is the one from the tax year before that in which the deceased died.
Examples
Joan Brown died on 9 May 2004 and the grant was taken out on 21 July 2004. The correct threshold to use was £255,000.
David Smith died on 7 June 2004 and the grant was taken out on 21 August 2004. The correct threshold to use was £263,000. | 
