Charity begins at home

MALCOLM GUNN FTII, TEP of Haarmann Hemmelrath discusses the impact of the pre-owned assets charge on three cases.

GORDON BROWN'S VISIT to Africa some while ago to announce his charitable efforts on behalf of that continent made headline news at the time, and rightly so. Those in Government have a clear duty to show sensitivity and compassion for all those upon whose lives their actions may have an impact, and to proceed in a spirit of reasonableness and respect for their fellow citizens.

Agnes

Agnes unfortunately does not live in Africa; she lives in the United Kingdom. I have acted for her for about 25 years and she is now well into her 90s. I have not dared to tell her how her income tax problems are about to become impossible, and there is virtually nothing she can do about it.
Agnes is a very cautious lady. From time to time, as her tax adviser, I have mentioned tax planning devices which she might like to consider, but they were all rejected on the basis that she would not want to go in for anything which might be considered dubious or which might be attacked by the Government.
What she did do, however, many years ago, was a type of Ingram scheme in relation to her flat. This is the only property she has and it is now worth something like £600,000. What Agnes agreed to do was to grant a reversionary lease to her son, with the timing being broadly sufficient to enable her to stay in the property for the rest of her life. This of course is not the precise scheme which was examined by the House of Lords in the Ingram case, but the effect of it is broadly the same.
As we all now know, the House of Lords had no problem at all with this kind of arrangement. Counsel for the Revenue claimed 'the high moral ground' according to Lord Hoffmann, but he saw no reason at all why people should not be permitted to do as Lady Ingram had done. It was not correct, as the Revenue claimed that 'it simply must be contrary to the policy of the statute for a donor to be able to give away property such as a house and go on enjoying the benefit of the property by continuing to live there'. Far from it; the policy of the statute was that 'it requires people to define precisely the interest which they are giving away and the interests, if any, which they are retaining. Once they have given away an interest, they may not receive back any benefits from that interest'.
It is relevant to point out that the gift with reservation provisions go back as far as the Customs and Inland Revenue Act of 1889 and so it is a bit rich for HMRC to allege, 110 years later, that everybody had been misunderstanding them and misusing them. It is not all that clear why HMRC suddenly decided that this was the case after such a long lapse of time, but it seems highly likely to me that it has little to do with the high moral ground, and much more to do with the decision taken by the Government not to raise the basic rate of income tax, thus giving itself unending financial problems which are causing stresses throughout the tax system.
The pre-owned assets legislation introduced in FA 2004, Schedule 15 was the evidence for one of the pressure points. Dawn Primarolo said in the standing committee debates that 'we are concerned specifically with the range of schemes that allow wealthy taxpayers to give their assets away, or achieve the appearance of doing so, and so benefit from the inheritance tax exemption for lifetime gifts, while in reality retaining continuing enjoyment of and access to those assets, much as before'. She later continued in the following terms: 'the Government wanted to send a clear message that artificial avoidance of that kind is not acceptable'.
Going back to my thoughts about the Government having sensitivity and respect, I have to say that I have the utmost difficulty in reconciling those remarks in the House of Commons with the judgment of Lord Hoffmann five years previously in the House of Lords. In fact, one has to conclude that the Government fundamentally disagreed with Lord Hoffmann's remarks about the policy of the gift with reservation provisions. Nevertheless, the Ingram judgment set out what the law is in the United Kingdom and the Government is free to change it, but I would suggest that it is not free to disagree with it.
Going back to Agnes, as a result of the pre-owned assets legislation she now faces an annual income tax charge on the benefit of staying in her property which is not far short of the market rent of it, which is £25,000 a year. This will produce an income tax liability for Agnes of at least £5,500.
Unfortunately Agnes's only income is £16,000 (although it has its complications, hence my involvement). On my last visit to her, I did not dare to tell her that financial Armageddon is looming. She is frail and elderly and, although in remarkable health, the worry would be too much for her. I came away, hoping to find a solution to the problem.
No doubt the Government would be quick to point out that it has provided a way out for Agnes. All she needs to do is to elect back into the gift with reservation provisions and the problem will melt away like mist in the morning sun. Unfortunately, that leads to even worse financial Armageddon. The son's capital gains tax base cost for the property is exceedingly low and so electing back will basically mean that the whole value of the property will be taxed twice over, once to inheritance tax when Agnes dies and then also to capital gains tax when the son sells it. Such a result is clearly ridiculous and, as her tax adviser, I cannot put it forward as a serious solution.
She could pay rent to her son so as to benefit from the full consideration exemption at Sch 15 para 5(d). But how would she do that on an income of only £16,000? The son could agree to leave the rent outstanding as a loan, but the chances are that there will be no deduction for any such loan on the death of Agnes owing to the provisions of FA 1986, s 103 and the son would have £10,000 of income tax to pay without the money to pay it. In other words, each year's rent will lead to total tax of 80% being due on it. Would the Revenue accept that full consideration has been given if all it amounts to is an IOU? Undoubtedly not, as a commercial landlord would impose stringent terms on a tenant who failed to pay rent. So this idea is fraught with problems.
There is much talk of the benefits of the donee putting a property back in trust for the donor for life, and then reverting to the donee. Trusts of this type have various benefits under the capital gains tax and inheritance tax provisions. However, there is no way of avoiding the capital gains tax cost of setting up the trust as there is no longer any holdover relief to a settlor-interested trust. Setting up the trust in these circumstances will therefore incur a very substantial capital gains tax bill and there is no money available to pay it. That therefore is not an available option, and in any event we read in the standing committee debates on Schedule 15 that the Government wanted to send a clear message that artificial avoidance is not acceptable. If that which the House of Lords considered to be entirely within the policy of an 1889 statute is described by the current administration as artificial tax avoidance, what are they thinking about those who adopt the statutory revertor to settlor trust reliefs?

Archie

Now consider for a moment the position of Archie whose scheme was far more artificial. He gave the works of art in his stately home to his son but they are still hanging on the walls at home. There is a procedure which you follow under the Bills of Sale Act 1878 to achieve this. To avoid the gift with reservation of benefit provisions, Archie pays a rent to his son at the rate of 1% of the value of the works of art, this being full consideration according to the expert opinion of a professional firm of valuers. This arrangement was another planning device which was firmly in the sights of Schedule 15, and indeed Dawn Primarolo referred to it in response to a point that people would not be able to avoid the 5% charge on chattels. She said this would be an issue only if they do not elect to pay inheritance tax.
Unfortunately, once again she got the law wrong. Para 11(5)(d) of Schedule 15 contains an exemption for cases where full consideration or the use of an asset is being paid, and that is what Archie's valuers say he is doing. HMRC may disagree, but even if they do, there is still no question of Archie electing to pay inheritance tax. He has either made a gift with reservation and is caught anyway, or alternatively he is paying full consideration and is not therefore caught by any of the provisions.

Andy and Paula

Next there are Andy and Paula, a couple in their 40s who have a chain of shops throughout Surrey. The business has been relatively successful and, as Andy is not all that taken with stock exchange investments, he decided to invest his surplus profits in a let property. At the same time he wanted to do some estate planning. So an Eversden trust seemed ideal for him and it was set up about three years ago. Paula's interest in possession lasted for six months and the trust is now in its discretionary period with Andy receiving the rental income. Despite Andy's obvious reservation of benefit in the trust, it is not caught by the inheritance tax gift with reservation provisions, nor for some bizarre reason is it caught by Schedule 15. It would have been caught if he had preferred to invest on the stock exchange, but by some lucky fluke he wanted to invest in a let property and so has no tax liability under the pre-owned assets régime.

Further thoughts

I must say, I cannot fathom why Agnes has been singled out for punishment under the pre-owned assets régime, whereas Archie, Andy and Paula all escape scot-free. Agnes does have some savings, but not only will it alarm her to learn all of a sudden that her annual income tax liability is rising to a figure which is not far short of 50% of her income, but also it will distress her to use her savings to pay her annual income tax bill.
The pictures of Gordon Brown in Africa were very charming, but here at home I am struggling to see how the pre-owned assets régime shapes up to the principles of sensitivity and reasonableness which one would expect to see from a civilised Government. Agnes was never a tax avoider. She did no more than that which the House of Lords said she was quite entitled to do and she should therefore have been treated with respect, not with disdain.        
Malcolm Gunn is a tax consultant with Haarmann Hemmelrath where he provides a consultancy service to other professional firms. He can be contacted by telephone on 020 7382 4862 or by e-mail at Malcolm.Gunn@haarmannhemmelrath.com.

Issue: 4018 / Categories: Comment & Analysis