Inheritance Tax: the Tip of an Iceberg

The name 'Melville' has, up to now, brought to mind the author of the novel Moby Dick and the fictional great white whale of the same name. But in future Melville may, at least for some, be more likely to evoke images other than malevolent ocean-going monsters. For them Melville may mean not a great American novelist, but a United Kingdom tax case decided in a context of seemingly little importance to them, but which turned out to be the tip (not stretching the nautical metaphor too far, I hope) of an inheritance tax iceberg of disastrous proportions. How has this come about?
Avoiding capital gains tax
The curious thing about Commissioners of Inland Revenue v Melville [2000] STC 627 is that it arose in the context of the avoidance by taxpayers who wanted to make gifts free of capital gains tax, rather than inheritance tax.
Making gifts for inheritance tax purposes is, given the potentially exempt transfer régime, generally not terribly difficult. So long as the gift falls within certain categories, inheritance tax is payable only if the donor fails to survive the gift by seven years. The plot does thicken, however, where the assets to be gifted are investments pregnant with gain because, unless something clever is done, the gift will trigger a charge to capital gains tax.
The scheme
Certain schemes were devised to avoid such a charge. The idea behind such schemes was to avoid the charge to capital gains tax by structuring matters so that capital gains tax holdover relief was available under section 260, Taxation of Chargeable Gains Act 1992. This was in itself easily achieved — one simply transferred the investments to a discretionary trust for the intended donees. This, however, had an unpleasant side effect — such a transfer qualified for section 260 holdover relief only if it gave rise to an immediate chargeable transfer for inheritance tax purposes. Inheritance tax thus appeared to be the price of avoiding capital gains tax.
The schemes tried to overcome this problem by arranging matters so that although there was an immediate chargeable transfer, the value transferred by that transfer was relatively small and fell within, or barely exceeded, the taxpayer's unused inheritance tax nil band. The taxpayer, by making a token chargeable transfer, had the best of both worlds — he could claim section 260 holdover relief without actually having to pay any inheritance tax.
The Melville variant
Melville was concerned with the inheritance tax consequences of one of the various approaches used to effect the token chargeable transfer. The Melville variant involved the taxpayer making a transfer to a discretionary trust with the taxpayer being able, after 90 days, to exercise a power of appointment under which he could appoint the trust fund to anyone including himself. Although various powers conferred on the trustees were capable of adversely affecting the value of the taxpayer's general power of appointment, these powers were exercisable during the settlor's life only with his consent.
The arguments
The taxpayer argued that the effect of the transfer to the trust was, in effect, that since he could effectively revoke the trust after 90 days all that he had given away was the income that arose during the 90 days.
The Capital Taxes Office did not agree: it took the view that the taxpayer's general power was not comprised in his estate for inheritance tax purposes and that therefore he had made a chargeable transfer of the entirety of the property transferred into the discretionary trust.
The decision
Mr Justice Lightman found for the taxpayer — his power was a valuable right in the taxpayer's estate.
Who cares, anyway?
A United Kingdom tax adviser might say that this is great for people undertaking capital gains tax planning exercises, but otherwise, given the fact that revocable trusts are the exception rather than the rule in United Kingdom estate planning, so what?
Identifying the iceberg
It is at this stage that the iceberg can be identified. Icebergs may be of little interest to landlubbers like taxpayers in the United Kingdom (I know, the nautical metaphor is breaking down, bear with me), but they are of serious concern to ocean-going vessels, and there are plenty of those around in the form of offshore revocable trusts set up by wealthy foreigners. The reason Melville concerns those navigating such vessels is best shown by an example.
Pity poor Herman
Assume that Herman, a wealthy denizen of Nantucket, established in Boston a very substantial discretionary trust which he reserved the right to revoke. In 1982, Herman took up residence in the United Kingdom for employment reasons. He subsequently acquired a modest London home. In 2000, Herman retires and boards a plane to return to his beloved Nantucket, where he intends to live out his days fishing, making only occasional visits to his residence. The plane crashes and Herman dies. Given Herman's longstanding residence in the United Kingdom, he was domiciled in the United Kingdom for inheritance tax purposes when he died. Since he had a permanent home only in the United Kingdom, he also has a treaty domicile in the United Kingdom.
Even though Herman was domiciled in the United Kingdom, inheritance tax might appear not to be a problem because on his death Herman owned few assets of any consequence, all his assets instead being held within the discretionary trust. Furthermore, since the trust was set up in 1975, it predates the reservation of benefit provisions. In any event, all the property comprised in the trust was situated abroad when he died and so was excluded property.
One might be forgiven for thinking that Herman was in the clear for inheritance tax purposes. This is where Melville comes in. The power to revoke a trust is no different for these purposes than the Melville taxpayer's general power of appointment. Under Melville, Herman's right to revoke the trust formed a very valuable asset in his estate. Since Herman was domiciled in the United Kingdom for inheritance tax purposes, the fact that his right to revoke the trust may be situated outside the United Kingdom will not have prevented that right from being chargeable.
How about poor Pepe?
Melville is not relevant just to foreigners who have become domiciled in the United Kingdom for inheritance tax purposes. It could also affect foreigners who are not so domiciled, but whose right to revoke a trust is situated in the United Kingdom. In such a case that right will be subject to inheritance tax wherever the settlor may be domiciled.
Attention in particular needs to be given to revocable trusts with one or more trustees resident in the United Kingdom. Although such trusts have for many years taken advantage of the fact that 'professional trustees' resident in the United Kingdom are treated as non-resident for capital gains tax purposes, their use in recent years has proliferated as various wealthy Central and South Americans have sought to cope with changes to their domestic tax systems by using trusts with one or more professional United Kingdom resident trustees.
Interests in possession
If the foregoing is not sufficient to cause panic on the bridge, consider what happens where a revocable trust confers an interest in possession on the settlor. In such a case, the settlor is treated by section 49(1), Inheritance Tax Act 1984 as owning the trust property. But that does not displace the fact that he also owns the right to revoke the trust, which right is apparently, under Melville, a free-standing right with a value equal to the value of the property comprised in the trust fund. The result is that the settlor may stand to be taxed by reference to twice the value of the trust fund. The danger of this kind of double taxation was pointed out to Mr Justice Lightman.
Onward and upwards
Little purpose will be served at this stage by analysing Mr Justice Lightman's decision in any detail. The point in issue is in fact a difficult one (and one which has concerned me for years), and it is expected that the Revenue will take the case to the Court of Appeal.
Conclusion
A future historian of inheritance tax may see Melville as one of the first cases to address the implications of one of the cornerstones of inheritance tax, namely the aforesaid rule in section 49(1). He will also note the irony — the taxpayer's victory in a narrow capital gains tax context was, as matters stand, a much wider inheritance tax disaster for taxpayers generally.
Present day practitioners, less concerned with such academic niceties, now need to consider carefully the wider implications of the case for any of their clients with revocable trusts.
Barry McCutcheon is in chambers at 8 Gray's Inn Square, Gray's Inn, London WC1R 5AZ.

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