Feature

posted 21 Nov 2002 in Volume 8 Issue 1

The family home:
An opportunity? Maybe not

Practitioners will be well aware of the kinds of difficulties inherent in giving away the home. However, the Eversden case has raised some important issues that have interesting implications for tax planning. Emma Chamberlain, a barrister at 5 Stone Buildings, examines the case and assesses how a client might be advised on their tax planning as a consequence.

Your longstanding client Mr Savage, aged 65, rings you up on Monday morning. “Good morning,” he says. He comes straight to the point. “Now look, I’ve just been reading the Sunday Times business pages and I gather that you’ve been missing a trick or two on my inheritance tax planning.” Your heart sinks. Mr Savage is well known throughout the firm as someone who reads the papers at the weekend and rings up on Monday asking for the latest ‘simple’ tax scheme. He still blames you for refusing last year to set up an offshore trust to hold all his assets. “What particular planning did you have in mind, Mr Savage?” you ask.

“Well,” he says, “there’s this scheme called Evershed or Essex or Somerset, something like that. Anyway, the point is that even I can understand it: I put my house in trust for my wife and then the trustees terminate her interest the next day and it goes to my children. I can go on living in the house, so no worries there, and there is none of that reservation of benefit problem you are always going on about because of something to do with the spouse exemption. Tell you what – you crack on with drafting the documents this morning and then I can come in and sign everything this afternoon.”

You take a deep breath. “Mr Savage – it’s not quite that simple.”

Mr Savage interrupts. “Now look,” he says, “I’m fed up with your negative attitude to a bit of creative tax planning. If you won’t do a simple task like this for me, I’m going to go down the road. There’s a firm there that’s a bit more up to the minute with all this stuff and I’m sure they’ll be more than happy to help. They dropped a leaflet through my door the other day asking me, why pay inheritance tax when it was only voluntary. That’s the sort of positive attitude to tax planning I like. “

“Mr Savage” you say firmly. “I am not dismissing the idea of using the case of Eversden to assist you on your inheritance tax planning but you need to be aware of all the pros and cons. I suggest you come in with your wife this afternoon and we discuss it fully then.”

Mr Savage rings off, having agreed to see you at 2.00pm ‘sharp’ as he puts it, and you have four hours to marshall your thoughts on the whole matter. You know that the usual cautions on using the house for inheritance tax planning will be of no avail here. Mr Savage has read the newspapers, “and they say the whole thing is fine.” You decide to go back to basics and read the case of Eversden again for yourself.

Before you do that, however, you remind yourself of the main difficulties that can arise when giving away the family home:

Avoiding reservation of benefit, which makes the whole exercise totally ineffective for inheritance tax purposes;
Creating an unnecessary capital gains tax charge through loss of the principal private residence relief on the home. If you don’t own the house any longer, it is going to be difficult to preserve the PPR exemption;
Manufacturing a gain by creating a different type of chargeable asset;
Creating an unnecessary income tax charge by payment of rent etc;
Creating a structure that makes moving difficult later for Mr Savage and his wife;
Ensuring the structure does not jeorpardise the client’s security and does not result in unforeseen inheritance tax charges or matrimonial claims. You are aware that one of Mr Savage’s two children is in ill-health so you don’t want to add property unnecessarily to that child’s estate.

With this in mind, you read the case of Essex, Executors of Somerset Deceased and IRC [2002] STC (SCD) 39, a Special Commissioner’s decision, which was then appealed. Judgement was given by Lightman J in IRC v Eversden and another on 10 July [2002] STC 1109.

The facts of Eversden

Mrs Greenstock set up a trust in 1988 in favour of her husband for life, remainder on discretionary trusts for a class of beneficiaries that included herself.

She transferred into that trust on interest in possession trusts for Mr Eversden a 95 per cent interest in her home, Beechwood Cottage, retaining five per cent personally. Nothing further was done. Husband and settlor occupied the property. Mr Greenstock died in 1992 and inheritance tax was paid on the full value of the assets held in trust since he had an interest in possession in the whole. (Contrast this with the normal situation where there is no inheritance tax payable until the last spouse’s death.)

On Mr Greenstock’s death, Mrs Greenstock decided to move and, in due course, the property was sold and a replacement property, 6 Barn Meadows, was purchased along with an investment bond. Meadows and the Bond were also owned as to five per cent by Mrs Greenstock personally and 95 per cent by the trust on discretionary trusts. Mrs Greenstock occupied the Meadows until her death but received no benefit from the bond.

On the Settlor’s death, the Trust Fund was worth £171,000 (the Meadows) and £149,213 (the bond). The Revenue assessed her to inheritance tax on the basis that having regards to FA 1986 s102 she had reserved a benefit in the trust property. She was among the class of beneficiaries and had occupied Meadows. Her executors appealed on the basis that she was excluded from benefit and in the alternative that the initial interest in possession given to the husband meant that section 102(5)(a) operated to disapply s102 and the reservation of benefit provisions: the disposal of property by way of gift was an exempt transfer by virtue of IHTA 1984 s18 (transfers between spouses).

So far, the executors have won at the Special Commissioners and at the High Court. The Revenue has appealed and the case is due to be heard in May 2003. There are three important points that have so far emerged from the Eversden case.

1. Being a discretionary object means a reservation of benefit

The first point is that the executors of Mrs Greenstock failed in their argument that, despite Mrs Greenstock being a discretionary beneficiary, she had not reserved a benefit. Lightman J held that given Mrs Greenstock was a potential beneficiary within the class of beneficiaries, the fact that she may not have ever been the positive object of the trustees’ discretion was irrelevant. There was still a reservation of benefit. This confirms what was generally thought to have been the law. The mere possibility of adding the settlor as a beneficiary would also be considered by the Revenue as a reservation of benefit. Equally, if the spouse of the settlor is a member of the class of discretionary beneficiaries this will not generally cause inheritance tax problems, (unless, for example, there are reciprocal settlements), although of course it may raise income tax and capital gains tax issues.

2. No carve-out on replacement property

Second, Lightman J also made certain comments re: The Trusts of Land and Appointment of Trustees Act 1996 (TLA), regarding entitlement to occupy the family home. Like the Special Commissioner, he appeared to accept that in relation to the original property Beechwood, the settlor’s occupation was attributable to her retained interest and therefore to this extent the ‘carve-out’ principle worked, (implying that there was no reservation of benefit by virtue of her continued occupation per se although there was still a reservation of benefit under the first head above).

However, he felt that there was a change in respect of the replacement property Meadows. While the occupation of Beechwood might be, “referable to a specific proprietary interest retained”, along the lines set out in Ingram v IRC 2000 AC 293 his argument appears to have been that the settlor did not occupy the replacement property under the same carve-out principle but rather by reason of a new agreement entered into between the settlor and the trustees. The settlor had no right to occupy the new property purchased merely because she had contributed to the purchase price. Having, “regard to the real nature of the transactions and the beneficial interests concerned”1, the settlor did not succeed in carving out a separate proprietary interest. Instead, the settlor and trustees entered into a separate and new agreement to give her a right of occupation over Meadows, thus conferring a benefit on her. There was no carve out but a ‘conferring’ of benefit by the trustees.

This reservation of benefit in itself would not matter given the protection of section 102(5) (see next point below). However, Lightman J seems to go further: “Far from the settlor being excluded from benefit she thereafter enjoyed this benefit effectively to the exclusion from benefit of the beneficiaries under the Settlement.”

He did not explicitly state that she had an interest in possession in the whole which in effect, would mean that the whole trust property would be taxed as part of her estate by virtue of s49 IHTA 1984 anyway and the question of reservation of benefit would be irrelevant. However, the Revenue now appears to take this view. The taxpayer is cross-appealing on this point.

3. No reservation of benefit

The final point is that Lightman J upheld the taxpayer’s contention that a disposal of property into an interest in possession trust for the spouse is treated as one exempt gift from settlor to spouse. It is not three separate gifts into trust, only one of which is exempt (the life interest) and the others (being the discretionary trusts and the ultimate default trusts) are not. (The multiple gifts idea was broadly the argument of the Revenue before the Special Commissioners).

Lightman J agreed that since the whole value of the house gifted was attributable immediately after the transfer to the donee spouse’s estate, section 18 IHTA 1984 must apply to exempt the gift. The fact that the gift is made into a trust for the spouse to be held on successive interests does not mean that the donor spouse makes more than one disposition. Nor should it matter if the transfer of value, (i.e., the loss to the donor’s estate), is in fact greater than the value of the gift to the spouse, see Revenue Press Release of 15 April 1976. (This could occur in relation to gifts out of a controlling shareholding.) The exemption still extends to the whole value transferred.

The duration of the life interest of the spouse was also held by Lightman J “after anxious consideration” to be irrelevant and so the Revenue failed in its further argument raised in the High Court that the reservation of benefit arose at the point of termination of the life tenant spouse’s interest.

In effect then, the current state of the law is that the provisions of section 102(5) FA 1986 apply so as to exclude the operation of the reservation of benefit provisions when there is an exempt gift of the house by one spouse into an interest in possession trust for the other spouse. The reservation of benefit exception for exempt transfers to spouses contained in section 102(5) is equally applied to sections 102A and 102B in relation to land by virtue of section 102C(2). The result is that although Mrs Greenstock reserved a benefit in the property she had given away (either because she was within the class of beneficiaries or had continued to live in the house), this did not matter because she had the protection of section 102(5)(a). Clearly the principle is applicable not just to houses but can apply to any asset in which the settlor wishes to retain some possible interest.

Implications for tax planning

How does this help us in relation to tax planning now? The present proposal envisages that Mr Savage gives away his interest in the family home into an interest in possession trust for his wife but continues to live there without reserving a benefit for inheritance tax purposes.

It is, however, clear that the mere retention of a personal interest in the house by the settlor cannot necessarily provide any argument that the settlor occupies by virtue of that personal interest when a new property is purchased. Thus there is no point in Mr Savage retaining part of the house personally. It may be preferable to transfer the whole into trust but reserve him an interest in possession in part of the house under the terms of the trust. It is also clear that some care will be needed to avoid Mr or Mrs Savage being treated as having an interest in possession in the entire house merely by virtue of their occupation.

The statements of Lightman J in the case also suggest that the position where nil rate band discretionary trusts are set up on the first spouse’s death with the deceased’s half share in the house going into that trust will need to be reviewed with considerable care. The Revenue has sometimes queried these arrangements arguing that the surviving spouse has an interest in possession in the trust by virtue of her exclusive occupation. It may be less easy to refute this argument now given the comments of Lightman J and SP 10/79.

The proposal to Mr Savage

When he comes in, you suggest that he could now gift his interest in the home to an interest in possession trust for his wife. You explain that the interest in possession trusts are defeasible – that is, the trustees can terminate those interests in possession at any time at their discretion and without the requirement to obtain any consents.

“Is there stamp duty?”, asks Mr Savage. “No” you respond. “There are no stamp duty concerns since it is a gift. I know your property is not mortgaged.“

“What about capital gains tax on the gift?” asks Mr Savage. You reassure him that you have checked his file and he has always occupied the property as his principal private residence and never elected for any other property to be his main residence for capital gains tax purposes.

“I would like to be a trustee with my wife” says Mr Savage. “I know that we will need another one but you can be the third trustee if you want.” You advise strongly that the trustees should not be Mr or Mrs Savage.

“That’s all very well” says Mr Savage “but under this idea my wife still has an interest in possession in the property and that means it will be taxed on her death even if not on mine.” You then advise that the trustees will after a suitable interval consider exercising their powers so as to terminate Mrs Savage’s interest in possession in the trust in part. Instead, the property could then be held on defeasible interest in possession trusts for the children. However, it would be sensible to ensure that the parents also have an interest in possession in at least a small part of the trust fund and that all interest in possession beneficiaries are given the right to live in the property. It is expressly stated that no such person is excluded from occupation.

You stress to Mr Savage that all the children’s interests are defeasible i.e. they can be ended by the trustees at any time. This gives some protection if one of the children divorces although for this reason it is not advisable that the children are trustees.

“What happens if my wife dies before me?” asks Mr Savage. You explain that on the death of Mrs Savage under the terms of the trust unless the trustees determine otherwise, his wife’s remaining interest in possession could pass to Mr Savage and then down to the children. The idea is that inheritance tax will be paid on the last spouse’s death only on the value of that fractional share in which the interest in possession is retained. (s50(1) IHTA 1984.)

The parents and the children and remoter issue and anyone else thought appropriate will be within the class of potential beneficiaries. You decide that a power to exclude beneficiaries (e.g for the divorcing child situation) might also be useful.

“Hang on” Mrs Savage interrupts, having been quite silent up to then. “I understand all that business about my husband not reserving a benefit but what about me? I’m the one whose life interest is terminated, I go on living in the property so surely I have made a gift with reservation. And what happens if I die within seven years?” Mr Savage looks impressed – he had not thought of either of these points.

You explain that there is indeed a deemed PET on the termination of Mrs Savage’s interest in possession. She will certainly need to survive seven years and therefore a downside of the scheme is that, if she dies in the next seven years, inheritance tax will be payable earlier than would otherwise have been the case. Normally, there is only inheritance tax payable on the last spouse’s death. You suggest that maybe decreasing term assurance should be taken out by the trustees on her life to cover this problem. “More expense”, grumbles Mr Savage.

You add that there should not be a reservation of benefit made by her so the home should not remain taxable in her estate. For the reservation of benefit provisions to apply, the disposition of property must be made by way of gift. Although on termination of her interest, Mrs Savage has made a transfer of value, the value transferred being equal to the value of the settled property (section 52(1) IHTA 1984), that transfer is not a gift unless the wife consents to the termination of her interest. It would also be preferable that she is not a trustee. The wife has done nothing voluntarily at all – there is no element of bounty by the wife since she does nothing herself.

You point out that Eversden, of course, is not necessarily authority for the second stage of the scheme, only for the first stage of the above arrangements, i.e, that the gift to the interest in possession trust for the surviving spouse is an exempt transfer to which the reservation of benefit provisions do not apply. In Eversden, the Revenue did in fact collect inheritance tax on the death of the donee spouse who still had an interest in possession on death. “Usual caveats”, grumbles Mr Savage. “What about if we want to move? Will I have to pay capital gains tax?”

It is indeed the case that any chargeable gains realised by the trustees will be taxed on the settlor under s77 TCGA 1992. However, by letting the parents have an interest in possession in part only of the property, this should secure the PPR capital gains tax exemption on the whole of the house held in trust if there is a later sale – see s225 TCGA 1992. Thus, the trustees can sell the house and buy a replacement property without a tax charge.

On the death of the settlor and spouse, the base cost uplift to market value would still be on only a limited part of the property (i.e., that part in which the relevant settlor/spouse has an interest in possession). However, even if the house shows a substantial gain on death, the capital gains tax should not be an issue provided that a sale by the trustees is done within 36 months of the last spouse’s death.

Difficulties

There are, however, further difficulties on Eversden type schemes, particularly where the planning is in relation to the house. A few of these which you will need to point out to Mr Savage include:

1. What trusts should arise on the determination of Mrs Savage’s interest, particularly in the light of Lightman J’s comments?

If there are discretionary trusts (generally only used when the value of the home is small) and the settlor and/or spouse are left in sole occupation, there is a risk that the Revenue will contend the spouse and settlor have interests in possession in the whole. The tax planning exercise is frustrated and the whole house is still subject to tax on their deaths. See also Woodhall v IRC [2000] STC (SCD) 558 and Faulkner v IRC [2001] STC (SCD) 112 for further comments in this area.

If all interest in possession beneficiaries including the children have a right to occupy the home and no beneficiary is excluded arguably they should each be treated as having an interest in possession in their percentage share but the provisions of ss12 and 13 Trusts of Land and Appointment of Trustees Act (TLA 1996) still need to be considered.

2. How long should the initial interest in possession of Mrs Savage last

Her interest in possession in the whole must endure for a reasonable length of time, see for example Hatton v IRC 1992 STC and compare Fitzwilliam v IRC STC 1993. The court might excise a short-lived or illusory interest in possession and, of course, in those circumstances the spouse exemption would not be available.

One would want to avoid a situation where the trustees include the parents and the trustees must exercise their discretions, (for example to terminate the interest in possession), independently.

3. Reversal on appeal and legislation

Eversden may be reversed when the appeal is heard next May. In that event, any planning done now will have failed. In order to avoid the difficulty that Mrs Savage may then have made a PET for no good result, one might want to set up the trust now with an interest in possession in her favour but the trustees do nothing further until the case is heard.

At that point, they review the position. Indeed, legislation may be introduced in Finance Act 2003 and announced in the November statement stopping the scheme although it is unlikely that such announcement will be retrospective and therefore trusts already established may still be worthwhile.

4. Death of child

If a child dies holding an interest in possession in the home, there would be inheritance tax payable on his share even while the parents are alive. It may be possible to avoid such a charge, e.g., if the child is married but the position can be uncomfortable.

5. Associated operations

There is, of course, the question of associated operations under section 268 IHTA 1984 to consider. The operations, (namely the gift into trust and the termination of the life interest), are surely associated, although they may not be relevant. Do the two operations together increase the transfer of value made by Mr Savage? Arguably not. It is just the first gift into trust that constitutes the transfer of value (albeit an exempt one). Alternatively, under para 6(1)(c) schedule 20 FA 1986, has the settlor obtained a benefit by virtue of any associated operations? See Macpherson v IRC 1989 AC 159 and compare more recently Reynaud v IRC 1999 STC (SCD) 185 and Rysaffe Trustee Co Ltd v IRC 2002 STC 872. Even if the operations are associated and relevant does the effect of this mean that the initial gift to the spouse is ignored? The words in section 268(3), “except to the extent that the transfer constituted by the earlier operations but not that made by all the operations together is exempt under section 18 above”, might suggest that there is no credit but not that the gift to the spouse is ignored merely that it is not added to the total transfer of value.

Conclusions

These are some of the problems that you point out to Mr Savage. There are other issues to consider. For example, suppose Mr and Mrs Savage divorce.

“Well would you do it?” he asks slightly chastened. You hesitate. “The planning certainly has possibilities but your wife does need to survive the seven years else you could end up paying more inheritance tax and it is not without risk” is your general advice. You stress in particular that the principle established in Eversden, i.e., that one can rely on the spouse exemption on gifts into interest in possession trusts to ‘block’ the reservation of benefit provisions is not settled law yet, since the taxpayer may lose on appeal.

Mr and Mrs Savage decide to return next week once they have thought everything through.

Reference:

Which earlier on in the judgment he stated it was always important to consider in relation to carve outs.

Emma Chamberlain is a barrister at 5 Stone Buildings Lincoln’s Inn London WC2A 3XT Tel 0207 242 6201. She specialises in private client tax and trust matters and writes and lectures widely.