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DESPITE THE HELPFUL clarification and/or generous treatment in some ambiguous areas given by HMRC in their response to the joint paper (COP 10) submitted by The Chartered Institute of Taxation, the Society of Trusts and Estates Practitioners and the Low Incomes Tax Reform Group, it is clear from the paper that a number of difficulties remain in relation to the pre-owned assets income tax legislation. 'Walking the POAT', Taxation, 8 December 2005, page 275 summarises HMRC response.
In this article, I will focus on one area: the question of loans, sales and other disposals of land. All statutory references are to FA 2004, Sch 15 unless otherwise stated.
Basic approach
The draftsman of the pre-owned assets tax legislation has taken the approach that if the two basic conditions are satisfied in relation to land, outlined below, the taxpayer is subject to the tax unless he falls within a specific exclusion or exemption. Unfortunately as we will see, the draftsman has not succeeded in protecting every innocent transaction.
The result is that people who save no inheritance tax can still pay pre-owned assets tax. Since it is an income tax which the taxpayer has to self-assess correctly each year, tax advisers need to know when there might be a problem and advise their clients accordingly. Moreover it is a tax with a long tail. The taxpayer will be unhappy to find that a transaction done in 1987 may now result in him paying income tax based on the open market rental value of a house he occupies.
Land
Paragraph 3 applies when, in any year of assessment, an individual occupies land, whether alone or together with other persons, and either of two conditions is met. The first condition is the disposal condition and the second condition is the contribution condition.
The word occupation is not defined and HMRC have set out in some detail their view of how it is to be interpreted; see the guidance notes of March 2005 and the comments in the COP 10 letter. I would suggest that it requires the taxpayer to use or to be physically present in the property for at least part of the year. Hence more than one property may be occupied. HMRC suggest that if possessions are stored in a property, this constitutes occupation although, presumably, such storage must amount to exclusive use of the property. If I leave a suitcase at my daughter's flat, I can hardly be said to occupy it!
The disposal condition is satisfied if, at any time after 17 March 1986, the individual owned an interest in the land now being occupied or in other property, the proceeds of the disposal of which were applied by another person towards the acquisition of an interest in the land and the disposal is not an excluded transaction. This would not only cover cases where, say, X carves out an Ingram lease for himself and gives away the freehold reversion, it would also cover a situation where X gives Y Blackacre and Y sells Blackacre and buys Whiteacre which X occupies. In these circumstances, X may not pay pre-owned assets tax due to the exemptions in para 11 but prima facie he is within the charge.
The contribution condition is satisfied if, at any time after 17 March 1986, the individual has directly or indirectly provided, otherwise than by an excluded transaction, any of the consideration given by another person for the acquisition of an interest in the land or an interest in any other property, the proceeds of the disposal of which were directly or indirectly applied by another person towards the acquisition of an interest in the land. So if X gives Y cash to buy a house which X occupies, X is caught by pre-owned assets tax unless the cash gift was before 6 April 1998 (see the article in December) or the cash gift was made more than seven years prior to X first occupying the property and is therefore an excluded transaction. The key word to note is 'provided'.
What are excluded transactions? These are contained in para 10 and the most relevant for the purposes of this article are:
- outright transfers (whether gifts or sales) to the spouse;
- arm's length sales at full value of the entire interest in the property;
- an outright gift of money by the individual to another person made at least seven years before the individual occupies the land.
In addition, Regulation 5 of the Charge to Income Tax by Reference to Enjoyment of Property Previously Owned Regulations 2005 gives an exemption from pre-owned assets tax where there is an arm's length disposal of part of an interest in land with an unconnected person, or an arm's length disposal of part of land with a connected person if the disposal was made before 7 March 2005.
Exemptions
Even though a transaction may satisfy the disposal or contribution conditions, pre-owned assets tax may not be payable if the taxpayer falls within one of the para 11 exemptions. The two most important are found in paras 11(1) and 11(3)(5). There is no charge if the property in question is part of the taxpayer's estate anyway for inheritance tax purposes, e.g. he owns it or has an interest in possession in it (para 11(1)). Nor is pre-owned assets tax payable if the taxpayer has reserved a benefit in the property (para 11(3)) or he would have been treated as reserving a benefit in it apart from one of the statutory exemptions. The aim is to ensure that if property is subject to inheritance tax on the taxpayer's death, or would be but for a specific statutory let out given by Parliament, there should be no pre-owned assets charge.
Non-exempt sales
The legislation also caters for sales of the whole interest in the land at an undervalue. It does so by providing that where the whole of an interest in land is disposed of at an undervalue, the annual rent is reduced to take account of the consideration paid. In effect, the intention is to limit the pre-owned assets charge to the undervalue element.
The definition of non-exempt sale only covers sales of the whole interest not sales of part (for any value) and it does not cover exchanges of property but only cash sales. Nor does it protect transactions where the contribution condition rather than the disposal condition is satisfied.
Example 1
X sold for £800,000 land worth £1,000,000; its rental value is £50,000. The intention of the draftsman is that pre-owned assets tax is paid on a taxable benefit of £10,000: i.e. one fifth of the rental value equating to the undervalue element. This is described as the 'appropriate proportion'.
However, in many cases a non exempt sale will involve an element of gift. In these circumstances, the taxpayer is within the reservation of benefit rules if he continues to use the property which he has sold. In Example 1, the gifted element (in value terms) is one-fifth, the same as the appropriate proportion for the purpose of the pre-owned assets charge. It therefore follows that the reservation of benefit (para 11(3)) exemption applies. Hence, in many cases non exempt sales are wholly outside the charge. It might be argued that the para 11(3) exemption is, on its face, limited to cases where there is a reservation of benefit in the relevant property while here the reservation is in part only of the relevant property. But the position is not clear.
Analysis of transactions
How does all this relate in practical terms to the taxpayer who will in due course have to complete his tax return for 2005-06? The easiest way to demonstrate the rather bizarre effect of the rules is by way of a series of illustrations starting with the straightforward gift. Examples 2 to 7 use Rose and Tom who have lived together for some years as co-habitees. They are not connected persons but Rose spends her weeks in London and her weekends in Oxford with Tom.
Example 2: Gifts of cash
In 1999, Rose gave £200,000 cash to Tom. Tom uses all the cash to buy a house in Oxford for £400,000, the rest being funded by commercial borrowing.
For inheritance tax purposes, Rose makes a potentially exempt transfer. It is accepted by HMRC that there is no gift with reservation on the cash gift provided the gift to Tom is not conditional on him buying house. The tracing provisions do not apply (see FA 1986, Schedule 20 para 2).
For pre-owned assets purposes, the contribution condition has been satisfied. Rose has provided consideration for Tom which is used by him to fund the purchase. It is not an excluded transaction because the gift was after 5 April 1998 and she occupied the Oxford house within seven years of the cash gift. Rose pays income tax on half the market rent since half the purchase price was funded with her contribution.
Note that even if Rose and Tom have subsequently married, this does not then protect the transaction. Rose still pays pre-owned assets tax. Hence the diligent accountant must ask his clients whether they gave cash to a spouse for the purchase of a house prior to the date of any marriage and, if so, when.
Example 3: Gifts of cash — joint purchase
In Example 2, the pre-owned assets problem arises because Rose has satisfied the contribution condition and does not fall within any of the exemptions or exclusions. Contrast the position in Example 3 if the property is jointly purchased.
Rose gives £200,000 cash to Tom. Rose and Tom then buy a house jointly for £400,000 two years later and share occupation.
The gift of cash by Rose is a PET. There is no reservation of benefit on the principles outlined above.
In contrast to Example 2, it is thought that there is no pre-owned assets charge provided that Tom continues to occupy the house with Rose. The wording in para 11(8) is very unclear but appears to require one to assume that Rose has in fact given an undivided share in land to Tom, otherwise the reference to (c) in para 11(8) would have no meaning. Hence if donor and donee are in joint occupation, they are protected from the charge because they are deemed to satisfy the co-ownership exemption within FA 1986, s 102(B)(4).
Example 4: Gifts of land — whole house
Rose gives the whole house she owns to Tom and they both occupy it.
This is clearly a gift caught by the reservation of benefit provisions. Therefore there is no POA charge because Rose is protected under para 11(5)(a).
Example 5: Gifts of land — share of house
Rose gives a share of a house she owns to Tom and they both occupy it.
There is a gift for inheritance tax purposes but, while Tom occupies with Rose and pays no more than his share of the expenses, there is protection from the reservation of benefit provisions under FA 1986, s 102B(4) (co-ownership exemption). If Tom moves out, a reservation of benefit will arise.
While Tom is in occupation there is no pre-owned assets charge because para 11(5)(c) confers protection: the disposal satisfies s 102B(4). If Tom moves out, there is still no charge because Rose is protected under para 11(5)(a) — she is caught by the reservation of benefit rules so there is no need to charge her to income tax as well.
All of this has a certain logic and is in keeping with the principle that pre-owned assets tax should only be payable where inheritance tax is being avoided contrary to the intention of Parliament.
In Example 6, it would appear to make no difference whether Rose and Tom share occupation or own the property jointly. Nor technically would it assist the position if Tom repaid Rose or they later married. She has still satisfied the contribution condition. Note also that loans made since 17 March 1986 could be caught, since loans are not outright cash gifts and therefore could never come within the seven year exclusion in para 10(2)(c).
Is the tax adviser going to have to ask all his clients whether any loans were made between members of the family including loans between husband and wife prior to marriage? Why does HMRC want to tax such transactions even if the loan is interest free? The loan is taxed as part of Rose's estate on her death. If the loan is written off by Rose (which is presumably what worries HMRC), the pre-owned assets tax legislation may be wide enough to catch such a transaction already or, if not, could easily be amended.
In the interests of self assessment, the hope is that HMRC modify their current position. Loans are common not only between cohabitees but between other family members. Take for example the elderly mother who lends cash interest free and repayable on demand to her daughter to buy a house in which the daughter and her family live and Mum later moves in. The loan is taxed on Mum's death. Why should Mum also have to pay pre-owned assets tax while she is alive? It is hard to see why this transaction should be taxed so much more adversely than Mum giving a share of her house to her daughter with everyone in joint occupation. The latter saves inheritance tax and avoids pre-owned assets tax!
Example 6: Loans
Rose lends cash to Tom and Tom buys a house for Rose and Tom to live in.
There is no inheritance tax event assuming the loan is repayable on demand. The value of the loan is an asset of Rose's estate and subject to inheritance tax on her death.
HMRC take the view that the contribution condition may have been satisfied because a loan constitutes the provision of consideration and therefore pre-owned assets tax is due. The COP 10 letter suggests that both commercial loans and interest free loans are caught. Has Rose in fact 'provided' anything within the meaning of the contribution condition? In the context of other income tax provisions such as the old Part XV settlement provisions, 'provide' has been held to connote some element of bounty; see CIR v Leiner 41 TC 589 and CIR v Plummer [1979] STC 793. On that basis, if the loan is commercial, no bounty has been given.
If Rose's loan is interest free, is the provision of funds the whole loan or merely the interest free element? Or could one argue that nothing has been provided by Rose as such since it is Tom who provides the consideration by his promise to repay Rose? At present, HMRC certainly seem to consider that interest free loans are caught. Securing the loan on the property does not in their view mean the loan derives its value from the land and hence Rose is not protected under para 11(1).
Sales
The position on sales at an under value or sales of part is complex and is demonstrated in Example 7.
Example 7: Sales
Rose sells part of her house to Tom.
If the sale is at full value, there is no inheritance tax issue. There has been no diminution in Rose's estate and, since there is no gift, the reservation of benefit provisions are irrelevant.
For pre-owned assets purposes, if the sale is at full value it is protected under Regulation 5 since cohabitees are not connected persons. If, however, Rose was Tom's mother and the sale took place after 6 March 2005, pre-owned assets tax is payable even if Rose retains the cash and pays tax on the interest from it. This is because they are connected persons.
If the sale is at an undervalue, the position is more difficult. For inheritance tax purposes, a sale at an undervalue involves some element of gift and therefore potentially a reservation of benefit. Arguably the reservation of benefit is in the undervalue element only rather than in the whole property (see HMRC manual which adopts this approach) although this is open to question. One might then say that such a disposal of part is protected from a reservation of benefit under FA 1986, s 102B(4) (co-ownership protection) while Tom is in occupation because Rose has disposed of a share in land and they both occupy it.
For pre-owned assets purposes, there should be no income tax charge on the element of undervalue if it is subject to a reservation of benefit as a gift or would be but for the co-ownership protection. See paras 11(5)(a) or (c). However, pre-owned assets tax is arguably payable on the cash received by Rose whether or not she retains such cash. The non-exempt sale provisions do not apply to sales of part and the basic disposal condition is satisfied. So the position is the exact opposite of Example 1 (sales of whole at an undervalue).
Unnecessary tax
The above are common transactions. They are not often done for inheritance tax reasons but to facilitate living arrangements between members of the family. Accountants will not relish telling such clients about an income tax liability in respect of a transaction done many years ago. In the writer's view the Government urgently needs to review the policy in this area.
Emma Chamberlain is a barrister at 5 Stone Buildings, Lincoln's Inn, London WC2A 3XT, tel: 0207 242 6201, e-mail: emma@jmchamberlain.freeserve.co.uk. She is co-author with Chris Whitehouse of Pre-Owned Assets and Tax Planning Strategies, 2nd edition, published by Sweet and Maxwell in December 2005.
