Given the sharp increase in property prices over recent years, many people find that the increased value of their family home prompts them to consider inheritance tax mitigation. This is especially true if the nil-rate band (which increased from £255,000 to £263,000 from April this year) falls far short of the value of their home. Clients often do not wish to part with other assets that provide them with an income so wish to attempt inheritance tax mitigation using the family home.
Inheritance tax was introduced through the Inheritance Tax Act 1984 replacing transfer tax. The Gift with Reservation (GWR) rules (The Finance Act 1986) prevent assets from falling outside an individual’s estate for inheritance tax purposes where the individual continues to benefit from those assets gifted. Gifts caught by these GWR rules may not be effective for inheritance tax mitigation purposes. If the reservation of benefit ceases, the gift becomes a potentially exempt transfer (PET); if the individual then survives a further seven years then the asset will fall completely out of their estate for inheritance tax purposes.
Various schemes have been available to shield the family home from inheritance tax while allowing the donor to continue in occupation, thus avoiding the GWR problem.
However, in a press notice issued on 10 December 2003 together with the Chancellor’s pre-budget statement, an intention was announced to attack schemes where individuals have disposed of assets but continue to enjoy the benefit of ownership. In his eighth budget last month, the intention to legislate within the Finance Bill 2004 was confirmed so that “income tax will be charged on the benefit people get when they have arranged free (or below market rent) continuing use of assets they once owned or provided the funds to purchase”.
The Inland Revenue’s attack concerns “pre-owned assets”. Anyone who gets a benefit of a previously owned asset (free of charge or below market rent), or where they provided the funds to purchase, will be affected. Where the family home is a pre-owned asset the charge to income tax will be made under Case VI of schedule D, which will be the market rent for the property. This will also affect replacement assets. There will be a set-off for rent actually paid. There are exclusions for incidental use, express reservation of a right to continue to use (occupy) and there will be a “substantial” de minimis of £2,500 per annum exemption. This new ‘pre-owned asset’ tax does not apply if the transaction was to an unconnected party and was an arm’s length bargain.
This new tax will be retrospective in effect. It will affect all schemes where they were created after 18 March 1986. Expensive and elaborate schemes may well have been created, incurring stamp duty charges and possibly capital gains tax (CGT), and it could well be that these schemes will now be caught by the new legislation.
The Ingram-style arrangements, where the donor carves out a lease for himself and gifts the freehold, were hit by anti-avoidance legislation in 1999. However, where schemes were successfully set up the lease remains in the taxpayer’s estate and is fully chargeable to inheritance tax on the donor’s death. Existing schemes such as this could still work if the donor owns the lease for at least seven years and continues to occupy the property as a result of that pre-existing right prior to the gifting of the freehold. But since the scheme will take at least 14 years, the donor could be subject to an income tax charge and will need to consider whether to pay a market rent (or elect for the GWR rules to apply).
One particular scheme which is commonly known as the ‘debt scheme’ involves the donor creating a life interest for themselves in the property. The home is then sold to the trustees at market value using an interest-free loan to the trustees, which is charged against the home and repayable on demand. The donor occupies the property and pays all outgoings. A second trust is then created for the donor’s chosen beneficiaries (not including themself) and they gift the debt to that trust as a PET. As the gift is only the debt there is no gift with reservation. Where the home (or any replacement) is the donor’s main residence there will be no CGT. Only any increase in the value of the home against the debt will remain in the estate and be subject to tax. It is believed that the intention of the changes were certainly to attack this type of scheme, although it remains unclear if the pre-owned assets will include ones in which an individual had an interest in possession or whether this will be accepted as an express reservation and caught by
pre-existing anti- avoidance provisions.
Where an income tax charge does arise retrospectively on an existing scheme, what are the clients’ choices?
- Pay income tax on the market value of the pre-owned asset as from 6 April 2005?
- Pay market rent?
- Unscramble the arrangement?
- Elect for the gift with reservation of benefit rules to apply?
The answer will depend upon the individual circumstances of each case.
It will be necessary for clients to calculate the likely income tax charge. If it is too high, then they will need to see if the arrangement can be unscrambled, maintaining if possible the tax advantages. This could be very difficult with some trust arrangements. If it cannot be unscrambled then it may be necessary to elect for GWR to apply to that asset by 31 January 2007 (this means essentially the purpose of the scheme would have failed and inheritance tax would become payable on the asset). Unfortunately, where people have opted for such schemes and incurred stamp duty and/or possibly CGT, these monies will not be reclaimable.
There has been massive objection to these proposals. And because the draft legislation is not yet published, there remains some uncertainty about the actual scope of the new income tax charge. Clients should review their arrangements once the detail of the legislation is available.
In the meantime, clients now looking to mitigate against inheritance tax on the family home should be very cautious and avoid sophisticated tax planning.
There are still some schemes that can help save inheritance tax. Consider the following:
- Split occupation: the property could be converted into flats or some form of separate dwelling. This could create inheritance tax savings and the GWR rules may not apply.
- Move home: a larger property could be sold, a smaller one purchased and the proceeds gifted away.
- Share occupation: a child caring for an elderly parent could acquire a share in the home without the GWR rules applying.
- Outright gift: the property could be gifted away and market rent paid (and reviewed).
- Offshore considerations: certain offshore trusts borrowing on the property may still be effective and worth consideration.
- Wills: most importantly, clients should make sure that their wills are up to date and seek professional advice (essentially the use of nil-rate band discretionary trusts) to ensure maximum inheritance tax saving on death.
Individuals’ circumstances vary. Clients must be warned that schemes are undertaken as the law stands at the time. Future changes in the law may affect their validity for tax mitigation.
Penny Catterick is a solicitor in the tax trust and probate department of Bevan Ashford