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2 - Inheritance Tax Mitigation: The Basics
Chapter 2
Inheritance Tax Mitigation: The Basics
Overview of the Chapter - and the Subject
2.1
In 1986 IHT replaced Capital Transfer Tax (CTT), which itself had taken the place of Estate Duty in 1975. Estate Duty was primarily a death duty, but also caught certain lifetime gifts made within seven years before death (as indeed does IHT). The introduction of CTT sent shockwaves through both the professions and the public at large, in combining a genuine lifetime gifts tax with a death duty, together with a comprehensive regime for taxing discretionary trusts. However, the introduction of the potentially exempt transfer (PET) with IHT in 1986 went some way to mitigating the burden of the gifts tax. That year saw also the introduction of the reservation of benefit (GWR) regime, a revival from Estate Duty, in an attempt to prevent a taxpayer in making a lifetime gift from ‘having his cake and eating it’.
A variety of successful attempts to get round those GWR rules, as upheld in the courts, led to some piecemeal tinkering with the regime before the introduction of the pre-owned assets (POA) income tax from 2005/06. The POA regime imposes an income tax charge on donors of land, chattels or settled ‘intangibles’ who had managed successfully to circumvent the GWR rules while still enjoying a benefit from the asset given away. And then, in 2006, what was presented as the ‘Inheritance Tax Alignment for Trusts’ was in substance a concerted attack on both non-discretionary trusts existing at 22 March 2006 and new lifetime trusts, by making it generally rather more expensive in IHT terms to hold assets in trust than to hold them beneficially. While the full consequences of this are still becoming clear as the impact of FA 2006 works its way through the system, the new regime quite evidently does not spell the death of trusts (as explored in Chapter 4).
This core Chapter of the Book surveys in brief the avenues down which a person wishing to mitigate the burden of IHT might walk, most of those topics to be expanded in subsequent Chapters. First, however, it is worth saying something about the scheme of IHT as a whole as we now have it in IHTA 1984 (renamed in 1986 from the original Capital Transfer Tax Act 1984) and, for the GWR regime, FA 1986. IHT having been introduced as a ‘new’ tax, albeit subject to some subsequent amendments, the scheme of the Act generally follows a fairly logical order.
The main charges and definitions
2.1.1
IHT is charged on the value transferred by a ‘chargeable transfer’ (IHTA 1984 s1), which is a ‘transfer of value’ made by an individual except an ‘exempt transfer’ (IHTA 1984 s2(1): see 2.1.4 and 2.2). A transfer of value is a disposition made by a person which causes the value of his estate immediately after to be less than the value immediately before the disposition (IHTA 1984 s3(1)) but, in this, no account is taken of ‘excluded property’ (IHTA 1984 s3(2)).
Excluded property is, generally, (a) property situated outside the UK owned by someone domiciled outside the UK , both under the general law and for IHT purposes (IHTA 1984 s6(1)); (b) a reversionary interest (except where owned by the settlor or his spouse/civil partner) to the type of life interest in a settlement which is taxed as if the beneficiary owned the underlying property - a so-called 'estate' interest in possession (IHTA 1984 s48(1)); and (c) property in a settlement situated outside the UK where the settlement was made by someone domiciled outside the UK for IHT purposes when made (IHTA 1984 s48(3)). That is, if you like, the territorial limitation on the operation of IHT.
TAX TIP: An individual who is prospectively entitled under a settlement, that is on the death of the current beneficiary who has a qualifying interest in possession, could give away his interest under the settlement with no IHT consequences (even if he were to die the following day, ie as excluded property he will not have made a PET). Nor indeed will there be any CGT implications, assuming the settlement has always been UK resident and he did not acquire his interest for value (TCGA 1992 s76).
Accordingly, the tax looks for chargeable transfers, whether made during lifetime or on death, and taxes them. However, there is a significant category of lifetime chargeable transfers, as PETs, which are transfers of value (of whatever amount) made by an individual to another individual, or into a trust for a disabled person, which are assumed to be exempt when made and do not become chargeable except in the event of the transferor’s death within seven years (IHTA 1984 s3A). Such treatment was, before 22 March 2006, also extended to a gift into trust in which an individual had a right to income (interest in possession) – called a ‘qualifying interest in possession’, the legislative expression for an 'estate' interest in possession - or into a favoured accumulation and maintenance trust for children (see 2.3.3(b)).
In the case of a chargeable lifetime transfer, whether immediately chargeable, eg a gift into trust (generally, of whatever kind on or after 22 March 2006) or a PET which becomes chargeable by reason of death within seven years, the rate of tax charged will be 40% unless the amount of the chargeable transfer falls within the transferor’s nil-rate band (£312,000 for 2008/09), in which case the rate will be 0%. The rate of IHT on an immediately chargeable lifetime transfer is 20% to the extent that it exceeds the nil-rate band as reduced by chargeable transfers made within the previous seven years (IHTA 1984 s7). If death follows within seven years of this new chargeable transfer the rate is increased to 40%, with a credit for any tax already paid. The nil-rate band is given according to the order of gifts within a seven year period. In the case of gifts made on the same day it is allocated pro rata.
Example 2.1
For the last ten years Belinda has paid premiums of £3,000 per annum on a life policy on her life written in trust for her family. This makes use of her £3,000 annual exemption in each year. On top of that she has made gifts as follows:
• on 1 January 2003 £100,000 to her daughter (with no chargeable transfers in the seven years before that). This was a PET and even if Belinda dies within the next seven years will not attract IHT;
• on 1 January 2005 £300,000 into an accumulation and maintenance settlement for her grandchildren. Again, this was a PET when made. Provided that Belinda dies at a time when the nil-rate band is no less than £300,000 (the sum of the gift to the daughter and the gift to the A&M trust) there will be no further IHT to pay; and
• on 1 January 2007 £100,000 to her son. Again, this is a PET, but should Belinda die when the combined total of that plus chargeable transfers made in the previous seven years exceeds the then nil-rate band, for example on 1 October 2008 (tax year 2008/09, when the nil-rate band is £312,000), the excess viz £188,000 will attract IHT at 40% of £75,200. This assumes that the IHT is paid by Belinda’s son. If in fact it is paid by Belinda’s executors, this will be treated as a further gift by her and will have to be ‘grossed up’ to find the IHT payable.
TAX TRAP: A PET which becomes chargeable on death within seven years may trigger IHT which could have been avoided if there is a surviving spouse/civil partner, by letting the value in excess of the nil-rate band fall into exempt residue and having the survivor make a PET in the hope of survival for seven years. The moral: always when planning a PET consider the impact of death within the following seven years.
Death
2.1.2
On death the deceased is treated as if immediately before he died he had made a transfer of value equal to the value of his estate immediately before his death (IHTA 1984 s4(1)). The estate includes all the property to which he is beneficially entitled (IHTA 1984 s5). This will include certain, but not all, interests in possession under a trust (see 2.1.6). Liabilities may be deducted provided either they were imposed by law or were incurred ‘for a consideration in money or money’s worth’. Such a deemed transfer of value on death may be exempt, for example on passing to a surviving spouse/civil partner or to charity, or it may be chargeable. If chargeable it may be subject to a relief at either 50% or 100% for qualifying business and agricultural property or, to the extent that the chargeable value exceeds the prevailing nil-rate band (£312,000 in 2008/09), it will attract tax at 40%. Any balance of the nil-rate band not taken up by chargeable transfers made in the seven years before death will reduce the IHT otherwise attracted by chargeable transfers on death. Where with a married couple or registered civil partnership all or part of the nil-rate band on the first death is unused, the unused proportion can augment (up to 100%) the nil-rate band on the death of the survivor after 8 October 2007 (see 18.4.3).
A 2008 Special Commissioner’s case considered the impact on the valuation of minority holdings in two companies of rights over those shares (Executors of McArthur deceased v HMRC SpC 700). Mr McArthur had made loans to the companies and had received an option to convert the loans to £1 ordinary shares at par as a substitute for repayment in cash. The loans were repayable on demand, but Mr McArthur had neither demanded the loans nor exercised the conversion options by the time of his death. Had he chosen to exercise the options immediately before his death, he would have had a majority holding in the companies, neither of which was eligible for business property relief. The executors argued that the options had ceased to exist at Mr McArthur’s death, or if they had not, that there should be a discounting effect on valuation. Special Commissioner J Gordon Reid QC, agreeing with HMRC, held that the loans and related conversion rights or options were valid, subsisting and enforceable immediately prior to the death; there was more than sufficient evidence in the books and records of the companies to prove the existence of the loans and conversion rights. By way of comment, presumably had Mr McArthur exercised either option at a time when the shares were worth more than par, he would have enjoyed an immediate increase in the value of his estate. Further, had the point been spotted before his death and the options terminated, there would presumably have been a chargeable transfer at that point. I do not know if the case is going to appeal, but there is an obvious moral in terms of ensuring that there are no such arrangements between a shareholder and the company or, if there are, that the tax analysis has been thought through. [24 October 2008]
Dispositions which are not transfers of value
2.1.3
There are some dispositions which on the ‘estate before less estate after’ principle reduce the estate but are not transfers of value, viz.:
• those not intended to confer a gratuitous benefit, provided either they were made in a transaction at arm’s length between unconnected persons (eg a ‘bad bargain’ to other than a member of the family) or they were such as might be expected to be made in an arm’s length transaction between unconnected persons (IHTA 1984 s10);
• dispositions for the maintenance of the family (IHTA 1984 s11). A member of the family includes a spouse/civil partner, an ex-spouse/civil partner and a child (including a step-child and an adopted child). A disposition will not be a transfer of value if made to a spouse/civil partner or a child of the transferor or spouse/civil partner which is either for maintenance or, where for a child, for maintenance, education or training up to the age of 18 or later cessation of full-time education or training. The disposition may take the form of a transfer of capital (see 13.2.1 and McKelvey v HMRC (2008) SpC 694);
• a waiver of dividends within twelve months before the right accrues (IHTA 1984 s15);
• the grant of an agricultural tenancy in the UK, Channel Islands or Isle of Man if for full consideration in money or money’s worth (IHTA 1984 s16); or
• certain post-death variations or disclaimers or transfers on ‘precatory trusts’: see 2.14 and Chapter 19 (IHTA 1984 s17). So, for example, a written variation or disclaimer by the original beneficiary of an inheritance under a Will or an intestacy, made within two years after the death, is treated as if it were made by the deceased under his Will (IHTA 1984 s142).
Exempt transfers
2.1.4
The basic lifetime exemptions are dealt with at 2.2: viz. the £3,000 annual exemption, the £250 small gifts exemption, normal expenditure out of income and gifts in consideration of marriage. The two main exemptions which apply to both lifetime gifts and gifts on death are as follows:
• transfers between spouses/civil partners (IHTA 1984 s18). Where the transferee spouse/civil partner is, but the transferor spouse/civil partner is not, domiciled in the UK for all IHT purposes (see 15.3 and 16.4), the exemption is limited to £55,000, on, in effect, a seven year cumulative basis. Where the transferee spouse/civil partner is, but the transferor spouse/civil partner is not, domiciled in the UK for all IHT purposes (see 15.3 and 16.4), the exemption is limited to £55,000, on a lifetime basis; and
• the charities exemption, which depends on the definition in the Income Tax Acts, broadly a UK registered charity (IHTA 1984 s23 and s272).
There is also a minor exemption for both lifetime gifts and gifts on death to gifts to political parties (IHTA 1984 s24). To qualify, at the last General Election, either at least two members of the party must have been elected to the House of Commons or one member elected and not less than 150,000 votes cast for candidates who are members of the party.
Certain transfers of value are ‘conditionally exempt’, broadly of national heritage property or where such property is offered in lieu of IHT or CGT (IHTA 1984 s30-s35A). This is considered in more detail in Chapter 14: see also 2.11 for a summary.
There is a complete exemption from IHT for the estate of a member of the armed forces who dies on active service against an enemy – or from a wound inflicted, accident occurring or disease contracted at that time (IHTA 1984 s154). Traditionally, the exemption is construed favourably by HMRC (in relying on an assessment from the Ministry of Defence) and there is no time limit on the period elapsing between the date of the wound, accident or disease and the death.
Reliefs
2.1.5
A transfer of value may be a chargeable transfer, though in computing the value transferred may attract a relief. The principal reliefs (whether given at 100% or at 50%) are for qualifying business and agricultural property, considered at 2.5, in summary and at 6.2 and 7.2 in more detail (IHTA 1984 ss103-113B for business property relief (BPR) and ss115-124C for agricultural property relief (APR)).
A very limited deferral relief is given to woodlands insofar as they do not attract relief as agricultural or business property (IHTA 1984 ss125-130): see 7.4
A relief called informally ‘quick succession relief’ or QSR is given where property is subject to two or more chargeable transfers within a five year period (IHTA 1984 s141), the second or latest transfer occurring usually on death. In that event the tax chargeable on the second transfer is reduced by a percentage of tax charged on the first, on a sliding scale depending upon the period elapsing between the two transfers: see 18.1.2.
A particular relief (albiet not expressed as such) is given on post-death events (considered in more detail at 2.14.2 and in Chapter 19). For example, where a Will creates a ‘relevant property’ trust, an appointment by the trustees within two years after the death escapes the normal ‘exit’ charge (IHTA 1984 s144).
Relief may be given under a double tax treaty or, as ‘unilateral relief’, where in the absence of a treaty tax similar to IHT is charged on the asset in that jurisdiction (IHTA 1984 ss158 and 159).
Settlements
2.1.6
There are two main regimes for settled property, with a third, minor, regime, all of which are discussed at 2.3 and in more detail throughout Chapters 3 and 4. The first is the ‘relevant property’ regime, which was introduced by CTT for discretionary trusts in 1975. The trust is treated as a separate taxpayer and suffers ten year anniversary charges at up to 6%, with a system of exit charges on the withdrawal of capital between ten year anniversaries. Second, the ‘section 49 regime’, which applies to all interest in possession trusts made before 22 March 2006 but only to certain interests in possession arising since that date, treats the beneficiary as absolutely entitled to the trust fund (IHTA 1984 s49(1)): hence, the professionally colloquial term ‘estate interest in possession’. That means that, for example, on death of the beneficiary the trust property in which he has had a right to income is added to his free estate, and a single ‘estate rate’ is calculated, to be applied separately to the free estate and the settled estate (subject of course always to exemptions such as the spouse/civil partner exemption). Third, introduced by FA 2006 with the demise of the accumulation and maintenance trust, is the ‘age 18-to-25 trust’ for children (or in certain cases grandchildren) of the settlor which has its own charging regime similar to the relevant property exit charges.
Anti-avoidance
2.1.7
With the introduction of IHT in 1986 came the ‘reservation of benefit’ or ‘GWR’ rules, inherited from Estate Duty (FA 1986 s102 and Sch 20). In broad terms, if when a person dies he is enjoying a benefit from something he has given away since 18 March 1986, that asset is treated as forming part of his chargeable estate. If the benefit ceased during his lifetime he is treated as having made a PET, so that if more than seven years elapsed after the cessation of benefit there are no IHT implications. If the benefit ceased within the seven years before his death, it is treated as a chargeable lifetime transfer. See 2.13.1.
Following well-publicised successful attempts by taxpayers to devise ways around the GWR regime, such that they would continue to enjoy the benefit of the gift while having made an effective transfer for IHT purposes, the draconian pre-owned assets (‘POA’) regime was introduced from 2005/06 (FA 2004 Sch 15). The charge applies where (subject to certain exclusions) a person enjoys some benefit from land or chattels which he has given away and which do not form part of his estate either under general principles or under the GWR rules. In that case, subject to an annual de minimis of £5,000 of value per taxpayer, the value of the benefit attracts income tax each year. A POA charge also arises where an intangible asset (eg cash or shares) is comprised in a settlor-interested trust. There is then an annual income tax charge on 6.25% (for 2008/09) of the market value of the trust property. See 2.13.2 for more detail.
The Basic Lifetime IHT Exemptions
2.2
The principle
2.2.1
If a gift (or, technically, a ‘disposition’) is exempt when made, it does not matter, in IHT terms at least, that the donor dies within the following seven years – or even a day later. Note, incidentally, that to be effective the gift must be ‘perfected’, that is if made by cheque the cheque must have been cleared (Curnock (Curnock’s personal representative) v CIR [2003] SSCD 283 (SpC 365)). Two of the exemptions mentioned below, those for gifts to spouse/civil partners or gifts to charities, apply whether the gift is made during lifetime or on death. But most of the exemptions apply only to lifetime gifts: once the prospective donor has died, it is too late. The first exemption (potentially exempt transfers or PETS) is conditional on survivorship for seven years, whereas the following ten are absolute.
Exemptions should be distinguished from ‘reliefs’, especially for qualifying business or agricultural property (see 2.5): an exempt gift is not a chargeable transfer, whereas a gift of qualifying business or agricultural property is a chargeable transfer, albeit reduced to either 50% or nil.
Potentially exempt transfers (PETs)
2.2.2
The scope of the PET regime was dramatically cut down by Budget 2006, as no longer can a PET be made into a trust (other than a trust for a disabled person). However, in broad terms, a gift to an individual which he survives for seven years is IHT exempt, whatever the amount (IHTA 1984 s3A). If he dies within the seven year period the gift is chargeable. The nil-rate band is attributed to gifts made in the seven years before death according to the order in which they were made (after of course having knocked off any exemptions).
Tapering relief is available if death follows at least three, but less than seven, years after the gift:
Years between transfer and death Percentage of full tax rate
Not more than 3 100%
More than 3 but not more than 4 80%
More than 4 but not more than 5 60%
More than 5 but not more than 6 40%
More than 6 but not more than 7 20%
There is no benefit from tapering relief if the whole gift falls within the nil-rate band, because no IHT is chargeable. However, even if death does follow within three years, making a PET could bring valuation advantages, as the taxable value is that on the date of the gift, not at the date of death.
Certain points need to be borne in mind with PETs, as outlined below.
(a) The danger of premature PETS
The effect of the legislation (IHTA 1984 s7(1)) can easily go unnoticed. In particular, it can render the IHT effects of making a PET worse than if the assets concerned had been left in the transferor’s estate on death.
Example 2.2
Bertie made a gift of £300,000 to a discretionary trust on 1.6.01. This was a chargeable transfer and IHT was paid accordingly. Five years later he made a PET of £100,000 to his son. Bertie died on 1.8.08 with a fully chargeable estate of £500,000 (after the 2001 chargeable transfer had dropped out of cumulation).
IHT on the failed PET (at 2008/09 rates) is £40,000, since the 2001 transfer formed part of Bertie’s cumulative total in 2006.
IHT in the death estate will be £115,200 calculated (as expected) by including the failed PET in the cumulative total.
By contrast, had the PET never been made and had instead Bertie’s son had taken a share of residue under the Will, with the consequence that a further £100,000 would form part of the death estate, tax on the enlarged estate of £600,000 would again be £115,200. On these facts therefore extra IHT arising out of the PET is £40,000.
TAX TRAP: This ‘7+7=14’ trap is easily overlooked. Even where the transferor of a chargeable transfer is likely to survive that transfer by seven years, caution should await their elapse before making a PET, to avoid the possibility of an unnecessary IHT liability.
(b) Falls in value since date of PET or chargeable lifetime transfer
What happens where the asset given away falls in value following the gift, so that its value at the date of the transferor’s death within seven years is lower than its value at the date of the gift? There is a measure of relief: subject to conditions, the person liable to pay the tax on the PET or chargeable lifetime transfer may claim that the lower value be taken (IHTA 1984 s131). However, note that this cannot apply where the asset given is a wasting asset, or to the extent that the fall in value occurs within the nil-rate band. The latter may seem unfair, since it has the effect of pushing up the IHT liability on the rest of the estate by denying it part of the nil-rate band, but the rule is apparently so drawn intentionally. Where the transferee has sold the asset before the transferor’s death, the lower sale value may be taken into account instead of the market value at the date of death, provided that the sale has been made by the transferee or his spouse/civil partner in an arm’s length sale to an unconnected purchaser.
TAX TRAP: Do bear in mind the IHT downside of a fall in value of the subject-matter of a lifetime gift. The loss of the nil-rate band on death to that extent could be an unwelcome twist.
(c) Ensure no reservation of benefit
If a benefit is reserved from the gift, the asset will not effectively leave the chargeable estate until such time (if ever) as the benefit ceases (FA 2006 s102(3) and (4)). See 2.13.1.
(d) The pre-owned assets regime
The POA charge with effect from 2005/06 can catch successful attempts made since March 1986 to avoid the reservation of benefit rules. If a person has disposed of land or chattels – or contributed to their acquisition – and he occupies the land or possesses the chattels, there is, subject to some exemptions, an annual income tax charge on the benefit. A similar point applies in relation to ‘intangible’ property (life assurance policies and the like) owned by a trust from which the settlor can benefit. See 2.13.2.
(e) Other taxes
See 2.15 for the possible impact of Capital Gains Tax (CGT), Stamp Duty Land Tax (SDLT) and even Value Added Tax (VAT).
The spouse/civil partner exemption
2.2.3
The exemption is unlimited except where the donor is UK domiciled and the donee is or is deemed to be non-UK domiciled, in which case there is (rather odd) historic limitation to £55,000, on a lifetime basis (IHTA 1984 s18). See 13.2 and, for domicile, 15.3 and 16.4.
As to transfers between spouses/civil partners, it has been traditionally axiomatic that on death (and you never know who is going to go first) each individual should own at least £312,000 (for 2008/09) of chargeable value to pass to a beneficiary other than the survivor. This can be achieved by careful Will drafting – see Chapter 18. Otherwise the wastage of the exemption could cost up to £124,800 (40% of the nil-rate band). However, the advent of the transferable nil-rate band from 9 October 2007 (see 18.4.3) makes this unnecessary.
The annual exemption
2.2.4
Gifts of £3,000 in a tax year are exempt (IHTA 1984 s19). To the extent that the allowance in one year is unused, it can be carried forward for one year (only). This exemption is ‘per donor’ (whereas the £250 exemption is ‘per donee’). While it might not seem very much (and was raised from £2,000 as long ago as 1981), regular use can get £30,000 IHT-free out of the chargeable estate over a ten-year period – or £60,000 per married couple/ civil partnership.
HMRC Inheritance Tax interpret the statute (specifically, IHTA 1984 s19(3A): see IHTM 14143) in circumstances where more than one transfer of value is made in a particular tax year as follows: the annual exemption should be deducted from the first gift (not otherwise exempt), whether a PET or not. This is disadvantageous to taxpayers where the donor survives seven years and the annual exemption may be wasted on a gift which subsequently proves to be wholly exempt. The practical advice is in any year to make a chargeable transfer before a PET. Where more than £3,000 is given in any year, any unused balance from the preceding year may be used.
The annual exemption might be used to pay premiums on a life assurance policy written in trust for others or to make gifts in kind – a painting worth up to £3,000, for example. Alternatively, consider setting up a stakeholder pension, as from 6 April 2001, for a child or grandchild: a payment of £2,880 (net of 20% basic rate tax in 2008/09, ie £3,600 gross) can be made for a minor beneficiary, although of course the benefits cannot be taken until age 50, to rise to 55 from 2010/11 (which many might consider an advantage).
In the case of a parental gift, there is no income to be caught by ITOIA 2005 s624. However, somewhat strangely, s624 will apply to the income from a £3,000 cash ISA set up from 6.4.01 for a 16 or 17 year old unmarried child of the donor.
TAX TIP: It is axiomatic that regular (and recorded) use should be made of the annual exemption. In the absence of other contenders for the gifts, stakeholder pensions might be thought quite a sensible thing to set up, within the annual exemption and/or the normal expenditure out of income exemption (see 2.2.6).
The £250 small gifts exemption
2.2.5
A gift of up to £250 (but no more) to any individual in a tax year is exempt (IHTA 1984 s20). Note that this exemption cannot be used in conjunction with the £3,000 annual exemption (IHTM 14180). So a gift of £3,250 to a particular individual, in circumstances where the previous year’s annual exemption has been used and so cannot be carried forward (but with no other transfers of value in that tax year), will be covered by the annual exemption as to £3,000 and, as to £250, if not by the normal expenditure out of income exemption, as a PET.
TAX TIP: Consider the advantages of occasional or even annual £250 gifts to (say) God-children made during one’s lifetime rather than by Will – and the donor might even get the bonus of a thank you letter.
Normal expenditure out of income
2.2.6
A transfer will be exempt only if (taking one year with another) it was made out of income leaving the transferor with sufficient net income to maintain his usual standard of living, ie without resort to capital. HMRC have traditionally argued that a pattern of expenditure of at leasft three years must be shown, though the Bennett decision in 1995 (see below) roundly disapproved this. A pattern of giving should be started as early as possible. Records should be kept to back up any claim if necessary. The gifts must be made out of income (which, not surprisingly, does not include the proceeds of sale of shares: see Nadin v IRC [1997] SSCD 107 (SpC 102)).
Expenditure will of course include income tax and all regular expenditure of an income nature – as opposed to capital, eg extending the house. This exemption is quite extraordinarily useful and is generally underused. It is important to keep careful records, in the event that death falls within seven years after a gift in a series, in order to convince HMRC that that gift was exempt. Where the exemption is used over a number of years, it does not matter if in one of those years there was a deficit (out of which of course no gift can be made), so long as ‘taking one year with another’ there was a surplus and gifts were made out of that surplus.
Note the helpful principles set out in a leading case (Lightman J in Bennett & Others v CIR [1995] STC 54) [14 November 2008]:
• ‘normal expenditure’ means expenditure which, when it took place, accorded with the settled pattern of expenditure adopted by the donor;
• a settled pattern can be established either by examining the donor’s expenditure over a period of time, or by showing that the donor has assumed a commitment, or adopted a firm resolution, regarding future expenditure and has thereafter complied with it;
• there is no fixed minimum period during which expenditure has to be incurred; a single payment implementing the commitment or resolution may be sufficient;
• where there is no commitment or resolution, a series of payments may be required;
• a pattern need not be immutable, but it must be intended to remain for a sufficient period (barring unforeseen circumstances); thus, ‘death bed’ resolutions would be excluded;
• the expenditure need not be fixed nor need the recipient be the same on each occasion. The amount of the gift may be fixed by a formula, eg a percentage of earnings, or by reference to an ascertainable liability, eg the cost of nursing home fees, and the donees may be a general class, eg family members or needy friends; and
• tax planning does not disqualify the expenditure.
In Bennett, the taxpayer was the life tenant of her late husband’s Will Trust. The trustees had on her instructions paid to her three sons total income of some £28,000 in February 1989 and then £180,000 in February 1990, a few days before the taxpayer’s death. Nevertheless, applying the above criteria, Lightfoot J was satisfied that ‘normality of expenditure’ had been achieved. He said that the donor had had a single and continuing intention regarding the surplus trust income and that that intention was put into effect. The decision in this case is likely to prove helpful in situations where a life assurance policy has been written in trust and where the grantee of the policy has died unexpectedly having paid only one or a very limited number of the regular premiums which would have been due had he survived.
TAX TIP: As with the annual exemption, it is axiomatic that where the taxpayer does have post-tax income surplus to normal living requirements this extraordinarily valuable exemption is used. Clear records should be prepared each tax year to provide the necessary evidence in case of death within the following seven years.
The marriage/civil partnership exemption
2.2.7
Quite a bit of value can be extracted from the chargeable estate(s) when a son or daughter (or step-son or daughter) gets married or enters into a civil partnership (IHTA 1984 s22). The exempt amounts depend on the relationship between donor and donee, as follows:
· £5,000 per parent;
· £2,500 for grandparents; and
· £1,000 for all others.
Gifts in kind as well as in cash are exempt, as are certain types of settled gift.
The gift must be an outright gift to or for a party to the marriage/civil partnership: hence there is no exemption if the celebrations are called off.
The charities exemption
2.2.8
This is an exemption which applies to gifts on death just as to lifetime gifts (IHTA 1984 s23). However, one advantage of lifetime gifts of course is the possibility of Gift Aid income tax relief, both basic rate recovery for the charity and higher rate relief for the donor. See 12.2 and 12.3.
Gifts to political parties
2.2.9
The qualification is two MPs at the last General Election or one MP and not less than 150,000 votes (IHTA 1984 s24).
Gifts for national purposes
2.2.10
Gifts to the National Trust etc (including Government Departments!) are exempt (IHTA 1984 s23: see IHTA 1984 Sch 3 for the list of bodies).
Gifts of shares to employee trusts
2.2.11
To secure the IHT exemption, the beneficiaries of the trust are restricted to a class defined by particular employment or type of employment and their relatives (IHTA 1984 s28, with the conditions set out in s86). Where there is a particular employment, the class must comprise all or most of the employees or the trust must be an approved profit-sharing scheme. Trustees must hold at least 50% of the company and no participator (broadly a 5% shareholder) must be able to benefit.
Estate Duty surviving spouse exemption
2.2.12
Where Estate Duty was paid (or would have been payable but for reliefs or the threshold) on the death before 13 November 1974 of the first spouse to die and the survivor has a life interest under the Will, no IHT is chargeable on the second death (IHTA 1984 Sch 6 para 2). However, the related property rules may affect the chargeable value of the free estate or other property taxed on death.
Note that there will also be no IHT implications arising from an inter vivos termination of the life interest (even if death follows within seven years), though in that event the CGT-free uplift on death would have been wasted.
TAX TIP: An ‘Estate Duty protected life interest’ should be kept in place until the death of the survivor. The fund will be free from IHT and the acquisition cost of the assets will be market value, with the CGT-free uplift in value on death.
The Use of Trusts
2.3
A convenient recipient of lifetime gifts
2.3.1
Where a gift is to be made but a suitable donee does not present himself, a trust can be a useful mechanism. Even if death follows within seven years, the value charged to IHT will be that prevailing at the date of the gift, not at the date of death, by when it may have grown. The full range of exemptions and reliefs is available for transfers into trust as for other types of property. Note that, on termination of an interest in possession, use of the life tenant’s annual exemption(s) requires notice by the life tenant to the trustees (IHTA 1984 s57). The same point applies to the life tenant’s marriage exemption.
Settlor and spouse/civil partner should be excluded
2.3.2
To be effective for IHT purposes the settlor must be excluded from benefit to avoid the GWR regime (FA 1986 s102): see 2.13.1. Note again that there is no pro rata provision. The settlor’s spouse/civil partner can be included, although this will have income tax implications (under ITTOIA 2005 Part 5 Chapter 5) and, before 2008/09, also CGT implications (TCGA 1992 s77, repealed from 2008/09). However, these anti-avoidance provisions will not apply if the spouse/civil partner can benefit only after the settlor’s death.
The key IHT distinction
2.3.3
Chapter 3 describes the tax-efficient management of existing trusts and Chapter 4 considers the tax implications of making new trusts. In broad terms, the IHT treatment of a lifetime trust will fall into one of what were two categories before 6 April 2008, but are now just two ((a), and (c) below). The age 18-to-25 trust (category (d)) is essentially a type of Will trust, although before 6 April 2008 property within the accumulation and maintenance regime coud be converted into such a trust.
(a) The relevant property regime
This applies to discretionary settlements and almost every other type of lifetime settlement made on or after 22 March 2006, except where the beneficiary is disabled (IHTA 1984 s58 and see 3.8.1).
The general principle with such settlements is that at commencement the settlement inherits a cumulative total equal to that of the settlor on the day prior to creation plus the value of other funds settled by the settlor on the day of creation (related settlements). There are then two principal charges:
(i) a ten-year anniversary charge, which is applied to the then value of the trust fund, given the initial cumulative total and funds leaving the trust in the preceding ten years (IHTA 1984 s64 and see 3.7.3). This is computed so that over the course of an assumed generation, some 33 1/3 years, the trust fund attracts tax at the 20% lifetime rate. This means a maximum tax charge every ten years of 6% and very often less than that, given availability of the nil-rate band and any reliefs; and
(ii) an exit charge, which varies according to whether it occurs in the first ten years or thereafter (IHTA 1984 s65 and see 3.7.4). In the first ten years the notional value charged is equal to that of the assets advanced, by reference to a given fraction of the rate at which tax would be payable at the exit date on the funds settled given the initial cumulative total. This means that if the initial funds settled plus any additions to the settlement fall within the nil-rate band in force at exit within the first ten years, there is no exit charge whatever the then value.
TAX TRAP: the rate of tax on exit within the first ten years is found by reference to the value of the assets when settled before BPR or APR (IHTA 1984 s68(5)(a)). It is not enough therefore for the initial value to be within the nil-rate band solely because of APR/BPR, as this could give rise to a positive rate of tax. However, this will matter only if the property concerned does not itself attract APR or BPR. The exit charge after the first ten year anniversary is an appropriate fraction of the rate charged at the previous anniversary.
(b) Accumulation and Maintenance trusts (A&M trusts) made before 22 March 2006
This are a special category of settlement (defined in IHTA 1984 s71), made broadly for children or grandchildren of the settlor, which received special treatment as discretionary settlements from 1975 to 2006 through an exemption from the ten year anniversary and exit charges (see 3.4). However, no new such settlements can be made on or after 22 March 2006 and a transitional regime which ended on 5 April 2008 applied to such A&M trusts in being at that date (see 3.5).
(c)The ‘section 49 regime’
This embraces settlements which are treated as if the underlying trust property were owned beneficially by the beneficiary (IHTA 1984 s49(1)), namely interest in possession settlements made before 22 March 2006 so long as the interest in existence at that date continues or is replaced by a qualifying ‘transitional serial interest’ (see 3.6). This point also applies to life interests under Wills whenever the death occurs (called ‘immediate post-death interests’ or IPDIs): see 18.3. That means that, for example, on death of the beneficiary the trust property to which he has had a right to income is added to his free estate, and a single ‘estate rate’ is calculated, to be applied separately to the free estate and the settled estate (subject of course always to exemptions such as the spouse/civil partner exemption).
(d) The ‘age 18-to-25’ trust
This type of trust, whether arising out of an A&M trust for the settlor’s children or grandchildren or created under a Will for the testator’s children (IHTA 1984 s71D), suffers an exit charge at a maximum of 4.2%, rather as under the A&M regime (see 18.5.4).
Impact of Finance Act 2006
2.3.4
For the rich (however one defines that term), it is clear that the FA 2006 IHT ‘Alignment of Trusts’ has had a significantly damaging effect. This is because one of the great advantages of making a trust for one’s children or grandchildren – and of course the spouse/civil partner can safely be a trustee, while being excluded from benefit – is that the capital is not available to creditors nor indeed will it generally be vulnerable in matrimonial proceedings. But now, making any lifetime trust with an initial chargeable value – or any addition to a trust - which causes the settlor to exceed his nil-rate band triggers to that extent an IHT liability at 20% (to rise to 40% if he dies within seven years). The only exceptions to this rule are an exclusively charitable trust (exempt) or a qualifying trust for a disabled person (a PET).
See also 4.6.1.
The Family Home(s)
2.4
The problem
2.4.1
The relentless rise in house prices over the last 20 years or so, albeit now suffering something of a reversal, is a problem not just for the first time buyer but also for the next generation on the deaths of the older property-owning generation. This is of course especially the case if one or more children want to carry on living in the home which may have been in the family for some generations. So, what does one do, other than simply moving out and making a gift which one survives by seven years?
It was in response to several well-publicised successful attempts to avoid the GWR regime that the POA rules were introduced from 2005/06: see 2.13. While there are various planning possibilities open, the overriding concern must be the taxpayer’s own security of tenure if contemplating any form of lifetime gift. There is an obvious commercial risk in making a gift of the house to the children, even if the donor manages to avoid both the GWR and POA regimes. If the children then become insolvent or embroiled in matrimonial difficulties the house may have to be sold. Also, there is probably not much point in entering into an arrangement which might escape the rules on a technicality but which is more than likely to be attacked by HMRC later on.
Some solutions
2.4.2
The above said, there are certain well-established routes, for example:
· Giving the house away and occupying it thereafter for ‘full consideration’. This may mean either paying a rack rent on a three-year renewable lease on arm’s length terms or ‘buying a lease’ for one’s life expectancy by paying a capital sum (on part of which, the term being likely to be for less than 50 years, the recipient will have to pay a measure of income tax).
· Alternatively, if one of the children is sufficiently wealthy, it is possible to enter into the sort of equity release scheme one might otherwise do with a financial institution, whereby he sells the house for full value and then buys back a lease for life (on the standard terms of a tenancy, but without having to pay rent).
· Further, likely to be more than an option perhaps with a second or holiday home, a person could give away a share in the house and occupy it from time to time with the children, each of them paying a fair share of expenses. Such an arrangement if properly structured avoids both the GWR and POA regimes.
· A person might simply sell a large house and trade down for less cash, giving away the balance (after paying off any mortgage) to the children.
The important point in all this is obviously that relationships between the family and the extended family are happy and likely to remain so.
One should also be aware of the main residence relief from CGT. If the house or a share in the house is owned by one or more of the children who do not in fact live there, then the gain will be building up for charge on ultimate disposal by them – except perhaps in the event that they do come and live there and stay in occupation until death.
All this is the subject of Chapter 5.
The Reliefs for Qualifying Business and Agricultural Property
2.5
Outline description
2.5.1
These reliefs are given in most cases at 100%, and are generous indeed. It has to be a major surprise that successive Labour Governments have not since 1997 sought to reverse the rate increases introduced by a Conservative Government in 1992. The rules for both reliefs (business property relief and agricultural property relief – BPR and APR) are complex, covered in Chapters 6 and 7 respectively. In each case one must determine the type of property which qualifies and the time it has been owned or (in the case of agricultural property) occupied – generally two years. Neither relief is given if at the date of transfer the property is subject to a binding contract for sale (IHTA 1984 ss113 and 124). Certain types of business or agricultural property attract relief at only 50%.
(a) BPR: ‘relevant business property’
The property must be (IHTA 1984 s105):
· a business, or an interest in a business, which must be carried on with a view to profit;
· unquoted shares or securities;
· a controlling holding of quoted shares;
· land or buildings, machinery or plant used in a business by a company controlled by the deceased, or by a partnership of which he was a partner; or
· land or buildings, machinery or plant owned by trustees and used in a business where the deceased had a life interest.
(b) BPR: period of ownership
The relevant business property must have been owned for at least two years, subject to relieving provisions for replacement property and for property inherited on the death of a spouse/civil partner (IHTA 1984 ss106, 107 and 108).
(c) BPR: rate of relief
100% relief will be given for the first two categories above, otherwise 50% (IHTA 1984 s104). Shares in AIM companies are treated as unquoted companies.
(d) BPR: type of business
The business must not be an investment or a dealing business (IHTA 1984 s105(3)). Generally speaking, BPR is given only to trading businesses. Accordingly, a business of owning property which is let residentially or commercially will generally not attract BPR. Many businesses will be ‘mixed’, comprising a number of different elements. Here regard must be made to the whole, to see whether the trading or the investment side predominates.
(e) BPR: excepted assets
Even if the business as a whole qualifies, there may be some assets in the business regarded as ‘excepted assets’ (IHTA 1984 s112). These will be excluded from relief where broadly not used in the business nor required for future business use, that is, the proprietors of a business cannot simply ‘park’ spare cash, surplus to business requirements, in the business and necessarily expect to get BPR on all the cash: that said, however, see 6.2.6(d).
(f) APR: 'agricultural property'
This is defined as (1) agricultural land or pasture; (2) woodland and buildings used for intensive rearing of livestock or fish, if the occupation of the woodland or building is ancillary to agricultural land or pasture; and (3) cottages, farm buildings and farm houses together with their land as are ‘of a character appropriate’ to the property (IHTA 1984 s115(2)). A controlling interest in a farming company will also attract APR.
(g) APR: the ownership or occupation test
The deceased must have occupied the agricultural property for agricultural purposes for at least two years, or must have owned the agricultural property for at least seven years, with continuous occupation by someone for agriculture (IHTA 1984 s117). There are reliefs for replacement of property within that period and for property inherited on the death of a spouse/civil partner (IHTA 1984 ss118 and 119).
(h) APR: rate of relief
The rate is 100% if (IHTA 1984 s116):
· the deceased has vacant possession, or the right to obtain it within 12 months (24 months by concession) of his death;
· the deceased had owned his interest in the land since before 10 March 1981 and would have been entitled to the old ‘working farmer’ relief, with no right to vacant possession since then; and
· the deceased was the landlord of a tenancy commencing on or after 1 September 1995.
Otherwise, he will get only 50% relief, typically where he is the landlord of property let under a tenancy under which he does not have the right to get vacant possession within 24 months.
(i) APR: 'agricultural value'
APR is given not on the market value of the property (like BPR), but on the ‘agricultural value’ only; this presumes that the property is subject to a perpetual covenant prohibiting non-agricultural use (IHTA 1984 s115(3)). District valuers have been using this to argue for a discount of up to one-third on the market value of the farmhouse, with support from the October 2005 Lands Tribunal decision in Lloyds TSB (as personal representative of Antrobus deceased) v IRC, under reference DET/47/2004.
A comparison
2.5.2
BPR is given only broadly to businesses which, or shares in unquoted companies (including AIM companies) which, trade – and which trade at a profit. By contrast, APR can be obtained by an agricultural landlord, whether at 100% or at 50%: here the qualifying period of ownership is seven years. Nor is the view to a profit required for APR. BPR is given on a worldwide basis, whereas APR is limited to property in the UK, the Channel Islands and the Isle of Man. BPR is applied to market value, while APR is limited to ‘agricultural value’ (see 2.5.1(i)). The big advantage which farmers have over other businessmen is that APR can be given to the farmhouse, though this has been exciting recent adverse scrutiny from both HMRC and the Courts (see 7.2.2).
Woodlands can attract BPR, provided that they are managed in a business-like way (annual accounts, VAT registration etc), even if it is hard to show a profit on an annual basis: see 7.4.3.
Chattels
2.6
Overview
2.6.1
It often comes as something of a shock to people to discover quite how much the contents of their house (or houses) and other personal possessions are worth. But all that value is potentially subject to IHT on death; subject of course to the spouse/civil partner (and possibly the charities) exemptions. There remains still a widespread but mistaken belief that in valuing chattels on death there is a permissible discount from market value of something up to one-third. That is not the case, as HMRC Inheritance Tax have been reminding us at various points over the last two to three years. The statutory valuation rule is ‘the price which the property might reasonably to fetch if sold in the open market’ at the date of death (IHTA 1984 s160).
So, what’s to be done? The answer could be (as developed at 8.3):
Planned lifetime giving (without retention)
2.6.2
Remember for example that the £3,000 annual exemption could be constituted by chattels just as much as by cash. A gift will be a disposal for CGT purposes and so will trigger a liability if the total chargeable gains exceed the annual exempt amount for the year (£9,600 for 2008/09). There is an exemption for chattels if the value does not exceed £6,000 (which applies to a set of chattels given away at the same time: TCGA 1992 s262). But of course, to be effective for IHT purposes there must be no continuing enjoyment of the chattel; hence, alternatively:
Consider an effective gift of the chattel followed by continued enjoyment by the donor ‘for full consideration’
2.6.3
So long as full consideration is paid (whatever that may mean) there is specific exemption from both the GWR regime (FA 2006 Sch 20 para 6(1)(a)) and the POA regime (FA 2004 Sch 20 para 11(5)(d)). It has been customary over recent years for prospective donor and donee, eg mother and son, to have a gift of chattels by mother to son to be accompanied by a licence or lease arrangement under which typically mother covenants to pay the insurance premium on behalf of son and on that basis to pay such an annual fee independently agreed between qualified agents acting for each party as will constitute full consideration. In the present marketplace this may amount to no more than 1% of market value, to be kept under review every three years. This of course, on which the donee must pay income tax, compares rather favourably with the 6.25% (for 2008/09) annual amount on which the income tax liability is based under the POA regime, assuming no GWR. As noted at 2.6.2, the CGT implications of the gift must be considered.
While such arrangements were being vigorously challenged by HMRC Inheritance Tax some years ago, that threat appears now to have receded. On the other hand, anyone entering into such an arrangement needs to be warned that it is not exactly for ‘widows and orphans’ and so, while taking the best advice and complying with it, nothing can be guaranteed. But of course once seven years have passed after the gift and the PET has become exempt (and full consideration continues to be paid for the rest of the donor’s life or until she ceases to enjoy the assets), the chattels concerned will effectively have been extracted from the chargeable estate free of IHT while enabling continuing enjoyment, at only a relatively small annual cost.
Investments
2.7
Investments within a person’s ownership may take a variety of forms: equities, unit trusts, government stock, PEPs or other rather more weird and wonderful creatures. But, like any other property the market value will fall into charge at death. While, under the Enterprise Investment Scheme and Venture Capital Trust Scheme, certain income tax and CGT reliefs are available during life, the only IHT saving opportunity open here is BPR for shares listed on the Alternative Investment Market (AIM) as to which see 2.5 for a summary and 6.2 for more detail. The GWR regime applies to gifts of investments as much as to any other property. And, in the case where GWR does not apply, and there has been a disposal of investments into a settlor-interested trust, there may be an annual income tax liability on 6.25% (in 2008/09) of the market value under the POA regime.
The difficulty of course is that everyone needs to live – and usually requires income for that purpose. There is no point in making an effective gift of a substantial amount of investments, surviving for seven years, then only to find that the donor has nothing left to live on. But investments will take their place in the overall family plan. It may be that:
(a) there are some investments surplus to requirements which, subject always to CGT considerations, can be given away;
(b) the balance of the investments can be slanted rather more to the production of income than capital growth on which of course 40% IHT will ultimately have to paid; or
(c) developing the concept of total return, a person may feel that he can ‘afford’ a rather larger gift of investments than might otherwise be the case if he can ‘live off capital’ in relation to the remainder – taking a reasonably conservative view of continuing life expectancy.
All this is developed in Chapter 9.
Life Assurance and Pension Arrangements
2.8
Life Assurance
2.8.1
The classic use of life assurance is to build up, outside the chargeable estate, a fund which can be used to pay at least part of the IHT burden on death. There is a wide variety of different types of life assurance policy, of which the main ones are described at 10.2. The ‘traditional’ product for spouse/civil partners or civil partners is the so called ‘joint lives and survivor’ policy which would pay out on the second death, the spouse/civil partner exemption removing any IHT liability on the first death. While it is no longer generally possible to get income tax relief on premiums paid on new policies, the payment of annual premiums within a donor’s financial 'comfort zone’ might be regarded as a sensible investment. In capital terms one is taking property out of the ultimate chargeable estate to fund a growth investment also outside that estate to meet part of the ultimate liability. The policy should of course be written in trust, to avoid the policy proceeds falling into the chargeable estate, typically for a class of beneficiaries, and so each premium is a gift which might be protected by either the £3,000 annual exemption or the normal expenditure out of income exemption from IHT.
But for those who are minded to do something a bit more adventurous, there are two particular ‘products’ promoted by the life assurance industry which HMRC have confirmed are effective to avoid both the GWR and POA regimes, even though some benefit or possibility of benefit is retained by the donor/settlor. Of course, the use of trusts in such cases has been rather curtailed by FA 2006, since no-one will want to incur an immediate IHT liability at 20% of the excess of the chargeable transfer over the nil-rate band threshold. But such products, namely the gift and loan arrangement and the discounted gift trust, remain attractive in principle. They are described in more detail at 10.5. It will be important to be able to form a positive view on the likely investment performance of the fund(s) underlying the policy.
Pensions
2.8.2
The regime introduced from 6 April 2006 to take the place of a good eight or nine different regimes which preceded it, whether retirement annuities or personal pensions, has rather changed the landscape. This regime is described at 11.2. Generous income tax relief is given on pension contributions, up to the lesser of the individual’s net relevant earnings and the contribution limit for the year (£235,000 for 2008/09). And, when it comes to taking the benefits, apart from the well-established option of income drawdown as an alternative to converting the whole fund into an annuity on retirement, there is under the FA 2006 regime the new possibility on reaching age 75 with funds still left in the pension pot of taking out an ‘alternatively secured pension’ or ASP.
While any funds remaining at death can be used to pay pensions to a surviving spouse/civil partner or financial dependent, it is clear that any money ultimately left after the deaths of all such individuals cannot effectively be used to mitigate IHT. In particular, one option has been closed off by FA 2007: it is not possible to transfer money into the pension pots of other scheme members.
Charitable Giving
2.9
Inheritance tax
2.9.1
The IHT exemption for gifts to charities was outlined at 2.2.8 and is explored further at 12.2 and 12.3.
Income tax
2.9.2
A payment to a charity, which may be one-off or regular, can attract two forms of tax relief under the Gift Aid regime (FA 1990 s25). First, a payment to the charity of an amount under deduction of income tax at the basic rate enables the charity to recover that basic rate tax from HMRC. So, with a basic rate of 20%, a payment of £80 is treated as a gross payment of £100 on which the charity can recover £20. This assumes that the donor has paid sufficient income tax or CGT to cover the tax recovery: if not, there will be an unexpected tax liability on the donor (under FA 1990 s25(8)). Second, to the extent that the donor is a higher rate taxpayer, he can recover higher rate tax relief on the amount of the gift, that is, £20 on the above figure. So the cost of putting £100 into the hands of the charity is just £60.
TAX TRAP: It’s an obvious point, but a potentially expensive one to get wrong: ensure that the donor has paid sufficient income tax and/or CGT in the year of the donation to support the tax reclaim by the charity. If not, the charity gets the tax back and the donor gets a tax bill.
Separately, there is also a relief for gifts of shares and securities and of land situated in the UK to charity (ITA 2007 ss431-446). And any gain arising on the gift does not attract CGT (TCGA 1992 s257). The charity is treated as inheriting the donor’s base cost. And so any gain realised by the charity on sale will not attract tax, assuming of course that the proceeds are applied for charitable purposes.
The Family Unit
2.10
What is it?
2.10.1
Long gone are the days where the family unit might be generally understood as meaning husband, wife and 2.4 children. And in very many cases, the needs of what might be called ‘the extended family’ must be taken into account. However, for purposes of this Book I am concerned primarily with just two (or possibly three) generations and a fairly close-knit set of relationships. The older generation might be a married couple, a civil partnership, a couple just living together or a single parent. The younger generation (if any) might be one or more children or step-children of any of the above, whether minors or aged 18 or over. The basic fiscal framework requires one to consider: (a) whether or not an IHT exemption, and indeed a CGT relief, applies on transfers of assets between members of the older generation; and (b) whether an anti-avoidance regime applies for income and CGT purposes for income and gains accruing to individual minor children or trustees for them.
Transfers between members of the older generation
2.10.2
The IHT exemption (see 2.2.3 and 13.2) has since 5 December 2005 applied equally to transfers between members of a registered civil partnership as to spouses. The interesting thing is that what matters is the legal relationship of marriage or registered civil partnership, not the fact that (as required by the CGT no gain – no loss rule) the couple are living together. Indeed, they may have separated many years before but for whatever reason, religious or otherwise, have not broken the legal relationship: the IHT exemption remains. The only point to watch is the case where the transferor is UK domiciled but the transferee is not, for all IHT purposes, in which case the exemption is limited to £55,000 on a lifetime basis (IHTA 1984 s18(2)).
The Capital Gains Tax position
2.10.3
By contrast, the rule that a transfer of assets between such individuals takes place on a ‘no gain no loss’ basis (TCGA 1992 s58) depends upon the couple living together at some time in the year of gift, even if the transfer follows the date of separation. The test is the old income tax one for mortgage interest relief purposes, viz that if there is a separation it is likely to be permanent (now in ITA 2007 s101). Once the separation (or divorce) has happened, a transfer in a subsequent year will be treated for CGT purposes just as any other transfer between individuals, that is, a disposal with the market value being treated as received by the disponor. Interestingly, while the basic exemption applies, it matters not whether the disposal is by way of sale or gift: even if by way of sale the actual sale proceeds are disregarded and the ‘no gain no loss’ rule is applied, so putting the transferee spouse/civil partner in the shoes of the transferor in terms of inheriting his historic base cost.
Providing for children: income tax
2.10.4
An anti-avoidance regime operates where income or gains arise to, or to trustees of a settlement for, minor children of the transferor/settlor. In broad terms, for income tax, subject to a de minimis limit of £100 per transferor per child per tax year, the income is treated as that of the parent (ITTOIA 2005 s629). The only exception is the case where the transfer of assets occurred before 9 March 1999 and the income from those assets belongs absolutely to the child as it arises (ie in particular Trustee Act 1925 s31 has been excluded, so that the trustees have no power to accumulate income, but must retain it for the child until such time as they can get a valid receipt, whether from the parent or guardian or from the child on attaining age 18). Income which is accumulated and then paid out in a subsequent year while the child is still under the age of 18 does not escape this rule.
Providing for children: Capital Gains Tax
2.10.5
The rule applying from 2006/07 to 2007/08 inclusive is similar to income tax where gains are made by trustees of a settlement under which a minor unmarried child of the settlor can benefit (and child includes a step-child). In that case the gains are treated as those of the settlor and thus can attract any annual exemption otherwise available. Any allowable losses or otherwise will attract tax at his marginal rate (TCGA 1992 s77, repealed from 2008/09).
However, if the assets are owned by the child absolutely, though because he is under age are vested legally in someone else as nominee or bare trustee, the gains arising on disposal are treated as those of the child and thus are capable of attracting his annual exemption or (before 2008/09) lower CGT rates of 10% or 20% rather than those of the parent. As from 2008/09 there is a single rate of CGT of 18%, although there remains the advantage of the child’s annual exemption. This is something of an oddity though one of which many have historically taken, and continue to take, advantage. The disadvantage of course is that come age 18 the child can call for transfer of the assets into his own name absolutely (see 4.6.3(c)).
Heritage Property
2.11
Two categories of favoured IHT treatment are given to qualifying heritage property (IHTA 1984 ss30 - 42). First, there is a conditional exemption given on transfers typically on death, though also during lifetime by way of chargeable transfer. Subject to giving certain undertakings, the contingent IHT liability is deferred until either those undertakings are broken or there is a further chargeable event without a renewal of the undertakings. Second, there is the system of ‘acceptance in lieu’ whereunder certain heritage property can be offered to and accepted by the nation for lodging in one of the national (or possibly local) museums in satisfaction of a liability to IHT or CGT. See Chapter 14 for further details.
The Foreign Element
2.12
Excluded property: the IHT exemption for non-UK domiciliaries
2.12.1
Where the deceased was domiciled or deemed domiciled in the UK at death, the estate will be liable to IHT regardless of where the assets were situated. If he was not so domiciled, IHT will apply only to assets situated in the UK. The normal domicile rule is extended in two circumstances, as explained at 16.4 (IHTA 1984 s267).
IHT mitigation for non-UK domiciliaries
2.12.2
Any assets which do not need to be situated in the UK from time to time (eg cash surplus to immediate spending requirements, investment portfolios etc) should be kept outside the UK. But it is more difficult with a house or flat and furniture: what can be done there? Some options are explored at 16.7.
Non-UK domiciled settlors and excluded property settlements
2.12.3
With settled property, the trust assets will be excluded property if situated outside the UK and if the settlor was domiciled outside the UK when the settlement was made (IHTA 1984 s48(3)). This applies regardless of a subsequent change of domicile by the settlor or indeed changes in the trust property provided that the property remains outside the UK. HMRC Inheritance Tax have traditionally accepted, and have recently confirmed, that the GWR rules are ‘out-flanked’ by the excluded property rules.
This is the rule even if the settlor has an initial 'estate' interest in possession and dies UK domiciled with that interest and if his children also UK domiciled have successive life interests. That said, there is a trap (under IHTA 1984 s80) in a case where the settlement gives initial estate interests in possession to the settlor and/or spouse/civil partner and, at the time when the interest of the last of them to have such an interest ends (typically on the second death), that beneficiary is actually or deemed UK domiciled, the settlement continues, generally on or after 6 October 2008. Whether or not there is a subsequent life interest, the trust will fall into the relevant property regime and so will attract ten year anniversary and exit charges, even if the trust fund is situated outside the UK. See 16.6.3.
Two Anti-Avoidance Regimes
2.13
Gifts with reservation of benefit
2.13.1
(a) The catch
A gift will fall foul of the GWR rules where either (a) possession and enjoyment of the property is not at or before the beginning of the relevant period bona fide assumed by the donee; or (b) throughout the relevant period the property is not enjoyed to the entire exclusion or virtually the entire exclusion of the donor and of any benefit to him by contract or otherwise (FA 1986 s102(1)). The ‘relevant period’ is that beginning with the later of the date of the gift and the date beginning seven years before the donor’s death. The rules apply only to gifts made on or after 18 March 1986. Payment of full consideration for any period will disapply the regime (FA 1986 Sch 20 para 6(1)(a)).
(b) The effect
If the benefit remains until death, the donor/settlor is treated as then entitled to the property (FA 1986 s102(3)), with no pro rata rule, so that he is regarded as making a chargeable transfer of the then market value of the property. If the benefit ends inter vivos, there is a notional PET at that time (FA 1986 s102(4)), so that there will be no adverse IHT consequences if he survives the termination by at least 7 years.
(c) The de minimis let-out: HMRC’s 1993 view for GWR – applied in 2005 to POA
The examples of non-GWRs given in Inland Revenue Tax Bulletin November 1993 (now in HMRC’s Revenue Interpretation RI 55) indicate that HMRC consider that the exception covers cases in which the benefit to the donor is insignificant in relation to the property given away. The test cannot be reduced to a single crisp proposition. HMRC do not operate the rule unreasonably to prevent donors from having limited access to property they have given away and HMRC apply a measure of flexibility in applying the test. HMRC have supplied some examples of situations in which they consider that a limited benefit is permitted to the donor without bringing the provisions into play:
· a house which becomes the donee's residence but where the donor subsequently stays (in the absence of the donee) for not more than two weeks of each year or stays with the donee for less than one month each year;
· social visits, excluding overnight stays made by a donor as a guest of the donee, to a house which he has given away. The extent of these visits should be no more than those which the donor might be expected to make to the donee's house in the absence of any gift by the donor;
· a temporary stay for some short term purpose in a house the donor had previously given away, eg convalescence by the donor after medical treatment, the donor looks after a donee convalescing after medical treatment or during redecoration of the donor's own home;
· visits to a house for domestic reasons, eg baby sitting by the donor for the donee's children;
· a house together with a library of books which the donor visits less than five times in any year to consult or borrow a book;
· a motor car which the donee uses to give occasional (ie less than three times a month) lifts to the donor; or
· land which the donor uses to walk his dogs or for horse riding, providing this does not restrict the donee's use of the land.
Where the benefit to the donor is or becomes more significant, the GWR provisions are likely to apply, eg:
· a house in which the donor stays most weekends or for a month or more each year;
· a second home or holiday home which the donor and the donee both then use on an occasional basis [though would this now not be capable of attracting the co-occupation exemption? (FA 1986 s102B(4)) and see 5.8];
· a house with a library in which the donor continues to keep his own books or which the donor uses on a regular basis, for example because it is necessary for his work; or
· a motor car which the donee uses every day to take the donor to work.
(d) FA 2006 blocks GWR avoidance device using life interest settlements
A common spousal Will structure over recent years has been to put the deceased’s share of the family home into a life interest trust for the benefit of both spouse and children. While the children would, if adult, typically not choose to live in the matrimonial home, they could do so nonetheless under the trust and their pro rata share of the house was treated as comprised in their estates and not in that of the surviving parent (under the IHTA 1984 s49(1) regime). The proportion of the deceased’s interest in the house which could be left within his nil-rate band on life interest trust for the children, the balance for the surviving spouse, would depend on both the value of the house and the extent of chargeable transfers made in the seven years before death plus any other chargeable transfers under the Will. But suppose the surviving spouse were left say, a 50% interest in the deceased’s half share.
The trustees might, in exercise of their powers of appointment, reduce the survivor’s interest to 10% and increase those of the children to 90%. This would be a PET by the survivor, ie exempt for IHT purposes on survival for seven years. But there would be no GWR because the transfer of value had been engineered by the trustees, not created by the beneficiary.
This effect was changed from 22 March 2006, to provide that in such circumstances the beneficiary is treated as making a gift so that, where the ben