The Pre-owned Assets Régime

The Pre-owned Assets Régime — I

BARRY McCUTCHEON, barrister, presents a comprehensive explanation of the new pre-owned asset rules.

SCHEDULE 15 TO the Finance Act 2004 has introduced an entirely new charging régime under which an individual resident in the United Kingdom will from 6 April 2005 be charged to income tax on an annual basis in respect of benefits he enjoys — or, in some cases, is capable of enjoying — from certain kinds of property owned by others which, broadly speaking, that individual previously owned or the acquisition of which he financed. It will be helpful to consider why the Government came to the view that such a radical course was in order.

Finance Act 1986

It all goes back to the Finance Act 1986, which introduced both potentially exempt transfers and the reservation of benefit rules. The former were clearly intended to encourage timely lifetime gifts, while the latter were clearly intended to limit the terms of any such gifts: one could give freely, but the gift had to be without any strings which allowed, or might allow, the donor to enjoy the gifted property in the future. Not surprisingly, ever since the introduction by the Finance Act 1986 of the potentially exempt transfer régime and the reservation of benefit provisions, tax advisers have been busy — in the Government's view, far too busy — devising methods by which individuals could make potentially exempt transfers of property which, without infringing the reservation of benefit provisions, they still continued to enjoy or to have the potential to enjoy.

The final straw

The Eversden case was first decided in the taxpayer's favour by a Special Commissioner in 2001. Prior to that decision, the planning technique which the Revenue challenged, and which was capable of being used in a variety of circumstances, had been employed by some taxpayers but the Commissioner's decision encouraged others to do so as well. The Revenue appealed and Mr Justice Lightman, in 2002, also found for the taxpayer. This led to a very large number of Eversden schemes being developed, marketed and implemented. Matters were made even worse when the Court of Appeal in 2003 upheld Mr Justice Lightman's decision.

This forced the Revenue's hand and the Finance Act 2003 introduced anti-avoidance provisions designed to defeat Eversden schemes implemented by disposals made after 19 June 2003. Needless to say, advisers scrutinised these new anti-avoidance provisions with a view to identifying any remaining loopholes, and a whole series of 'post-Eversden' schemes — some in the author's view of doubtful quality — appeared to brighten the lives of clients intent on having access to property which they had given away.

The Revenue soon began to get wind of the possibility of new schemes being implemented. Perhaps concerned that it was outgunned by tax advisers on the technical front, it appears to have concluded that another approach was called for, not just to tighten up the technical position but also to fire a shot, not just across taxpayers' bows, but into the bows of taxpayers contemplating tax avoidance.

Retroactive, not retrospective

A particularly noteworthy feature of the new régime is that the only time limit as to its application is that it does not operate with respect to arrangements put into effect before 18 March 1986 (which is also the starting date for the application of the reservation of benefit provisions). Strenuous representations were made that the régime was retrospective and should apply only to arrangements put into effect after, e.g. 9 December 2003, the date on which it was announced that the régime was to be introduced. The Government resisted this view, saying that although it affected structures put into place before the introduction of the régime, it imposed a charge only on benefits enjoyed after the introduction of the régime. It was therefore retroactive, but not retrospective.

The régime promises to apply to a wide range of arrangements implemented since 18 March 1986 which have successfully avoided inheritance tax, notably successful Ingram-based schemes and Eversden-based schemes. Many other arrangements, some 'innocent', may also be caught.

Guiding principles

The régime appears to be based on the following guiding principles:

Unfortunately, the actual provisions do not always give effect to these principles.

Basic structure

The broad structure of the régime is to establish a separate charging system for each of three different kinds of property:

Parallel charging codes

More than one of the charging codes can apply to an arrangement. Assume that X lives in a house owned by a company all the shares in which are owned by a discretionary trust of which he is the settlor and under which he can benefit. The régime is capable of applying to two assets: first, the house in which X lives under the charge on land; secondly, the shares in the company, under the charge on settled intangible property. There are provisions in paragraph 18 of Schedule 15 to prevent double taxation arising in such a case, but the point to bear in mind is that each situation must be carefully analysed for its consequences under the régime.

Associated operations

It is worth mentioning that the inheritance tax associated operations provisions are of limited relevance under the régime. They generally do not apply for its purposes, but are relevant for determining what is an 'excluded liability' (see below) and can be indirectly relevant in that they may apply for the purpose of determining whether or not property is subject to a reservation. In particular, although the régime uses the term 'disposition', it does not adopt the extended inheritance tax definition of that term whereby a disposition includes a disposition effected by associated operations. Indeed, as a general rule the legislation uses the term 'disposal' rather than 'disposition'.

The charging codes

Land

The charge on land, under paragraph 3, operates where in any year of assessment an individual occupies any land, whether alone or together with other persons and either of two conditions are met. The first condition, 'the disposal condition', is broadly that the land was previously owned by the individual or represents property which he previously owned. The second condition, 'the contribution condition', is broadly that he provided the money with which the land was acquired. Where paragraph 3 applies, an amount equal to 'the chargeable amount' is treated as the income of the individual chargeable to income tax. The 'chargeable amount' is, very broadly speaking, the rent which, applying various rules, is regarded as appropriate in the circumstances (paragraph 4). Assuming a notional five per cent return, the chargeable amount in respect of a property worth £200,000 would be roughly £10,000. The aforesaid rules promise to be productive of many difficulties in practice.

It may be that the individual is already paying a commercial rent. The rules regulating the computation of the notional rent are such that the notional rent may exceed the commercial rent actually being paid, in which case the régime applies to the excess of the notional rent over the actual rent. In practice, this is unlikely to be a concern because where a full commercial rent is chargeable, the full consideration let-out in paragraph 6(1)(a) of Schedule 20 to the Finance Act 1986 will normally apply; see the discussion below.

Chattels

The charge on chattels, under paragraph 6, applies where an individual possesses, or has the use of, a chattel, whether alone or together with other persons, and either of two conditions are met. The first condition, 'the disposal condition', is, as with land, broadly that the chattel was previously owned by the individual or represents property which he previously owned. The second condition, 'the contribution condition', is broadly that he provided the money with which the chattel was acquired. Where paragraph 6 applies, an amount equal to 'the chargeable amount' is treated as the income of the individual chargeable to income tax. The 'chargeable amount', although couched in terms of 'notional interest', is essentially what the legislation regards, applying various rules, as the price which would be paid to use or possess the chattel in the circumstances. Assuming a notional five per cent return, the chargeable amount in respect of a chattel worth £500,000 would be approximately £25,000.

On the basis of the foregoing, concern might be felt that problems would arise under the régime in respect of various arrangements entered into under which individuals have sought to avoid the reservation of benefit provisions by sheltering under the full consideration let-out in paragraph 6(1)(a) of Schedule 20 to the Finance Act 1986 by paying a 'full rent' for the use of chattels which they had given away but which they still enjoyed or had the use of; typically, works of art. The payment of full consideration was generally not onerous because normally independent experts engaged by the parties advised that only a relatively small rent was appropriate.

In the absence of provision to the contrary, individuals would now have to pay the annual paragraph 6 charge on the notional interest calculated by reference to the value of the chattels. Having said that, there is, as is explained below, a blanket exemption for property which is subject to a reservation or which would be subject to a reservation but for, inter alia, paragraph 6 of Schedule 20 to the Finance Act 1986, which contains the full consideration let-out in paragraph 6(1)(a). Accordingly, the régime will not apply in cases where existing inheritance tax arrangements are within paragraph 6(1)(a). While this is encouraging, it remains to be seen whether arrangements designed along the lines mentioned above are within paragraph 6(1)(a): it is understood that the Revenue is arguing that there is no market for rented chattels and that, in the absence of any such market, it is impossible to determine what constitutes 'full consideration'. If that argument succeeds, the reservation of benefit provisions will apply, in which case the régime will not.

Intangible property

The charge under paragraph 8 applies where the terms of a settlement, as they affect any intangible property comprised in the settlement which is or represents property which the individual contributed to the settlement, are such that any income arising from that property would be treated as the income of the settlor by section 660A, Taxes Act 1988. Section 660A is applied ignoring any benefit or possible benefit to the settlor's spouse from the settlement. The fact that no actual income arises is irrelevant. Note that although paragraph 8 is framed by reference to section 660A, the term 'settlement' is given the meaning it has for inheritance tax purposes by paragraph 1, not the meaning it has under section 660G for the purposes of section 660A.

As indicated above, 'intangible property' for this purpose means any property other than chattels or interests in land. The most common kinds of property that it will catch are shares, securities, insurance policies and bank accounts. Land or chattels comprised in a settlement would not be within paragraph 8. Nor, if the settlor did not occupy the land or use or enjoy the chattels, would the land be within paragraph 3 or the chattels within paragraph 6.

The Association of British Insurers has expressed concern to the Revenue that paragraph 8 will apply to a wide variety of insurance-based arrangements, including those employing the 'carve-out' principle which the Revenue accepted did not infringe the reservation of benefit provisions. It is understood that the Revenue's view is that such arrangements should generally also fall outside paragraph 8, but detailed guidance is awaited.

Where paragraph 8 applies, an amount equal to 'the chargeable amount' is treated as the individual's income chargeable to income tax. The chargeable amount is the notional interest return on the property. Assuming a notional five per cent rate of interest, the chargeable amount in respect of an insurance policy worth £250,000 would be £12,500. There is deducted from this amount certain other taxes payable in respect of the property, e.g. under section 660A itself or where the individual assessed to capital gains tax on chargeable gains attributed to him by section 86, Taxation of Chargeable Gains Act 1992.

A radically different approach

It is essential to understand that paragraph 8 adopts an entirely different approach from that adopted under the paragraph 3 land provisions and the paragraph 6 chattels provisions, in two ways. First, none of the 'excluded transactions' let-outs apply to prevent paragraph 8 from operating. Secondly, unlike the provisions dealing with the computation of the chargeable amount in respect of land and chattels, the provisions dealing with the computation of the paragraph 8 chargeable amount contain no provisions taking account of the retention of the person concerned of any interest in or rights over the settlement.

So, if X settles property on trusts under which he retains a reversionary interest, there will be an element of double taxation. For inheritance tax purposes, the reversionary interest will be prevented by section 48(1)(b), Inheritance Tax Act 1984, from being excluded property and so, e.g. on his death, will be comprised in his estate and, subject to any reliefs or exemptions, will attract a charge to inheritance tax. For régime purposes, the property in which he has retained his interest in possession will, prima facie, be within paragraph 8.

Exemptions and reliefs

The legislation provides certain exemptions and reliefs. It is important to understand their scope. The blanket exemptions discussed below apply to all three charging codes. The relief given to excluded transactions, covered in the next article, applies only in respect of the codes dealing with land and chattels. Last, the £5,000 annual exemption operates very differently from the inheritance tax £3,000 annual exemption, as is explained below.

Five blanket exemptions (paragraph 11) operate to prevent any of the three charging codes from operating.

1. Ownership exemption

Subject to one qualification, none of the three charging codes applies to an individual at a time when, for inheritance tax purposes, his estate includes the régime property. The purpose of this rule is straightforward enough: property already within a person's estate is already prima facie within the scope of inheritance tax. Were the régime also to apply to it there would be an element of double taxation.

Where at any time the value of a person's estate for inheritance tax purposes is reduced by an excluded liability affecting any property, that property is not treated as comprised in his estate except to the extent that the value of the property exceeds the amount of the excluded liability. A liability is an 'excluded liability' if (a) the creation of the liability, and (b) any transaction by virtue of which the person's estate came to include the régime property or property derived directly or indirectly therefrom are associated operations.

The purpose of this provision is thought to be to nullify the effectiveness of certain inheritance tax arrangements known as home loan schemes. In essence, these operated as follows. Assume X's family home was worth £500,000. He created a trust under which he had an interest in possession and sold his home to the trust for a purchase price left outstanding interest-free. He then settled the debt owed to him on accumulation and maintenance or interest in possession trusts for his children, thereby making a potentially exempt transfer. On his death, the value of the home was reduced by the amount of the debt. So, if on his death the home was worth £700,000, its value for inheritance tax purposes was only £200,000. If X survived the potentially exempt transfer by seven years, he had therefore reduced the amount on which inheritance tax was due on the home from £700,000 to £200,000.

If, under the régime, the debt is an excluded liability, the result will be that:

2. Derivative ownership exemption

The second exemption is that, subject to two qualifications, none of the three charging codes applies to an individual in respect of régime property, if that individual's estate includes property which derives its value from that régime property. This rule is more subtle than the first rule. It means that although an individual does not own property or have an interest in possession in property, the exemption will apply if other property to which he is beneficially entitled, derives its value from that property.

Assume X occupies land owned by a company of which he is the sole shareholder. The land is not in his estate and so is not covered by the ownership exemption. But the shares derive their value from the land and so are covered by the basic derived value exemption.

It may be that the value of the derivative property — in the example just given, the shares — is less than the value of the property from which it derives its value, i.e. the land. In that case, if the value of the derivative property is substantially less, the amount on which tax is charged under the régime is reduced by such proportion as is reasonable to take account of the inclusion of the derivative property in his estate.

The excluded liabilities restriction that operates in respect of the ownership exemption also operates in respect of the derivative value exemption, regardless of whether or not the substantially less rule applies. In applying this rule, the procedure is thus first to apply the excluded liabilities rule and then to apply the substantially less rule.

3. Reserved benefit exemption

None of the three charging codes applies to a person by reference to any régime property at a time when that property satisfies any one of four conditions framed by reference to the inheritance tax reservation of benefit provisions. The purpose of this exemption is to take out of the régime property which is already caught by the inheritance tax reservation of benefit provisions or which is excused from the operation of those provisions by certain let-outs in the reservation of benefit rules, including that in section 102B, Finance Act 1986 for sharing arrangements and that in paragraph 6(1)(a) of Schedule 20 to that Act where full consideration is provided. I will, for convenience, refer to such property as 'reserved benefit property'.

4. Derivative reserved benefit exemption

Subject to the substantially less rule, none of the three charging codes applies to régime property from which reserved benefit property derives its value. The purpose of this exemption is subtler than the reserved benefit exemption.

Assume X owns shares in a company which owns a house in which X lives. If X gives the shares to his son and lives in the house free of charge, X will reserve a benefit in respect of the shares but not the house. Therefore the reserved benefit exemption will not apply. But the shares will derive their value from the house, and so the house will be exempt under the fourth exemption.

5. Posthumous arrangements

Under the fifth blanket exemption, any disposition made by a person in relation to an interest in the estate of a deceased person is disregarded for régime purposes if, per paragraph 16, that disposition is not treated as a transfer of value for inheritance tax purposes 'by virtue of' section 17, Inheritance Tax Act 1984. Section 17 provides that none of the following is a transfer of value:

This article is adapted from Pre-owned Assets: Capital Tax Planning in the New Era, and the fourth edition of McCutcheon on Inheritance Tax, both to be published by Sweet & Maxwell in November 2004. Barry McCutcheon is speaking at an IBC Conference on 13 October; see page 625 of this week's issue.

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