The professor, the wife, the court, their chancellor

Before the Pre-Budget Report 2007 (PBR 2007), standard estate planning required that spouses or civil partners made full use of their individual nil-rate band (NRB) allowances. If the NRB of the first to die was wasted (for example, by his or her entire estate being left to the survivor), this could result in an additional inheritance tax (IHT) liability of up to £120,000 at the present rate and allowance (40 per cent of £300,000). For this reason, it was standard practice to make provision by will for a NRB discretionary trust in respect of which the survivor was often the primary beneficiary.
After the PBR 2007, NRB trusts are unnecessary for spouses and civil partners. This effectively means the end of so-called ‘debt/charge schemes’, which have become popular in recent years. However, many of the points raised in this article (which was substantially re-written as a result of the PBR 2007) remain relevant to existing schemes, including the particular tax issue raised in the case of Phizackerley v HMRC [2007] Sp. C. 591. I will finish by briefly considering the PBR 2007 and its implications for existing NRB trusts and schemes.

Debt/charge schemes
It is frequently the case that a family’s wealth is tied up in the home, with the result that there are insufficient other assets to satisfy the NRB trust. The concern was that if the first to die’s share of the home was put into the NRB trust, HMRC were likely to argue that the survivor had acquired an interest in possession (IIP) in it, by virtue of his or her sole occupation. If so, that share would be treated as part of the estate along with his or her own share, with the result that all or some of the first to die’s NRB was wasted.
There are good arguments against this view, but it was generally accepted that steps should be taken to avoid a run in with HMRC. Further, if the survivor did not have an IIP, there were CGT difficulties. No CGT uplift would be available on death, and it was doubtful whether the trustees could claim CGT principal private residence (PPR) relief when the house was eventually sold (since this depends on whether the survivor is entitled to occupy the property under the terms of the trust).
The debt/charge scheme was intended to avoid these problems. There are two ways in which the scheme was usually implemented:

The surviving spouse or civil partner provided an IOU equal to the value of the unused NRB (the debt scheme); or
The first to die’s share in the home was charged with payment of that sum (the charge scheme).

Either of these steps satisfied the trustees’ entitlement and so allowed the personal representatives (PRs) to assent the first to die’s share to the survivor as residuary legatee.
The intention was that the surviving spouse or civil partner’s estate on death would be reduced by the value of the outstanding debt or charge (as the case may be). Further, since the survivor became sole owner of the property, PPR would generally be available in respect of the whole of any increase in the property’s value as and when it was eventually sold.

Finance Act 2006
As a result of the IHT reforms in the Finance Act 2006, it is generally no longer possible to create qualifying IIPs on or after 22 March 2006. If the first to die’s share was put into the trust, it did not therefore matter whether the survivor acquired an IIP in it. That share would not be treated as part of his or her estate. However, there was a potential trap. If the survivor acquired an IIP within two years of death, it would be read back into the will under section 144 Inheritance Tax Act 1984 (IHTA). It would then be an “immediate post-death interest,” and therefore a qualifying IIP.
One solution was to wait two years before appropriating the first to die’s share to the NRB trustees in satisfaction of their cash entitlement.1 Section 144 IHTA cannot then apply. This had the considerable advantage of avoiding the complex tax issues raised by the scheme, including SDLT, section 103 Finance Act 1986 and the income tax on the repayment of the debt or redemption of the charge (which was generally interest-bearing or index-linked). The CGT position could also be improved. The trustees could safely appoint an IIP in favour of the survivor with a view to securing PPR. This would (post-Finance Act) have no IHT consequences. However, some practitioners remained of the view that debt/charge schemes were still preferable given the delay in completing the administration, and also because of doubts about whether PPR is available at all where, as is often the case, the trustees only own a beneficial share in land.2 Many schemes will therefore have come into existence even after the Finance Act 2006.

The Section 103 trap
It is obviously important that the debt or charge is deductible from the estate of the surviving spouse or civil partner, otherwise the tax saving will not materialise and the scheme will have failed. One potential problem in this regard is section 103 Finance Act which provides that:

“…if, in determining the value of a person’s estate immediately before his death, account would be taken, apart from this subsection, of a liability consisting of a debt incurred by him…that liability shall be subject to abatement to an extent proportionate to the value of any of the consideration given for the debt or incumbrance which consisted of –

(a) property derived from the deceased; or
(b) consideration (not being property derived from the deceased) given by any person who was at any time entitled to, or amongst whose resources there was at any time included, any property derived from the deceased.”

Thus, section 103 is capable of applying if:

On the death of the surviving spouse or civil partner;
There is an outstanding liability which arises from either;
A debt incurred by the deceased surviving spouse or civil partner; or
An encumbrance created by a disposition made by that spouse or civil partner.

What triggers the section is that the consideration for the liability has been derived, whether directly or indirectly, from property originating from the surviving spouse.
The effect of the section applying is that the liability is “subject to abatement to an extent proportionate to the value of any of the consideration given”.

Phizackerley
The section 103 trap was considered in Phizackerley. The agreed facts were as follows:

1. Dr Phizackerley (Dr P) was a consultant biochemist and a fellow of an Oxford college. Until 1992, he lived in college accommodation and had no accommodation of his own. In 1992, he retired. He and his wife purchased a small house (365a Woodstock Road, Oxford –“the House” –) as joint tenants. The purchase price was £150,000.
There was a mortgage of £30,000, which was repaid in 1994. Mrs P did not work during her marriage, and the funds must have been provided by Dr P. He was born in 1927 and Mrs P in 1925;
2. On 1st May 1996, Dr P severed the joint tenancy so that he and Mrs P held the House as beneficial tenants in common in equal shares;
3. Mrs P died on 26th April 2000. Her estate did not exceed £210,000 in value. By her Will dated 5th May 1996, she left a nil rate sum (described as the “Designated Sum”) on discretionary trusts (“the Settled Legacy”). She gave the residue of her estate to her husband absolutely;
4. On 28th December 2000 Dr P, Stephanie Phizackerley (the taxpayer) and John Patrick Phizackerley entered into a Deed of Assent, of Retirement and Appointment and of Agreement (“the 2000 Deed”) relating to the Settled Legacy;
5. Under the 2000 Deed, the deceased assented to himself an undivided half-share of the House and promised to pay £150,000 (index-linked) to the trustees of the Settled Legacy;
6. Dr P died on 2nd July 2002. He left a Will dated 5th May 1996. His estate was valued at £529,654 (ignoring the disputed liability of £153,222 which included the accrued indexation as at the date of death).

The Special Commissioner was asked to decide whether the disputed liability was deductible from the estate of Dr P or whether that deduction was prevented by section 103.
The Special Commissioner said that on the face of it Dr P fell into the section 103 trap. Mrs P’s share in the House was property derived from Dr P, being the subject matter of a disposition made by him and so the liability he undertook to the trustees was subject to abatement to the full extent of the debt.

The taxpayer’s argument and the decision
The taxpayer argued that sub-section (4) of section 103 provided an escape. A disposition is not taken into account for the purposes of section 103 if it is not a transfer of value and is not part of specified associated operations. Section 11 IHTA provides that a disposition is not a transfer of value if it is made by one party to a marriage in favour of the other party, and is for the maintenance of the other party. The taxpayer argued that the provision of a half-share in the House constituted a disposition for Mrs P’s maintenance.
HMRC contended that Dr P could provide his wife with somewhere to live without giving her a half-share in the House. Section 11 is not relevant to transfers between spouses because they are exempt under section 18 (inter-spouse transfers). Section 11 is needed in cases of divorce or separation. The transaction was a gift, not maintenance.
The Special Commissioner concluded that maintenance “has a flavour of meeting recurring expenses” and that whilst it is wide enough to cover the transfer of an interest in a house, that would apply “only if it relieves the recipient from income expenditure, for example rent”.
At the taxpayer’s request, the Special Commissioner made an express finding of fact whether the gift of the money for the half-share in the house was “not made with reference to, or with the view to enabling or facilitating, the giving of consideration” (the words derive from section 103(2)(b)). He decided that it was not. He considered that if the gift had been with reference to the giving of consideration, the house would not have been put into their joint names as joint tenants. The fact that the joint tenancy was severed four years after the purchase, at the time of making the wills, indicated that IHT planning took place in 1996 and that the gift was not made with reference to the giving of the consideration for the debt. This was no doubt intended to narrow the issues on an appeal but this has become irrelevant since the taxpayer is not, it is understood, pursuing an appeal.
The whole of the disputed liability was disallowed, even though the property derived from Dr P was worth only £75,000 at the date of the gift, considerably less than the value of the debt at death. This was presumably on the basis that the property had increased in value such that an abatement of the whole debt was proportionate to the consideration given for it. However, there is no discussion of this in the case.

Planning points
The section 103 trap was well known before the decision in Phizackerley.3 The decision itself is unsurprising. Practitioners have for some time taken care to (1) identify whether section 103 is a potential problem for the client and (2) if so, take measures to avoid it. As to (1), it is necessary to make enquiries about past gifts. Any gift made by the surviving spouse, no matter when it was made, will bring section 103 into play. Nor is it necessary for there to be a connection between the gift and the debt or encumbrance.
As to (2), the planning opportunities stem from the fact that section 103 cannot apply if the surviving spouse neither incurred the debt nor made the disposition that created the encumbrance. One way of dealing with the problem was therefore to implement the charge scheme. Although there was an encumbrance, it was not created by a disposition made by the surviving spouse or civil partner (it was thought better from this point of view that the survivor was not a PR or at least the sole PR). Careful drafting of the charge was required. It was important to ensure that the survivor was not made personally liable for the debt, otherwise section 103 might still apply.
Another possibility was to leave residue on IIP trusts for the surviving spouse or civil partner. The residuary trustees would then incur the debt, not the survivor. It was thought better from this point of view that the survivor was not the sole trustee (he or she would not normally wish to relinquish control of the trust altogether) otherwise he or she might still be viewed as incurring the debt.
One remaining difficulty was that if the charged property was subsequently sold and a further loan was made to enable the survivor to purchase a replacement, this would bring section 103 back into play. If residue was held on trust for the survivor, this problem would not arise for the same reason as discussed above.

Pre-Budget Report 2007
As a result of the Pre-Budget Report 2007, it is now possible for spouses and civil partners to transfer their NRB allowances so that any part of the NRB that was not used when the first spouse or civil partner died can be transferred to the survivor for use on their death. The way the new rules work is, broadly, that the NRB available on the survivor’s death will be increased by the proportion of the NRB unused on the first death. For example, if 50 per cent of the NRB on the first death is unused and the NRB when the survivor dies is £325,000, then that NRB will be increased by 50 per cent to £487,500. A claim must be made by the PRs of the survivor within the permitted period, which has not at the time of writing been fixed. The transferable allowances will be available to all survivors who die on or after 9 October 2007, no matter when the first partner died or dies.
The new rules mean that it is no longer necessary for spouses or civil partners to make provision for a NRB trust, at least for IHT purposes. There may be other reasons for making such provision, – for example, there are children of a former marriage. For IHT purposes however, the first to die’s unused NRB will be available on the survivor’s death. It follows that debt/charge schemes are redundant.
What about existing NRB trusts and debt/charge schemes? It may still be possible to take advantage of the new rules. Provided the first death has occurred within the last two years, it will be possible for the NRB trustees to appoint the trust property (which may comprise the benefit of the debt or the charge) to the surviving spouse or civil partner. That will be read back for IHT purposes under section 144 IHTA. The NRB will not have been used up and so can be transferred on the death of the survivor. If possible, it would be prudent to wait until the Finance Bill receives royal assent. However, there may be cases where the two-year time limit will expire before that happens, in which case the client will need to be warned of the risk of a change in the proposed legislation before a decision is made.
One point which will need to be watched carefully in the coming months is whether the proportion of the NRB which is transferable is affected by the value of the first spouse or civil partner’s estate. In its guidance, HMRC states that the amount of the NRB that can be transferred does not depend on the value of the first spouse or civil partner’s estate. Whatever proportion of the NRB is unused is transferable. This is another considerable improvement on the current rules. However, the draft legislation is ambiguous on this point (since it seems to refer to the deemed chargeable transfer made on the actual person’s death which must be limited to the value of his or her estate). The importance of this is that it may still be necessary for spouses and civil partners to arrange their affairs so that the maximum proportion of the unused NRB is transferable.

Leon Sartin is a barrister at 5 Stone Buildings, Lincoln’s Inn, London. He can be contacted on 020 7242 6201

References
1. Kessler QC, Drafting Trusts and Will Trusts, 8th ed., Sweet & Maxwell, ch.29;
2. Chamberlain and Whitehouse, Trust Taxation – Planning After the Finance Act 2006, Sweet & Maxwell, paras.28.16 and 31.25-26;
3. Encyclopaedia of Forms and Precedents, Wills and Administration, vol42(1), para.268-270 (2003 issue).