Meeting Points

Meeting Points
Ralph Ray FTII, TEP, BSc (Econ), Solicitor reports highlights from the STEP London Central Conference 2000.
Farmhouses
The practice of reducing, e.g. by one third, the agricultural value of farm cottages occupied by farm employees, is unlikely to be extended by the Revenue to valuable farmhouses, for example in the home counties. Following such cases as Starke and another v Commissioners of Inland Revenue [1995] STC 689, for a property to be eligible for agricultural property the house must be the centre of agricultural operations and in particular will not be eligible for the relief where the farmhouse has been let out to a third party (unless the lease is to a farming partnership).
Peter Twiddy referred to the much-publicised 'elephant test'. This has been applied to the growing of Christmas trees where inheritance tax woodland relief was refused. Moreover, although an activity may well constitute business property, there can then be no question of a house constituting the farmhouse.
Inheritance tax penalties
As regards current Capital Taxes Office policy relating to penalties and following tightening up of the rules in section 108, Finance Act 1999, Peter Twiddy emphasised that Capital Taxes Office policy is to apply penalties only in relatively rare circumstances. He instanced various circumstances where penalties are likely to be demanded by the that office, as follows:
Hopeful claims
A parent gifts unquoted trading company shares to his son during the parent's lifetime and the parent dies shortly afterwards. Thereupon the son made an onward gift and there was evidence that the solicitor acting for the son did not consider that business property relief would be eligible having regard in particular to section 113A(3), Inheritance Tax Act 1984 (ownership requirement throughout period from date of gift to date of death of donor). The solicitor, however, advised that business property relief should be claimed, hoping it would go through 'on the nod'. In these circumstances the Capital Taxes Office is likely to demand penalties.
Choosing too low a value
Personal representatives intend to sell a house shortly after the estate owner's death and before the six-month period on which interest accrues under section 226, Inheritance Tax Act 1984. The personal representatives have been given a range of prices and a low value is selected for the purpose of paying inheritance tax with delivery of the account. The actual much higher sale price is in fact returned within the six-month period. Mr Twiddy did not think it was an excuse to a penalty claim to argue that such practice by the personal representatives was 'businesslike'; the test is – was this practice 'reasonable'? The Capital Taxes Office's view is that it is definitely not reasonable and it is intended to help cashflow by paying a lower amount of tax on the delivery of the account.
Similarly a house may be put on the market by an estate agent following a death at a suggested figure of £600,000. However, the offer soon produces a great deal of interest with serious bids well above that figure, say at £800,000; nevertheless the former figure is inserted in the Inland Revenue Account. This practice is 'unreasonable' and could well give rise to a demand for penalties (see section 216(3)A, Inheritance Tax Act 1984).
Mr Twiddy contrasted this position with circumstances where the personal representatives/advisers are of the firm opinion that a particular estate agent, who has given a substantially higher value than others, has done this with the main motive of getting the business and is over-optimistic as to such a price. In these circumstances, the personal representatives would be justified in choosing an average value.
Unwarranted discounts
Mr Twiddy emphasised that the Capital Taxes Office particularly dislikes the not-uncommon practice of applying a specific discount to the market value to arrive at a probate value. No such discount is justified and in these circumstances a penalty is likely to be raised. Mr Twiddy contrasted an acceptable practice: the house of a deceased estate owner was agreed to be sold subject to contract. The price was accepted by the District Valuer. The sale fell through and a higher, unexpected price was obtained on an early sale. He did not consider it necessary to report this to the District Valuer so long as the original facts and circumstances were accurately reported.
Gifts with reservation
A current strategy is for, say, the husband to make a gift to a trust under which his wife takes an initial interest in possession for life or six months, whichever is the shorter or there are wide powers of termination and advancement. Husband and wife are capable of benefiting in the reversionary interest, e.g. by being added as possible beneficiaries of a discretionary or life interest trust.
On behalf of the taxpayer it is contended that although the settlor will almost certainly have made a gift, section 102, Finance Act 1986 will not apply as it is in terms excluded by section 102(5)(a) being an inter-spouse transfer. Peter Twiddy asserted that the Capital Taxes Office does not necessarily accept this position and may challenge it, particularly on the basis that the settlor has made two gifts, i.e. one to the spouse and a second one into the reversionary interest where the gift with reservation rules can apply.
He instanced a gift(s) of an apple where the giver gives one slice of say one third of the apple to A, and another slice of two thirds to B. Surely, Mr Twiddy asserted, there are two separate gifts where a gift with reservation can arise. He, however, contrasted this where the entire apple is given and it is provided that the beneficiaries divide the apple up themselves or presumably via trustees of a discretionary trust. It seems that the Capital Taxes Office accepts the situation that there would then be no gift with reservation.
For comments by tax counsel on Mr Twiddy's view, see last week's issue of Taxation at page 182.
Duty of personal representatives
How far do personal representatives and their advisers have to go, and what has to be the breadth of their enquiries? Peter Twiddy certainly would require full enquiries of the relatives and their professional advisers, and perusal of relevant accounts. He felt that to leave matters only to enquiries of relatives is insufficient - they may have forgotten the relevant circumstances. He felt it is a question of the 'feel', e.g. have the relatives made appropriate enquiries of the bank manager? The speaker did state, however, (and somewhat surprisingly) that it was not normally the duty of personal representatives and their advisers to peruse the bank statements of the deceased over the last seven years of his life – that would be asking too much.
The reversionary/deferred lease scheme
Peter Twiddy was asked whether he conceded that the anti-Ingram anti-avoidance provisions in section 104, Finance Act 1999 did not undermine the use of the reversionary/deferred lease scheme in relation to the home as contrasted with an Ingram carve-out scheme. He did not necessarily accept that contention for two main reasons:
 First, because the application of 'significant arrangements' in section 104, Finance Act 1999 has no time limit. It is a continuing phenomenon and with particular reference to a gift with reservation liability.
 Secondly, in relation to the 'full consideration' exemption, Mr Twiddy suggested such consideration should be given by the donee (who clearly has not given such consideration) and not, as is often contended, by the donor when he purchased the home.
Taper relief: options and pitfalls
Emma Chamberlain, barrister, of 8 Gray's Inn Square, spoke on taper relief: options and pitfalls. (The new provisions are contained in sections 66 and 67, Finance Act 2000.)
Trustees cannot claim business assets taper relief on an asset used in a partnership carried on by them. They can only claim in respect of an asset used in a partnership where the life tenant is a partner. See paragraphs 5(3)(a) of Schedule A1 to the Taxation of Chargeable Gains Act 1992 and contrast paragraph 5(2)(a).
However, an asset owned by an individual, trustee or personal representatives but used in a company can now qualify for business assets taper relief in a wider range of circumstances. An individual, trustees or personal representatives can claim business assets taper relief on an asset owned by them but used in any unlisted trading company for the purposes of its trade even if they own no shares in the company! Therefore clients should consider letting assets to unquoted trading companies, not individuals or partnerships.
Taper relief and pooling
Taper relief allows relief to be given from when an asset first comes into being – even if there is subsequent enhancement. Thus where there is a rights issue or a bonus issue, the new acquisition is identified with the previous holding under section 127, Taxation of Chargeable Gains Act 1992. Emma Chamberlain gave the following example.
Example
A buys shares in STEP Limited on 1 May 1998 for £1,000. In May 1999 he buys a further 1,000 shares in a rights issue, again at £1 each. On 31 May 2000 he sells his entire shareholding for £5,000. The old indexation rules would have calculated the indexation allowance from 1 May 1998 and 1 May 1999. But taper relief acts on the entire holding as if it were all acquired on 1 May 1998.
So two years taper relief is given on the gain of £3,000 - it is not necessary for the shareholding to be split. If, instead, A had acquired the shares in STEP Limited from a third party in May 1999 then it would have been necessary to split the shareholdings and this would have given rise to a gain on two separate acquisitions with taper relief running from two separate dates.
Sales of unquoted companies
Emma Chamberlain emphasised that a vendor of a company will need to consider the taper relief consequences of taking consideration in the form of shares or loan notes in the acquiring company.
If shares are taken, then the base date of acquisition for taper relief purposes remains the date on which the original shares were acquired, or 6 April 1998 if later.
The post-share exchange period will continue to be treated as a business period provided the purchasing company is a qualifying company in relation to the vendor. If the shares are unlisted or listed on the Alternative Investment Market, then no minimum percentage is required. If the vendor sells to a quoted company, then the gain on the ultimate sale of the new shares would be diluted for business taper relief where the post-exchange period is non-business – i.e. where the vendor is not employed or an officer of the acquiring group or does not have a 5 per cent interest in the acquiring company.
If the vendor sells out for non-qualifying corporate bond loan notes, these are securities and are treated in the same way as shares. The definition of 'shares' includes securities. Non-qualifying corporate bond status on the loan notes can be secured by arranging for the loan notes to carry conversion rights.
Taking non-qualifying corporate bonds is desirable where the vendor shareholder needs and is able to secure some additional business taper relief. For example, a vendor sells his shares and takes guaranteed loan notes which are not qualifying corporate bonds. Then business taper relief can continue to run on those securities if the vendor is an employee or officer in the purchasing company or it is unlisted.
But Emma Chamberlain warned practitioners to consider the anti-avoidance provisions. Do such loan notes breach the provisions in paragraph 10 of Schedule A1 to the Taxation of Chargeable Gains Act 1992 (periods of limited exposure to fluctuations in value not to count)? Are these normal commercial arrangements? Note that clearance under section 138, Taxation of Chargeable Gains Act 1992 etc. (exchange of securities in another company) will not cover this point. It would be a powerful argument for the taxpayer that the purchaser required loan notes to be issued.
Consider taking qualifying corporate bonds rather than non-qualifying corporate bonds if the vendor has already reached the maximum business taper position at sale – a qualifying corporate bond will preserve this. A non-qualifying corporate bond may not if the purchasing company is listed and the vendor is not an employee or officer. The apportionment rules will then apply to increase the rate of tax payable.
Put and call options
Paragraph 10 of Schedule A1 states that where there is only limited exposure to fluctuations in value of the asset, that period of limited exposure does not count for the purposes of taper relief.
Under paragraph 10(2) the taxpayer is not caught unless he or she is not exposed to a substantial extent to the risk of loss and is not able to enjoy to any substantial extent the opportunity to benefit. Both conditions have to be satisfied. If therefore the sale of an unquoted company is structured in the form of put and call options over the shares, there would be no problem if the options were geared to the value of the shares at the date of exercise rather than granted at a fixed price. However, where the option arrangements enable one to protect against loss but still take the profit, paragraph 10 should not be breached.
Put and call option arrangements based on different or formula based prices should defeat the application of paragraph 10. They will be a consideration if a vendor wants to delay a sale on the basis of falling capital gains tax rates in coming years and therefore postpone the exit date until after 5 April 2002.
Practitioners should make sure that the arrangement is an option and not a contract for sale.
Long term corporate planning
Emma Chamberlain suggested that it may be preferable to set up new trading companies as separate entities if they are likely to be sold after four years rather than as subsidiaries of a corporate group.
Owners of family businesses may now consider it is preferable to retain surplus profits and then later sell the shares in a share buy-back on retirement or to a third party. The corporate tax rates on profits retained may be as little as 20 per cent and the tax on the gain is 10 per cent. If the profit is instead extracted as a bonus or dividend, then the current combined company and individual tax rates vary between 40 per cent and 49 per cent.
Non-domiciliaries and UK homes
Michael Flesch QC of Gray's Inn Chambers spoke on the subject of United Kingdom property ownership by non-domiciliaries. He posed the following: assume an individual who is resident in the United Kingdom but domiciled abroad. How should he own his United Kingdom home, having regard to inheritance tax?
Traditionally the solution was to use a non-United Kingdom resident company, so that the shares constituted 'excluded property' for inheritance tax purposes. Typically, the shares in the non-resident company would be settled on offshore trusts.
Shadow director problem
From time to time the Inland Revenue used to suggest that they could tax individuals who utilised this structure, on the basis that they were 'shadow directors' of the non-resident company, within section 168(8), Taxes Act 1988 and accordingly liable to a benefit in kind charge under sections 145 and 146. It was generally considered by tax practitioners that this Revenue argument lacked technical merit. Indeed the Special Commissioners so held in an unreported case decided in 1993.
However, Michael Flesch emphasised that in R v Dimsey, R v Allen [1999] STC 846 the Court of Criminal Appeal held that an individual who owned his home through an offshore company could be taxed under sections 145 and 146 as a shadow director. It is still possible that the point will be re-argued in the House of Lords. For the moment, however, the speaker warned that it should be assumed that the shadow director provisions can apply to this home-owning structure.
Possible solutions: new purchases
Avoid the shadow problem
Ensure that the individual in question is not, as a matter of fact, a shadow director within section 168(8). But that is easier said than done. The speaker referred to the unhelpful decision in Secretary of State for Trade and Industry v Deverell [2000] 2 WLR 907 (where it was suggested that the mere giving of advice which was acted upon could make the individual a shadow director!).
Provide by means of insurance
Life assurance may be particularly appropriate where the non-domiciled individual is married and can therefore use the inheritance tax spouse exemption. Insure against the risk of both spouses dying within, say, six months of each other – this will be relatively inexpensive. And once the first spouse dies one will, in effect, have six months in which to take appropriate measures to avoid inheritance tax on the second death, for example borrowing arrangements as referred to below.
A mortgage arrangement
Another alternative is to borrow on the security of the United Kingdom home and deposit the borrowed money offshore. The debt charged on the United Kingdom property reduces the value of that property, for inheritance tax purposes: see section 162(4) Inheritance Tax Act 1984. Michael Flesch said that this sounds easy, but it can be expensive. One must also watch the deemed remittance rules in relation to the interest earned on the offshore deposit: see section 65(6), Taxes Act 1988.
Gift to the company
It is sometimes suggested that the individual in question, having purchased his United Kingdom home, could give it to the offshore company. This would avoid any incurring of expenditure by the company: see section 146(4)(a), Taxes Act 1988. Michael Flesch mentioned two problems. First, how does one avoid two charges to stamp duty? (See section 119, Finance Act 2000.) Secondly, and more importantly, the individual would have made a gift with reservation of United Kingdom property for inheritance tax purposes. Therefore this does not appear to be a particularly good idea.
Charge a rent
The non-resident company could borrow in order to purchase the property and then charge the non-domiciled individual a full rack rent. Depending on the precise figures, the interest paid by the company will reduce or eliminate the United Kingdom tax on the rent, the rent paid will reduce or eliminate any section 146 liability and the individual could use unremitted income in order to pay the rent. Application should be made to the Revenue for the rent to be paid gross.
Arrange occupation under the trust
The non-resident company grants an annual tenancy of the home to the trustees of the settlement owning the company and for the trustees to licence the individual to occupy the home. The argument is that the property is not provided by reason of employment but because the individual is a beneficiary. For inheritance tax purposes the value of the United Kingdom settled property (the tenancy) would be minimal.
However, Michael Flesch felt that this proposal may well be vulnerable to an attack under Furniss v Dawson.
Co-ownership
The home could be owned jointly by the individual and the company, e.g. as tenants in common. It would then be argued that the occupation was not as shadow director but as co-owner. The Revenue is likely to resist this contention.
Existing situations
Michael Flesch suggested one should first evaluate the 'shadow director' risk. What are the facts, having regard to section 168(8), Taxes Act 1988 and the decision in Deverell?
It may be sensible to dismantle the existing trust/company structure and adopt one of the suggestions made above. This will probably involve liquidating the company.
He warned as to the tax residence of the (hopefully) non-resident company. If there really is a 'shadow director' problem, might there not also be a risk that the company is resident in the United Kingdom? In that event, a capital gains tax liability could arise when the company is liquidated.
Bear in mind also the inheritance tax consequences of dismantling the trust/company structure. An interest in possession should (if necessary) be appointed prior to liquidation of the company, to ensure that the settled property comprises 'excluded property' at all relevant times.
 

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