Tax Efficient Settlements and the 1975 Act

Feature

posted 1 Apr 1998 in Volume 3 Issue 3

Tax Efficient Settlements and the 1975 Act

In the follow up her article on Deeds of Variation Sarah Lacey discusses the tax implications of post death variations under the Inheritance (Provision for the Family and Dependants) Act 1975.
Sarah is a Chancery barrister practising at 3 Stone Buildings, Lincoln's Inn.

We can breath a sigh of relief - another budget has come and gone without the anticipated shake up of Inheritance Tax and no fundamental change to Capital Gains Tax relief's except for that relating to indexation. It may only be a short reprieve, but in the meantime it is still possible to make a post death re-arrangement that will be treated for some tax purposes as taking effect from the deceased's death. As a result, the distribution of an estate can be altered in a "tax efficient" way, avoiding a tax charge upon the re-arrangement and in some circumstances saving or even avoiding the tax that would otherwise have been charged on the deceased's death. The most popular way of doing this is undoubtedly the "Deed of Variation" under section 146 of the Inheritance Tax Act 1984 and section 62 of the Taxation of Capital Gains Act 1992, as discussed in the last issue. However, opportunities also exist when compromising applications under the Inheritance (Provision for Family and Dependants) Act 1975.

The 1975 Act

Section 2 of the 1975 Act empowers the court to make one or more of the six types of order specified in subsection 2(1):

"if it is satisfied that the disposition of the deceased's estate ... is not such as to make reasonable financial provision for the applicant".

Which of the orders is chosen is a matter for the court's discretion, and under section 2(4) it has an additional power to order such consequential and supplemental terms as it thinks necessary or expedient

"for the purpose of giving effect to the order or for the purpose of securing that the order operates fairly as between one beneficiary of the estate ... and another..."

These terms can include, for example, an order that the deceased's will or the intestacy provisions should be varied "in such manner as the court thinks fair and reasonable" (section 2(4)(b)).

For these purposes, the net estate of the deceased available for financial provision can include:

(a) nomination property (section 8);

(b) property held on a joint tenancy immediately before his death (section 9), provided an application for its inclusion is made within six months of the grant of representation. This time limit cannot be extended; and

(c) property disposed of by him in the six years before his death, with an intention to defeat an application under the 1975 Act (section 10).

Section 19 of the 1975 Act

What effect does an order under the 1975 Act have on the tax payable in relation to the estate? Section 19 provides that:

"... for all purposes including the purposes of the enactment's relating to capital transfer tax, the will or the law relating to intestacy, or both ... as the case may be, shall have effect and be deemed to have had effect as from the deceased's death subject to the provisions of the order."

As a result, Inheritance Tax, Capital Gains Tax and Income Tax will all be calculated as if the deceased's will had been in the form of the order made by the court. The only exception is that section 19 does not apply to orders under sections 8, 9 or 10 of the Act, even though the assets recovered under those sections are treated as forming part of the estate.

Section 19 has two distinct advantages over Deeds of Variation. First, there is no time limit restricting its effect to orders made within a certain period, although there is, of course, an initial time limit of six months from the grant of representation within which an application under the Act must be made. That six month limit can be extended with leave. Secondly, section 19 operates regardless of any election to the Revenue.

At first glance, section 19 would appear to provide a glimmer of hope in circumstances where the two year time limit on tax efficient Deeds of Variation has passed. There are undoubtedly some cases where a late grant of representation means that a claim under the 1975 Act can be issued at a time when the parties already have a compromise in mind but it is no longer possible to execute such a Deed.

Unfortunately, however, the flexibility of section 19 is seriously limited by its wording. It only applies to an order "under" section 2, and the court will only make such an order if satisfied that reasonable financial provision has not been given. The reduction of tax is a legitimate motive for seeking an order (see Re Sainsbury [1967] 1 WLR 476 at page 480) but the parties must still demonstrate that the terms are properly within the court's jurisdiction. Evidence and a full court hearing are therefore required, even if the order is intended to give effect to a compromise, and all parties consent to it. This will inevitably increase costs, and these additional costs will have to be dealt with in the terms of the settlement.

The terms of the court order and tax efficiency

The difficulties may not end there. Re Goodchild [1997] 1 WLR 1216 is better known as a case on mutual wills, but it also contains a number of comments on the extent to which the court should consider tax when making an order under the 1975 Act. The testator and his first wife had executed wills in identical terms, each leaving their estate to the other absolutely, but otherwise on trust for their only son. After the death of the first wife the testator remarried and executed a new will leaving his entire estate to his second wife. The testator died in 1993, and his son alleged that his parents had made irrevocable mutual wills. At first instance Carnworth J held that the intention of the testator and his first wife were not in fact mutually binding. However, there had been a moral obligation on the testator to leave his first wife's estate to his son, and this was sufficient to justify an order in the son's favour under section 2 of the 1975 Act.

The matter was then adjourned, with the express intention of allowing the parties

"to arrive at a sensible financial arrangement, which meets as far as possible their respective requirements and is tax efficient" ([1996] 1 WLR 694).

Unfortunately the parties were unable to reach any agreement, and in February 1996 (and apparently upon the suggestion of the son's counsel) Carnworth J ordered that the sum of £185,000 should be transferred to trustees to pay the income to the second wife until her death or until the 1st of March 1996, whichever should occur first, and subject thereto for the son absolutely. The only reason for inserting the short life interest for the second wife was to ensure that the IHT exemption for transfers between spouses was not lost, while the subsequent termination of her life interest would be a Potentially Exempt Transfer.

The adjourned hearing is not reported, but it is apparent that Carnworth J's order included a "consequential and supplemental" provision under section 2(4)(b) of the 1975 Act to the effect that the testator's will should be varied so as to reflect the new life interest and gift over to the son. This may have been on the basis that such a settlement could not be ordered under section 2(1), although section 2(1)(d) clearly gives the court power to order a "settlement for the benefit of the applicant".

By the time Carnworth J made the final order the two year time limit for a tax effective Deed of Variation had already passed. However, this did not prevent the Court of Appeal upholding his judgement. Indeed, Morritt LJ stated (at page 1231D) that:

"if the order made is properly within the jurisdiction of the court the fact that it was sought with the motive of seeking to achieve a better tax position is usually irrelevant."

Unfortunately, Morritt LJ went on to make two further (unhelpful) comments. First, he suggested that:

"where the effect of the order is to confer a substantial advantage on the parties at the expense of the revenue ... the court should be satisfied that the order is not only within its jurisdiction but also one which may properly be made".

Secondly, after pointing out that he had not heard any argument on whether the order made was warranted by the terms of section 2(4), he stated that:

"that would be a matter for the revenue ... it is important for the future that if an order such as this is to be made the grounds on which it is thought to be authorised by section 2(4) should be clearly demonstrated, for the consent and wishes of the parties is not enough."

Whatever the meaning of Morritt LJ's words, the involvement of the Revenue in 1975 Act proceedings would undoubtedly be an unwelcome one. It could only increase the volume of evidence required, the length and number of hearings and, ultimately, the costs of the parties. If Revenue approval was required for an order made without consent there would have to be an adjournment. Furthermore, the Revenue will not give its views on the terms of every proposed compromise likely to result in a reduction in tax, any more than it will give advance approval of Deeds of Variation.

Pending further authority, the impact of Re Goodchild will remain uncertain. Nor is it clear to what extent it will affect orders other than those made under section 2(4)(b). Surprisingly, section 19 was not mentioned - even though in most cases the application section 19 will have the same tax result as that achieved by an order under section 2(4)(b).

Section 146 of the Inheritance Tax Act 1984

All is not lost, however. If a settlement is reached within two years of death, the application can be dismissed and the compromise set out in a Deed of Variation. The relevant provisions prohibit a Deed of Variation being made for any consideration other than the variation or disclaimer of other provisions in the will or intestacy rules, but the compromise of a claim under the 1975 Act is not treated as prohibited consideration for these purposes.

An alternative is to place the terms of the compromise into a Tomlin schedule, so that the court approval of its terms is not required.

A Tomlin order will not be within section 19, but it will be covered by section 146 of IHTA. Section 146(1) provides that:

"Where an order is made under section 2 of the ... 1975 Act ... in relation to any property forming part of the net estate of a deceased person, then, without prejudice to section 19(1) of that Act, the property shall for the purposes of this Act be treated as if it had on his death devolved subject to the provisions of the order."

It is not clear what the words of section 146(1) add to section 19(1) of the 1975 Act. However, section 146(8) expressly extends section 146(1) to orders "staying or dismissing proceedings under the 1975 Act on terms set out in or scheduled to the order", insofar as those terms could have been included in an order under section 2 of the 1975 Act.

The most obvious exclusions from this provision are settlements involving non-parties to the litigation, or property not comprised in the deceased's estate - but note that a compromise involving property brought back into the estate under sections 8, 9 or 10 will be covered by the section.

Indeed, with regard to section 10 (property disposed of by the deceased in the six years before his death, with an intention to avoid the 1975 Act), this is expressly stated in section 146(2). As a result, the tax that would have been due on the lifetime gift (either because the gift was chargeable or because it was a failed PET) is no longer owing, and a repayment of IHT is made to the personal representatives. Of course, the value of the gifts set aside will (together with any IHT reclaimed) be part of the deceased's estate and therefore liable for IHT at the death rates.

As with section 19, there is no time limitation on the operation of section 146, and no need to make an election to the Revenue. The section will therefore be effective in circumstances where a tax efficient Deed of Variation is no longer possible.

Capital Gains Tax

Unfortunately, the CGT legislation does not contain an equivalent to section 146, and section 19 of the 1975 Act is therefore the only statutory provision governing the position. However, it may be possible to set out the terms of the compromise in a Deed of Variation, and rely upon section 62(2) of TCGA. For that matter, although such documents are invariably referred to as "Deeds of Variation", there is no requirement that a variation under section 62(2) (or section 142 of IHTA) should be in the form of a deed. As a result, the Tomlin schedule itself may qualify as "an instrument in writing made by the persons or any of the persons who benefit or would benefit under the dispositions" within the meaning of those sections, although this has never been tested in the courts.

Income Tax

Again, there are no specific provisions dealing with the effect on Income Tax of a court order or compromise under the 1975 Act. However, subject to the terms of the order itself, section 19 provides that the new beneficiary is to be treated as having received whatever benefit is awarded to him with effect from the date of death, and he will be liable for Income Tax accordingly.

Conversely, the original beneficiary will not be liable for that Income Tax. He will have been taxed on a "receipts" basis on any income that he received in the period leading up to the compromise, so it may be necessary to make adjustments if the settlement requires him to hand that income over to the new beneficiary.

Section 19 therefore offers yet another advantage - it is the only provision which specifically deals with Income Tax in the context of post-death re-arrangements. Note in particulars that there are no provisions dealing the effect of a Deed of Variation on Income Tax. Indeed, the Revenue's view is that so far as Income Tax is concerned such a Deed cannot alter the past. The original beneficiary will therefore continue to be taxed on any income actually received in the period up to the date of the Deed, while drafting a Deed that takes this into account can be difficult.

Conclusion

Parties may compromise a 1975 Act claim in the same way as any other action, and the settlement has the potential to be as tax efficient as any Deed of Variation. The effect of Morritt LJ's comments in Re Goodchild are yet to be seen, but in most cases the parties themselves are unlikely to raise the point. After all, a tax efficient settlement will benefit all those participating in the estate, and may have played a crucial part in ensuring that sufficient funds are available to satisfy all parties to the compromise.

However, personal representatives should resist the temptation to get involved in negotiating the terms of the compromise, which is a matter for the relevant parties amongst themselves. In particular, costs incurred by representatives as a result of their participation in negotiations may not be recoverable from the estate to the extent that their involvement was unnecessary.

Neither the court nor the personal representatives have the power to force an unwilling party to settle. Furthermore, personal representatives have no power to compromise on behalf of the unborn, minors, mentally incapable beneficiaries and those that cannot be ascertained. In such situations the court's approval will be required. Masters of the Chancery Division and District Judges of the Family Division have an unlimited jurisdiction in this regard: see RSC Order 80 rules 11 and 12 and CCR Order 10 rules 10 and 11.

Sarah Lacey is a Chancery barrister practising at 3 Stone Buildings, Lincoln's Inn