What To Do?

What To Do? 

WHAT ACTION SHOULD clients be advised to take in the light of the excellent two-part summary on the pre-owned assets régime by Barry McCutcheon in Taxation, dated 16 and 30 September at pages 626 to 629 and 686 to 689 respectively? The first issue, for those who have been advising in this area over the last 18 years or so, is the impact on those arrangements that have been made. Here clients need to decide before 6 April 2005 how they will respond. The second, quite different, issue lies in the context of giving ongoing advice to clients: what structures can safely be considered now for the family home, in particular, as well as for chattels and perhaps also inheritance tax mitigation through life assurance policies?

All statutory references are to FA 2004, unless otherwise specified.

Unscrambling the past

So far as concerns lifetime arrangements for the family home, these arrangements will include:

Land: what's to be done?

Elect into GWR

Generally, it seems that the Inland Revenue would like everyone to opt into GWR by making an irrevocable election under Sch 15 para 21 (before 31 January following the end of the tax year in which the anti-avoidance rules first apply) that the assets concerned should be treated as part of the donor's estate. While there is an unscrambling for inheritance tax purposes, the analysis of the arrangements under the general law is unaffected. So other consequences will remain.

The principal point is the general downside of being caught by the GWR provisions, namely, assuming that the asset continues to appreciate in value, it will not benefit from the capital gains tax free uplift to market value on death (because it is not owned by the donor). All the implications of making such an election need to be considered carefully. The initial and continuing interim professional costs will have to be written off, quite apart from accepting the new costs involved in taking advice on unscrambling the scheme. Then the donee, who does not join in the election, should be informed and must accept that there is a prospective inheritance tax liability, of unknown amount, primarily on him, though with a residual liability on the personal representatives of the donor. This needs to be appreciated and could present a problem in particular cases.

Suppose, for example, that the donees were the trustees of a settlement who, for reasons best known to themselves, have advanced out the capital outright and have brought the trust to an end. This is all well and good if the trustees have taken appropriate indemnities, as they should have done, and those indemnities hold good. What happens if they have not, however? The trustees are personally liable and may be called upon for the tax.

It may be thought that electing under the transitional provisions is 'throwing in the towel'. Much will depend on the circumstances of the case, the value involved, the age and life expectancy of the donor, the time for which he wants to go on living in the property and his financial ability to meet the income tax charge, if he so chooses.

Pay the income tax

The next option therefore would be to pay the charge under Sch 15 para 4, accepting that the effect of the formula will be to increase the proportion of the appropriate rental value as the years go by. One of the problems here is the compliance costs in computing the figures each year, a subject addressed in the latest consultation document where the Revenue has asked for views on likely burdens and appropriate valuation intervals.

Pay for the benefit

Thirdly, it would be possible to avoid the income tax charge by ensuring that the donor pays, for his occupation or enjoyment, an amount equal to the appropriate rental value, though this must be under a legal obligation. It may be possible to restructure the arrangements to create a legal obligation without vitiating the inheritance tax effectiveness of what has been done. Note, in particular, that advantage cannot be taken of the de minimis rules in Sch 15 para 13 to bring the taxable amount below £5,000, as it is the gross and not the net benefit to which the de minimis threshold is applied.

Possibly one circumstance in which it might be thought reasonable to make an annual payment is if the donor is financially in a position to do so and the structure of the arrangements creates an income tax efficient situation, e.g., where the rent is received by grandchildren with available personal allowances or basic and lower rate bands to be used up — quite apart from getting money down a generation without involving a transfer of value. But all of this will have to be discussed within the family.

Terminate the benefit

The final possibility might be to bring the benefit to an end. If this is done before 6 April 2005, there will be no Sch 15 implications. Given that the arrangement continues to be preserved from GWR, moving out should have no inheritance tax implications (as would otherwise be the case with bringing a GWR to an end, in starting the seven-year risk period running with a potentially exempt transfer under FA 1986, s 102(4)). Incidentally, occupation means what it says, so (perhaps surprisingly) granting an exclusive lease or sub-lease of the property concerned and taking a benefit by way of rent will not offend against the new régime.

Chattels arrangements

Without retracing the history of this issue during the passage of Finance Bill 2004, the happy outcome found in Sch 15 para 11(5)(d) is as follows. If an arrangement for chattels (as well as for land) is protected from GWR because of the 'full consideration' let-out in FA 1986, Sch 20 para 6(1)(a), then neither would it be caught for pre-owned assets purposes. Payment of that full consideration could be by a lump sum as well as an annual amount. All this involves some rather tortuous drafting interpretation, which amounts to having to read the word 'and' as if it meant 'or'! That is the good news.

The bad news, as explained by Barry McCutcheon, is that Inland Revenue Capital Taxes is starting to query the effectiveness of a number of chattels licensing arrangements set up over the last ten to fifteen years relying on the para 6(1)(a) exemption. Under such arrangements, the donor parent would retain possession of the chattels, paying the insurance premium plus an arm's length licence fee, reviewed every three years, which might currently amount to just under one per cent of capital value. This is independently negotiated between recognised auction houses acting for donor and donee respectively. Capital Taxes seems to be saying that there is an insufficient, if any, market in such assets for it to be established what full consideration is at all. If so, then chattels can never benefit from the para 6(1)(a) exemption, in the same way as can, for example, land. It remains to be seen what is the outcome of this.

Otherwise, the options would appear to be much the same as for land.

Intangibles

The main target of the third limb of the Sch 15 rules, in para 8, seems to have been the plethora of insurance-based inheritance tax mitigation arrangements; or at least so everybody thought. Certainly, in trying to apply the rules to the main types of scheme on the market, they might appear to be roundly caught. This is insofar as the donor is a beneficiary under a settlement which, even if it does not produce income, would have any income that did arise assessed on the settlor under TA 1988, s 660A(1). The only exception to this might be the sort of loan trust where the benefit derived by the settlor (typically through five per cent annual withdrawals by the trustees from the bond comprised in the trust fund) would come to him not as beneficiary, but as creditor under a commercial arrangement.

That said, we have the surprising situation, as noted in Barry McCutcheon's article, that the Revenue seems to be suggesting, though not yet generally confirmed, that a number of these insurance-based arrangements are not caught by para 8. This appears to be on the basis that any actual or prospective enjoyment of the settlor is held for him not on the substantive trusts of the policy, but on bare trusts, and therefore outside Sch 8. That is, a rather uneasy situation exists. Until there is greater certainty, it has to be a case of 'watch this space'.

Planning

Every professional adviser will have views as to whether it is appropriate to advise clients to involve a family home at all in inheritance tax mitigation planning. If so, however, then what options are left?

Full consideration arrangements

These continue to be effective for GWR purposes, whether the donor pays an annual rack rent for his enjoyment or has paid an arm's length premium to secure occupation for his life, not being a 'settlement' for purposes of IHTA 1984, s 43(3). In order to secure exclusion from pre-owned assets under Sch 15 para 10(1)(a), there must have been a disposal of the whole interest in the property except for any right expressly reserved by him '… by a transaction such as might be expected to be made at arm's length between persons not connected with each other'. It is understood that Capital Taxes continues to consider whether it might be appropriate to allow this exclusion to a part, as well as a total, disposal. Meanwhile, it would appear to cover a sale of that interest subject to a reserved right to stay in the property for a period of years for an arm's length consideration paid by the donee, such as one might expect to find in equity release schemes in the market. Evidence of consideration and other terms is essential. There would be a liability for stamp duty land tax on the part of the donee, in whose hands also there would be a period of ownership not attracting main residence relief from capital gains tax. There may be other variants of securing this result.

Co-ownership

Statute protected co-ownership arrangements are expressly taken out of GWR by FA 1986, s 102B(4). Issues remain about the application of what is a statutory extension of the 1986 Hansard statement. For example, do the shares in the house given away to the co-occupying owners have to be equal, with the Revenue tending to argue that they must (albeit with no obvious foundation)? It is essential that careful documentation is kept of the sharing of expenses, so that it can be shown that the donor derives no benefit from payment by the donee. One of the particular issues, which remains unresolved, is the degree of occupation and enjoyment which must be shown by the donee, bearing in mind that, unlike the 1986 Hansard statement, the property concerned does not have to be a main residence. It may be that occupation of each of donor(s) and donee(s) need not be the same in intensity, though perhaps it should be similar in nature.

Similarly, such arrangements escape pre-owned assets by virtue of the exemption in Sch 15 para 11(5)(c). This refers expressly to the exemption from GWR.

This principle would also extend to farming partnership transactions relying on the co-occupation let-out (which assumes, to date at least, an initial transfer of value).

Gifts of cash

A very useful exclusion from the contribution condition was inserted at committee stage, now found in Sch 15 para 10(2)(c). An outright gift of cash made at least seven years before the earliest date on which the donor meets the disposal condition, whether for land or chattels, does not get caught by the new régime.

For example, father gives daughter £300,000 for which she buys a holiday home in north Norfolk. Provided that at least seven years expire before father occupies the home, there is no pre-owned assets issue. Note that if father does occupy, he cannot get out of the problem by paying the appropriate rental value. However, there is a question as to the meaning of occupation, as considered in various contexts in the Inland Revenue Manuals. Therefore occasional or sporadic visits to the property should not present a problem.

Conclusion

Sch 15 will not go away. Professional advisers need to grasp it with both hands now. Even if the adviser does not under some sort of retainer have a duty to advise on past arrangements, the need to preserve good client relationships is likely to mean that all possibly affected files are dug out of the archives and re-examined. Remember that innocent transactions, that is with no apparent inheritance tax avoidance motive, could also be caught. But time is passing. The client will not respond happily to having to pay (as he sees it) a second time for inheritance tax mitigation advice on the same assets. Over to you …

Matthew Hutton will be speaking on the pre-owned assets régime, and the implications for both past arrangements and future planning, at his estate planning conference in London on 15 November (details from mhutton@paston.co.uk).

--------------------

Visit www.brewermorris.com for the best tax opportunities in practice, industry and commerce - alternatively call Matthew Phelps on 020 7415 2815 to discuss your career situation.

Issue: 3978 / Categories: Comment & Analysis