The Inland Revenue consultation document
Why ECA readers should be particularly interested

On 11 December 2004, the Inland Revenue published a consultation document on the tax treatment of pre-owned assets. David Coldrick, ECA editor and partner at Wrigleys Solicitors, examines the contents of the document and assesses the feedback he has so far received from readers.

The consultation document on pre-owned assets gives the impression that it is geared to dealing with inheritance-tax avoidance in a small number of cases, but that is not what it actually says. Its tenor may suggest a different end result to the actual content but it is suggested that a carefully crafted consultation document should be constructed so that the content leads and the tenor follows. It is understandable if ECA readers feel that they must react to the words and not the tenor of the consultation document while hoping that the tenor is reflected in the end result.

It should be specifically noted that ECA readers are not, as a breed, primarily interested in complex inheritance-tax-planning schemes. Most readers, so far as they are involved in inheritance-tax planning at all, are not looking for “loopholes”, but simply to use established rules acceptable to the Capital Taxes Office in ways which benefit clients. Indeed, ECA readers are very aware that the needs of their vulnerable clients invariably involve the support of the taxpayer. Some readers have already expressed specific support for the government’s objective of revenue protection. ECA has also consistently given support to the aims of NHS Plan and the National Service Framework for Older People. There is little doubt in the author’s mind that ECA readers as a whole have no objection to the maintenance and indeed enhancement of efficient revenue raising in accordance with parliament’s democratically mandated role. There are those who may prefer to return to a time when taxes were generally lower but that is also accepted as unlikely, especially given increasing public expectations and thus demands in respect of the healthcare sector. Therefore, ECA readers start from a positive understanding of the role and need for effective revenue collection.

There are a couple of particular reasons why this consultation document is being addressed in this magazine. Those are as follows:

Tax raising from vulnerable persons. It claims to be part of the government’s “wider strategy to protect tax revenues”. But given the scope of the description of the proposed measure outlined in the consultation document it appears it may have a tax-raising function or at least a tax-raising effect. This may be disproportionately at the expense of vulnerable persons across all age groups as explained. This would be of very significant concern to all the caring professionals who constitute our readership. It is assumed that there is no intention to create such an effect and it is, therefore, hoped that by making a submission any inadvertent prejudicial impact may be avoided;
Double taxation of vulnerable persons. The consultation document states that: “Income tax will in future be charged on the benefit people enjoy when they have arranged free continuing use of major capital assets that they once owned.”

It notes that: “Arrangements like this are often made to get round the inheritance tax (IHT) gifts with reservation (GWR) rules. Essentially, these GWR rules are intended to stop people from giving their assets away, so that for IHT purposes they are out of their estate when they die, while still continuing to enjoy the practical benefits of owning them during their lifetime.”

The purpose of the proposals appears to be to charge income tax on assets given away under inheritance-tax-planning “schemes”. It appears to be assumed that this charge would be the ultimate deterrent to inheritance-tax planning with the family home and other valuable assets. But, while there appears to be an assumption that such gifting mostly has an inheritance-tax purpose, in many situations it does not. It is submitted that, in practice, non-tax reasons predominate. It is vitally important that this is understood before any measures are enacted that create an income-tax charge in situations where there would be an inheritance-tax charge on the asset involved both before and after a transaction against which the proposals appear to affix themselves.

In such situations, given that there would be no loss in terms of inheritance tax, it would seem inappropriate to apply what is a, it is assumed, an income-tax penalty. There is no inheritance-tax loss to make good. This amounts to double taxation and that will often involve the double taxation of a vulnerable person and their estate. Even if the proposals are designed to operate only upon very valuable assets, to effect double taxation may even then be inequitable. Further, it should not be assumed that all vulnerable people are less well off. They may be technically better off for a good reason, for instance, as a result of provision made for them by their family or as a result of compensation for a personal injury.

To these reasons for expressing a particular interest it may possibly be objected that the government’s aim is clear. It has nothing to do with the inheritance-tax-neutral situations, which the transactions below refer to. Thus, readers of ECA should not be concerned. It is all about hitting complex inheritance-tax-planning schemes effected by those on millionaires’ row and affecting nobody else. Unfortunately, the consultation document on a plain reading does not indicate that. It is submitted that if it was supposed to give such comfort it should have done so or should have done so rather more clearly.

Who may be affected by the proposed income-tax charge?

The section of the paper headed “Who is likely to be affected?” simply states: “People who continue to enjoy the use of assets (free of charge, or at a below market rent), which they formerly owned (or provided the funds to purchase).”

This sweeping statement incorporates a wide variety of possibilities. It is only somewhat modified elsewhere in the consultation document, suggesting that “big numbers” will need to be involved before it bites. But, given the broad nature of this comment, the possible ramifications are potentially far more extensive than the existence of certain inheritance-tax schemes would appear to merit and again, it is noted that not all vulnerable people are capital poor.

The details supplied in the consultation document do not explain the specific types of situation envisaged as being “caught”. The Revenue’s intention seems to be to catch schemes of the nature of a “twin trust”, although on the precise wording the release does not seem to do so. Having to make assumptions indicates that the document is lacking in sufficient detail to make the consultation a fully effective exercise and may, as indicated above, mean that unnecessary concerns are being generated to which a more detailed focused document could have helped to avoid. Making the assumptions, however, the twin-trust schemes involved complex trust and loan arrangements whereby a donor of a valuable house or chattels could reside or retain use of assets for which monies are owed at death reducing the amount in their inheritance-taxable estate. Due to the nature of the schemes, the GWR rules appear to have been successfully circumvented. To some extent these schemes have been neutralised or deterred so far as private residences are concerned by the introduction of Stamp Duty Land Tax on 1 December 2003 and it is wondered just how broad the perceived continuing problem, now apparently being tackled, is in practice. It is assumed that the problem is a historical one rather than a current and future one. This further assumption is supported by the comment in the consultation document that: “Arrangements which currently exist to provide benefits for former owners will not be chargeable if they have been dismantled or the former owner starts to pay a full rent by 6 April 2005.”

Retrospective nature of the proposed income-tax charge

It is the retrospective element that should be vehemently resisted. People who plan to give away their assets on the basis of present legislation should not suddenly find that they face an income-tax charge later. The government should surely aim to get the legislation right in the first place. It is perfectly proper that legislation on reservation of benefit should be changed to affect future gifts and that existing schemes are attacked through the courts on the basis of the legislation at the time they were made. However, it is submitted it is not acceptable for new legislation to catch gifts already made. For example, it would appear that Eversden type schemes (which readers will recall the Revenue did litigate and lose) will be retrospectively caught if the proposals go through despite the fact that legislation has been passed to stop future schemes.

Tax-based concerns over the proposals

Specialist bodies such as the Society of Trust and Estate Practitioners and the Chartered Institute of Taxation will offer detailed objections from a tax perspective but practitioners should also write in to ECA so that we can voice your concerns to the Revenue. ECA readers have offered some general points of concern:

The taxpayer should be allowed to organise their affairs with a reasonable degree of certainty and freedom from worry. Readers have already commented that they find that ordinary tax planning, even that effected before the GWR rules were introduced in 1986, may be affected by the proposals. This is considered to be especially objectionable particularly when the asset successfully removed from an estate for inheritance-tax purposes is now sought to be taxed by another tax, which deems them to have a theoretical benefit from that asset when they may now be elderly and of limited means rendering them unable to pay. As the asset may have been given away outright, they may be wholly incapable of recovering it before the deadline to avoid having to make payments. The possibility of an “undoing” appears to be assumed to be possible in the proposals. Inevitably, this may be a significant source of worry for some older clients. Given the dramatic increase in house prices, the relatively fixed nature of pensions and the decline in interest rates, it is no comfort for the proposals to suggest that only assets of great value will be affected. Many houses have such great value without a modern equivalent income in support. Any reduction in the level of certainty in a tax system is also submitted to remove one of the foundation stones of a successful market economy, which to a degree depends on the succession of productive wealth;
It is submitted that the methodology of using one tax – income tax – to counter the avoidance of another tax – in this case inheritance tax – is very unusual and may create an array of unforeseen problems as a result. While capital gains tax may be considered as a natural backstop to income tax by way of its preventing income-tax avoidance by conversion of income to capital gains, the use of income tax as an inheritance-tax, anti-avoidance measure is quite different. It is suggested that it is not a natural backstop. The nature of the proposals import artificial methods of calculation because there is no real income to assess. The words “clumsy” and “blunderbuss” have been used by readers. The use of “deeming” has also been criticised as “invidious”;
Alternatives are preferable. It is submitted that changes to legislation may, as an alternative, be directed to the improvement of the, already well-targeted, inheritance-tax GWR provisions to which the consultation document refers. The impression is that these have already deterred mass avoidance and that recent developments have acted as an even greater deterrent to both tax professionals and clients. It is submitted that this would do the work suggested as the government’s aim namely to protect tax revenues without having any potential to create the damage the imposition of income tax might well achieve as a side effect. It is also submitted that it is potentially far less costly to implement and administer such an improvement in the GWR provisions. The other solution, according to some readers, is for the government to accept that house prices have risen and that inheritance-tax thresholds should rise accordingly, thus eliminating much of the perceived problem.

The specific proposals in the consultation document

Turning to the detail of the proposed measures, the Finance Bill 2004 “will” it states include legislation providing for:

“Income tax to be charged each year (under Case VI of Schedule D) on the benefit of using as asset formerly owned by the user unless it has since been sold to an unconnected party in a bargain at arm’s length.”
“Extensions to cover cases where one asset is replaced by another, or where the beneficiary provided cash to fund the purchase of an asset for their use (rather than providing an asset they already owned).”
“Rules for valuing the benefit… [envisaged to be] at market rent where market evidence allows (for example, for real property) and at a specified percentage of capital value (for example, calculated at the “official rate” of interest for benefit in kind purposes in other cases, such as art or antiques.”

The use of the expression “will” is disappointing because it indicates that consultation cannot remove this proposal from the list of matters already being readied for the draft Finance Act 2004. As it is suggested that this approach to inheritance-tax avoidance may be open to the creation of problems, which can be avoided by a more traditional amendment to the inheritance-tax rules this is considered regrettable by the readers so far venturing their opinions and it is hoped that the “will” may be tempered in practice.

The details in the consultation document do not make it clear exactly what assets may be the subject of the income-tax charge. It refers to “real property” and “art or antiques”. But many transfers of ownership in this context may involve cash, shares and other assets and it cannot, upon the basis of document, be assumed that these are excluded. While the discussion of the rules submitted refers primarily to the main residence, the problems will inevitably apply to gifted and particularly entrusted property of this broader nature. It is hoped that exclusions should be applied evenly to all relevant asset classes.

The proposed exclusions from the proposed tax charge are inadequate

The consultation document adds that the basic rules of assessment will be subject to:

A set-off for any rent actually paid for the benefit;
An exclusion for incidental use;
An exclusion for cases where the donor has expressly reserved a right of continued occupation when making the gift;
A substantial de minimis exclusion set at a cash amount…
Any other exclusions or modifications that seem appropriate, given minister’s objective for the charge…
A power to make further exclusions by statutory instrument.”

The exclusions so far suggested are not sufficient to assuage the expressed fears of ECA readers as has been indicated above. It is at this point that it is hoped that readers’ submissions will be most useful to the legislative process:

“A set-off for any rent actually paid for the benefit.” This appears to be designed to ensure that clients who have use of property that they have gifted away or have transferred it into trust but who pay an open market rent for it, may continue to do that without an income-tax penalty and may also have the benefit of that property having passed out of their inheritance-taxable estate after seven years. To do otherwise would be to negate the efficacy of arrangements that are already in place and perfectly acceptable to the Capital Taxes Office as compliant with the GWR rules. Most of the cases that concern the clients of ECA readers are cases involving older people where no rent is payable. Indeed it would be inappropriate for various reasons to make such rental payments;
“An exclusion for incidental use.” This appears to follow the established inheritance-tax position that if property is gifted and the donor makes very limited use of it, such as by way of a short stay in their newly resident children’s home, this is ignored for the purposes of the GWR rules. It does not cover cases where a person remains in their own home after it has been gifted or transferred into trust. Reader’s submissions indicate this may be of serious concern;
“An exclusion for cases where the donor has expressly reserved a right of continued occupation when making the gift.” This appears to be consistent with the inheritance-tax rules. A gift or transfer into trust subject to such a right means that an “interest in possession” for inheritance-tax purposes will be likely to be retained by the donor. The GWR rules may not even be relevant. The reservation of such a right would make the transaction practically irrelevant for inheritance-tax purposes as the capital transferred will be taxed as their own at death. However, while gifts or transfers into trust may sometimes contain an express right of residence, the comment in the consultation document does not appear to refer to all forms of trust where there is either an interest in possession (such as a right to income) in the transferred property or a clearly reserved benefit by way of the donor being among the class of potential beneficiaries in a discretionary trust. Neither situation would be rationally created with a view to an inheritance-tax saving because that would not be the result achieved. Nor does the comment in the consultation document secure an exclusion for non-express rights of residence for a beneficiary with an interest in possession or obtained as a matter of the exercise of a discretion by the trustees. Many trusts contain a power for the donor to reside. That is not the same thing as an express reservation of a right of continued occupation. The proposed exclusion also appears to exclude the possibility of trustees creating such a right of residence after the creation of the trust;
“A substantial de minimis exclusion set at a cash amount…” A considerable sum, which is small enough to be ignored by the tax office, will secure an exclusion. It is not clear whether or not this refers to the capital value of the asset transferred or to the rental that it may generate. Identical properties may have the same capital value but a different rental value in different areas. They may conversely have the same rental values and different capital values. Any number of permutations are possible. Given house-price inflation, the geographically variable nature of rents and the economic cycle, it is submitted that even with an exclusion such as this anomalies and unfairness will occur. This reinforces the general submission as to the negative cost: benefits analysis of such an approach to inheritance-tax anti-avoidance provision. In the context of the possible application to vulnerable people it may be even more pernicious. It is also not true to say that all cases involving trusts and vulnerable people concern “small numbers”. A well adapted property purchased by a personal injury award or an inheritance subsequently transferred into a protective trust arrangement – without any view to an inheritance-tax saving – may be extremely valuable with capital and “deemed” rental in accordance with that value.

Situations caught by the proposed new income-tax charge

Situations that appear to be inadvertently caught by the proposed income-tax charge include a wide variety of situations where the owner of a residence (or other asset) transfers it into trust without any inheritance-tax-saving objective. There may be no right of residence (and indeed it may not be relevant given the asset type). This may be done for many reasons which include:

Settlements of funds received as a result of a personal injury. There are many cases where a mentally capable but physically or socially vulnerable person pays such an award over to trustees for their own protection. Fears over gold-diggers are common. There are also trusts founded in this (and other) situations because wider family members are involved in substance abuse and /or criminal activities, which renders the compensated person vulnerable to pressure and intimidation as to the use of their award. These awards can amount to some millions of pounds;
Peace of mind that something which is set in motion in lifetime is less prone to challenge upon death. Transfers of the family home into trust for the settlor for life and then to children often fall into this category. Other asset transfers may also fall into this category;
Settling moral obligations. These are very important to many people who wish those who have looked after them to receive recompense for that care. These obligations can be fulfilled in advance by way of gift or trust but usually the donor retains a benefit for life;
Transmission of burden while recognising the need to retain a degree of current income or residential security while alive. The burden may be administrative in respect of financial paperwork or in cash terms in respect of repairs and household insurance. Again this may be achieved by outright transfer or use of a trust;
Avoidance of problems on incapacity. Many people fear that through living longer they may be unable to deal properly with their assets in later life. Setting transmission in motion such as by a settlor interested life interest trust is often a means to this end. It ensures that physical and mental incapacity does not create problems. It may also reduce subsequent costs by avoiding the full-scale involvement of the Court of Protection;
The use of gifts and trusts can also significantly reduce delays and costs on death. The ultimate beneficiaries have the asset or the trustees can continue to deal with it without even the need of grant of probate of the will;
Deeds of Variation. These allow the distribution of a deceased’s estate to be altered inheritance tax efficiently. But first, while effective for inheritance-tax purposes, they must belong to the person effecting the variation. Certain of these could be affected.

This list is not exhaustive. Readers will have their own thoughts and additions to make. Please send your submissions to ECA, as explained in the paragraph on page five, as quickly as possible. This article is by the editor with assistance from Emma Chamberlain, barrister.