Pre-Owned Assets

Pre-Owned Assets

The Pre-Owned Assets Régime — II

BARRY McCUTCHEON concludes his guide, explaining excluded transactions, the impact on foreign domiciliaries, and the opt-out election.

CERTAIN TRANSACTIONS, CALLED 'excluded transactions' are given favoured treatment in that they are ignored in determining whether certain conditions in relation to the occupation of land and the use of chattels are satisfied. It is vital to note that excluded transactions are relevant only to chattels and land; they have no bearing on the treatment of intangible property comprised in a settlor-interested settlement. Excluded transactions fall into two categories. One category is framed in general terms: 'the general excluded transactions'; while the other: 'the special excluded transactions', is framed by reference to the provisions identifying the particular circumstances which cause land or chattels to be within the régime. All references below are to Schedule 15 to the Finance Act 2004 unless otherwise stated.

General excluded transactions

The disposal of any property is an excluded transaction in relation to the individual who made the disposal in four cases (see paragraph 10).

Transfer to spouse

A transfer of property is an excluded transaction if the property was transferred to a spouse or, where the transfer has been ordered by a court, to a former spouse.

Spouse entitled to interest in possession

A disposal is an excluded transaction if it was a disposal by way of gift (or, where the transfer is for the benefit of a former spouse, in accordance with a court order), by virtue of which the property became settled property in which the individual's spouse or former spouse is beneficially entitled to an interest in possession. This condition ceases to be satisfied if the spouse or former spouse's interest comes to an end during her lifetime.

Family maintenance dispositions

A disposal is an excluded transaction if the disposal was a disposition within the relief afforded to family maintenance dispositions by section 11, Inheritance Tax Act 1984.

Annual and small gifts exemptions

A disposal is an excluded transaction if the disposal is an outright gift to an individual and is for inheritance tax purposes a transfer of value that is wholly exempt by virtue of the annual exemption or the small gifts exemption.

Special excluded transactions

The paragraph 3 charge on land and the paragraph 6 charge on chattels both operate only if either a 'disposal condition' or a 'contribution condition' is satisfied. The legislation provides for two excluded transactions that are framed by reference to these conditions. In the first case, a transaction is an excluded transaction in relation to the disposal condition that exists in relation to land and chattels respectively. In the second case, a transaction is an excluded transaction in relation to the contribution condition that exists in relation to land and chattels respectively.

Arm's length transaction

For the purposes of the disposal condition in the land code and the chattels code, a disposal is an excluded transaction if it was of the individual's whole interest in the property, except for any right expressly reserved by him over the property, either:

Subject to one qualification, the arm's length or equivalent transaction test is the same as that in section 10(1)(a) and (b), Inheritance Tax Act 1984. The qualification is that the definition of 'connected persons' is modified so that:

In the standing committee debates and at report stage, the point was taken that the requirement that the disposal had to be of the vendor's whole interest in the property was unfair. It would not, for example, cover a sale of a half share in a property. The present position is thus that the legislation caters for a person who sells a property, retaining a lease, but not for a person who sells part only of his property. The Government has undertaken to reconsider this.

Concern has also been expressed that the requirement that the whole of the interest must be disposed of would prevent this relief from applying in the common situation where father and son farm father's land and the father gives the son half the land, in consideration of the son's efforts in the partnership. In such cases, as in Attorney General v Boden [1912] 1 KB 539, Revenue practice is normally to regard the full consideration let-out in paragraph 6(1)(a) of Schedule 20 to the Finance Act 1986, as preventing the father from having reserved a benefit, and it is thought that it would also prevent the new régime from applying.

Potentially exempt currency contribution

For the purposes of the contribution condition in the land code and the chattels code, the provision by a person of consideration for another's acquisition of any property is an excluded transaction, if it constitutes an outright gift of money in any currency by the individual to the other person, and was made at least seven years before the earliest date on which:

This means that if X gives Y £100,000 which Y uses to purchase a house, and X occupies the house only seven years after the cash gift, the contribution condition will not be satisfied. This incorporates into the land and chattels charging codes the equivalent of a potentially exempt transfer.

£5,000 annual exemption

An individual is not chargeable in a year of assessment if the aggregate of:

does not exceed £5,000 (paragraph 13). Assuming a notional five per cent return, the broad effect of this exemption is to take out of the charge, at present rates of return, property worth up to £100,000. This figure does not, however, constitute an equivalent to the inheritance tax nil rate band because once the £5,000 exemption is exceeded, the exemption is lost altogether.

The exemption is perhaps less generous than it looks. Assume A gives B land worth £150,000 and occupies it, that the appropriate rental value is £7,500 and that A pays B £5,000 a year in rent. The amount on which A is actually chargeable is only £2,500 (£7,500 less £5,000), but the exemption operates by reference not to that amount but by reference to the appropriate rental value, i.e., £7,500. The exemption therefore does not apply. The exemption also operates in this way in relation to chattels. The payment of consideration is irrelevant where the charge is under paragraph 8.

Foreign domiciliaries

Foreign domiciliaries, if not deemed domiciled by the special inheritance tax rules, generally have little to fear under the régime, though in some cases they may be troubled by the 'excluded liability' rules. Before considering the application of the régime in practice, it will be helpful to consider two reliefs provided by the régime in paragraph 12 for foreign domiciliaries: a basic relief and a settled property relief, and then, against that background, to discuss how the blanket exemptions assist foreign domiciliaries in situations where the reliefs do not do so.

The basic relief

The basic relief is that where an individual is not domiciled in the United Kingdom for inheritance tax purposes, the régime does not apply to him unless the property by reference to which the régime operates is situated in the United Kingdom. Note that one focuses on the property; it is irrelevant whether it is held by an individual, a company or a trust.

Assume Boris, a foreign domiciliary, occupies a Spanish villa owned by a United Kingdom company, the shares in which are owned by a trust of which he is the settlor. Both the shares and the villa are prima facie within the régime (under paragraphs 8 and 3, respectively). The relief applies in relation to the villa, which is situated abroad, but not to the shares, which are situated in the United Kingdom. If Boris becomes domiciled in the United Kingdom, the relief for the villa will no longer be available. Depending on the terms of the trust, the shares should be taken out of the régime under either the second or the fourth blanket exemption (see the first part of this article in Taxation, 16 September 2004 at pages 626 to 629).

The settled property relief

Under the settled property relief, in determining the application of the régime to a person who was at any time domiciled outside the United Kingdom, no regard is had to settled foreign situs property which is excluded property for inheritance tax purposes by reason of being comprised in a settlement made by an individual who was not domiciled in the United Kingdom when he made the settlement. Since the relief is framed by reference to section 48(3)(a), Inheritance Tax Act 1984, sections 80 to 82 will not be relevant.

Assume Svetlana, a foreign domiciliary, occupies a Spanish villa owned by an offshore company the shares in which are owned by a trust of which she is the settlor. Both the shares and the villa are prima facie within the régime (under paragraphs 8 and 3, respectively). Since both the shares and the villa are situated abroad, the basic relief applies in relation to both of them. If Svetlana becomes domiciled in the United Kingdom, the basic relief will cease to be available, but the settled property relief will be available in respect of shares but not the villa (which is not settled property).

Relevance of blanket exemptions

It might be thought that the example concerning Svetlana departs from the basic principle that individuals who have arranged their affairs in 'an acceptable manner' to take advantage of inheritance tax favoured treatment, e.g. that accorded to foreign domiciliaries, should not be caught by the régime.

This follows from the fact that for inheritance tax purposes, the only relevant asset would have been the shares, which would have been excluded property and so outside the scope of inheritance tax. In fact, that is unlikely to be the case, because in the vast majority of cases the blanket exemptions will apply so as to make up for any apparent deficiencies in the reliefs for foreign domiciliaries.

In the Svetlana example, although neither the basic relief nor the settled property relief will be available, under paragraph 11:

One other case is perhaps worth mentioning, i.e. that where the régime property is held by a company the shares in which are not settled. Consider the following examples.

Catherine

Catherine owns a company which owns a chattel which she uses. If she is domiciled abroad and the chattel is situated abroad, the basic relief will apply. If she becomes domiciled in the United Kingdom, the second blanket exemption will apply.

Peter

Peter occupies a villa owned by a company the shares in which he has given to his son. If he is domiciled abroad and the villa is situated abroad, the basic relief will apply. If he becomes domiciled in the United Kingdom and, as is likely to be the case, he has reserved a benefit in respect of the shares, the fourth blanket exemption will apply.

Let-outs and exemptions

The legislation does not establish any hierarchy between the reliefs and the blanket exemptions. In practice, it is simpler to apply the reliefs first because they are easier to apply conceptually than the first exemptions and, unlike the exemptions, are not subject to any qualifications.

Accommodation arrangements

For many years a foreign domiciliary who wished to own, say a house in London, was advised to establish a trust which owned all the shares in an offshore company which in turn owned the house. The thinking was that the relevant asset for inheritance tax purposes would be the shares in the company which would be excluded property for inheritance tax purposes. There then developed a protracted controversy with the Revenue concerning the possible exposure of the foreign domiciliary to a charge to income tax under what was then Schedule E by reason of the occupational benefit conferred upon the foreign domiciliary by him if he was an actual or a shadow director of the company. R v Dimsey [2001] STC1520 and R v Allen [2001] STC 1537 exacerbated this situation and new approaches were developed which did not involve a company owning the house.

Offshore 'home loan' arrangements

Often a two trust solution was used which was a variant of the home loan schemes. The essence of the arrangement was that the foreign domiciliary created two trusts. He funded the first trust, which could be discretionary, which in turn funded a company wholly owned by that trust. The company lent the funds to the second trust, which would normally be an interest in possession trust, which used the funds to purchase the house. The loan, which was secured on the house, was left outstanding interest-free and repayable on demand.

Assume the company lent the trust £1,500,000 which the trust used to purchase the house and that ten years later, when the foreign domiciliary died, the house was worth £2,000,000. For inheritance tax purposes, the house would have been used to reduce the debt owed to the company and so worth £500,000. Even if the debt was a United Kingdom situs asset, the relevant asset for inheritance tax purposes was the shares in the company, which were excluded property. The net result was to take the amount of the debt outside the scope of inheritance tax. In many cases, the foreign domiciliary and his spouse had successive life interests in the house, so that if the foreign domiciliary's spouse survived him, any charge on his death was deferred until the death of his spouse.

The régime has adversely affected the tax effectiveness of such arrangements. Although both the basic relief and the settled property relief will operate in respect of the shares in the company, neither of those reliefs will be available in respect of the house, because it is situated in the United Kingdom. If, as is normally the case, the foreign domiciliary has an interest in possession in the house, the ownership exemption will prima facie be available in respect of the house, but only to the extent that the value of the house exceeds the 'excluded liability' of, returning to the above example, £1,500,000. If the debt is an excluded liability, the first £1,500,000 of the house will be within the régime and be subject to annual charges. Such structures may thus need reviewing and possibly dismantling, with consideration being given to, for instance, covering the inheritance tax exposure with insurance as a simple option.

Last, to put matters in perspective, consider the position under the régime of a traditional property owning structure of the kind mentioned above, i.e. the United Kingdom property is owned by an offshore company, all the shares in which are owned by a settlement made by a foreign domiciliary. The shares in the company will be prevented by both the basic relief and the settled property relief from being within the régime, but what about the United Kingdom property? If the foreign domiciliary has an interest in possession in the trust, he will be treated as owning the shares in the company, which derive their value from the house, with the result that the house will be within the derivative ownership exemption. If he does not, then, assuming he has reserved a benefit under the trust, the derivative reserved benefit exemption will operate in respect of the house, with the same result.

Opt out elections

Under paragraphs 21 and 22, taxpayers can, by an election made on or before 31 January in the year of assessment that immediately follows the first year of assessment in which the régime applies to the property in question, opt out of the régime and back into the reservation of benefit provisions with respect to that régime property (or in the case of paragraph 3 or 6 property which has been substituted for the régime property and in the case of paragraph 8 property which represents or is derived from the régime property) on a once and for all basis. Where land or a chattel is concerned, only the 'chargeable proportion', i.e., broadly speaking, the value of the property not subject to inheritance tax in the year of assessment in question, is treated for inheritance tax purposes as property subject to a reservation.

To opt or not to opt

Whether or not it makes sense to opt into reservation of benefit will need careful consideration in each case. It may be that opting into reservation of benefit has no adverse inheritance tax implications for one or more of the following reasons:

On the other hand, the taxpayer may prefer to be taxed under the régime, perhaps because the taxpayer's life expectancy is such that it is less expensive to pay the annual charge under the régime than it is to bear inheritance tax on the property. In some cases, the taxpayer may wish not to burden the donee with the inheritance tax on the property.

The fact that a taxpayer has opted to pay charges under the régime during his lifetime does not of itself preclude the Revenue from invoking the reservation of benefit provisions on his death or, for that matter, during his lifetime should he cease while still alive to reserve a benefit in respect of property. Should the Revenue adopt such a course of action, it would have to refund the régime charges but, depending on the sums, it might conclude it was in its interest to claim inheritance tax on the basis of the reservation of benefit provisions. Taxpayers who opt to pay under the régime should therefore be confident that they are not subject to the reservation of benefit provisions.

Adapted from Preowned 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.

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