Feature

posted 4 Apr 2006 in Volume 11 Issue 3

Pre-owned assets and double trust schemes

While ECA readers will undoubtedly have been shocked by the trust-related changes in the March 22 Budget, they will recall the arrival of the pre-owned assets regime with equal horror. These changes are still debated and the same may be expected of the recent proposals. Barrister RICHARD WILSON assesses inheritance-tax savings schemes in the face of government anti-avoidance efforts, particularly in the light of income-tax charges brought about by the Finance Act 2004

Many clients, particularly those who are elderly and reliant on ever dwindling pension incomes, find that they have become asset rich but cash poor. The rapid increases in house prices over the past decade or so have resulted in inheritance tax (IHT) being an issue for people who lead a relatively modest existence, and live in ‘average’ properties.

For those taxpayers, the Holy Grail of IHT planning is the ability to give away their property while being able to reside there rent free, but with sufficient security of tenure.

Naturally, the Revenue and Parliament have sought to ensure that life is made as difficult as possible for those on their quest to find that Holy Grail. First came the Gift with Reservation of Benefit (GroB) rules in the Finance Act 1986.

After it was established by the House of Lords in Ingram v IRC [1999] STC 37 that those rules did not prevent the popular ‘shearing’ arrangements, changes were made to them by the Finance Act 1999, which introduced s.102A of the 1986 Act. Thereafter, the ingenuity of the tax planners gave rise to further schemes (IRC v Eversden [2003] STC 822), which in turn brought further legislative changes in order to counteract them (see s.102 (5A)-(5C) Finance Act 1986, inserted by Finance Act 2003).

Despite the legislative changes, certain IHT schemes remained effective, most notably the ‘double trust’ scheme, which was extremely popular. The scheme worked as follows: a settlor created a life interest trust (trust 1) of which he was life tenant. He then sold his home to the trustees of trust 1 in return for a debt, repayable only after the settlor’s death.

The Settlor then created a further life interest trust (trust 2) in favour of his children, and assigned the debt to the trustees of trust 2. He was excluded from benefit under the terms of trust 2, so that the assignment of the debt gave rise to a PET and no GroB. By virtue of the life interest under trust 1, the settlor retained an entitlement to live in the property rent free, and the property remained in his estate for IHT purposes (by virtue of s.49 IHTA 1984) but the value of the debt was deductible from his estate on death, thereby reducing the IHT liability if the settlor had survived for seven years after assigning the debt to the trustees of trust 2.

There were, inevitably, further complexities involved in the scheme (usually the result of the need to avoid a substantial capital-gains-tax (CGT) charge on the subsequent repayment of the debt) but, from an IHT perspective, the scheme was both relatively simple and effective.

While there were often murmurings from the Revenue concerning the validity of the scheme, it was generally accepted as having achieved the desired IHT saving.

Then came Schedule 15 to the Finance Act 2004. In a radical departure from their previous tactic of seeking to prevent schemes avoiding IHT, the Revenue introduced a hybrid income tax code, which is found in Schedule 15 to the Finance Act 2004. The charge is phenomenally complicated, and there are three separate charging regimes: one for property, one for chattels, and one for intangible property. In this article, I shall focus on the first, as it is in the context of the family home that the scheme (and the income tax charge designed to defeat it) has had the greatest impact.

The income-tax charge

A charge to income tax is imposed under paragraph 3 of Sch.15 in circumstances where, after 5 April 2005, a person, ‘the chargeable person’, occupies any land, ‘the relevant land’, and either the ‘disposal condition’ or the ‘contribution condition’ is met. The disposal condition is defined as being that at any time after 17 March 1986 (the date on which the GroB rules came into force) the chargeable person owned an interest in the relevant land or in other property, the proceeds of sale of which were directly or indirectly applied by another person in the acquisition of the relevant land and (in either case) the chargeable person has disposed of all or part of his interest otherwise than by way of an ‘excluded transaction’ (as to which see below). The contribution condition is that at any time after 17 March 1986, the chargeable person has directly or indirectly provided, otherwise than by way of an excluded transaction, any of the consideration given by another person for the acquisition of either an interest in the relevant land or an interest in another property, the proceeds of sale of which were directly or indirectly applied in the acquisition of the relevant land.

Thus, the scope of the basic charge to tax is very wide: subject to the application of any exemption, any arrangement whereby a chargeable person disposes of an interest in land that they occupy, or have contributed to the purchase price of such land. This is mitigated to some extent by the applicable exemptions and the range of ‘excluded transactions’.

Excluded transactions are defined by paragraph 10, as being the following in relation to the disposal condition:

a) A disposal by the chargeable person of his whole interest in the property (except for any right expressly reserved by him) either (i) by a transaction made at arm’s length with a person not connected with him; or (ii) by a transaction such as might be expected to be made at arm’s length between persons not connected with each other;

b) Certain transfers between spouses or spouses as part of the financial arrangements made on the termination of a marriage or civil partnership;

c) Dispositions for maintenance of family within s.11 IHTA 1984;

d) Gifts within s.19 or 20 IHTA 1984 (small gifts and annual exemption).

There is a different set of excluded transactions in respect of the contribution condition. While there is some overlap with the exclusions for the disposal condition (transfers on termination of a marriage or civil partnership, maintenance of family and small gifts, and annual exemption), there is no equivalent of the ‘arm’s length’ exception. This is perhaps understandable: if the consideration contributed is by way of an ‘arm’s length’ transaction (such as a loan on fully commercial terms) it is hard to see how it can be said that the creditor has contributed to the consideration for the acquisition of the property.

There is also an additional exempt transaction: an outright gift of money made at least seven years before the chargeable person satisfied the contribution condition. In respect of this latter excluded transaction, the Revenue has accepted that as the charge on pre-owned assets came into force on 6 April 2005, which is the first date on which the disposal condition could be satisfied. Consequently, any outright gift prior to 6 April 1998 will fall within the definition of an excluded transaction. For example, Mr and Mrs A gave £500,000 cash to their son in December 1997.

In March 1999, he used that cash to purchase a house for them, which they have occupied continuously ever since.

While there is a period of less than seven years between the gift of cash and the occupation, because the gift was made more than seven years prior to the first date on which the disposal condition could have been satisfied (that is, 6 April 2005), the transaction is excluded.

There are also numerous important exemptions from the charge to tax. The first (and perhaps most significant) is that no charge applies where the relevant property (or other property that derives its value from the relevant property, and the value of which is not ‘substantially less’ than the value of the relevant property).

This exemption is clearly intended to exempt from charge the common (and unobjectionable) situation where a person might settle property on himself for life, but it is also of considerable significance in relation to the double trust scheme, as the relevant property in such a scheme remains in the chargeable person’s estate – it is the deduction of the debt (which has been given away) that provides the IHT saving. In order to prevent this exemption from excluding double trust arrangements from the income-tax charge, the legislation contains provisions relating to what it describes as ‘excluded liabilities’.

These are defined in paragraph 11(7) as liabilities, the creation of which is an operation associated with “any transaction by virtue of which the person’s estate came to include the relevant property…”

If a liability is an excluded liability, its value is to be deducted from the value of the relevant property treated as part of the chargeable person’s estate for the purposes of paragraph 11. Whether this prevents the exemption from applying to the double trust scheme is open to question. While the liability in question (that is, the debt from the trustees of trust 1 to the settlor) is clearly an associated operation with the transfer of the property to the trustees of trust 1, it is strongly arguable that that transaction was not one ‘by virtue of which the person’s estate came to include the relevant property’ as the settler invariably owned the property beforehand, and by virtue of s.49 IHTA 1984, the transfer of it to trustees of a life interest trust for himself merely resulted (for IHT purposes) in that property remaining in his estate. However, the Revenue is likely to contest this point vigorously.

In addition, there are exemptions from charge where the relevant property is subject to a reservation of benefit, or would be but for the application of certain exemptions (such as the spouse exemption under s.102(5) FA 1986, sharing arrangements under s.102B FA 1986, or in accordance with s.102C(3) and Sch.20, para.6 FA 1986).

Where the tax charge applies, it is calculated by first ascertaining the notional value of the ‘benefit’ obtained in accordance with the formula R x DV/V. R is the rental value of the relevant land for the period in question; DV is the value of the interest disposed of (or the value of the consideration contributed); and V is the value of the land. The rental value is to be calculated on the basis of the assumptions as to the terms of a notional tenancy, as set out in paragraph 5. From the amount of the benefit is then deducted any amounts paid for occupation pursuant to a legal obligation. Then income tax is charged on the amount so reduced in the ordinary way.

The foregoing represents a relatively broad summary of what are highly complicated (and some might say poorly drafted) provisions. The impact of the introduction of the charge has understandably stopped the double trust scheme together with other IHT mitigation arrangements (such as the reversionary lease scheme) in its tracks. The main concern for clients who have previously entered into schemes such as the double trust scheme is what options they now have available to them.

The first option, which sounds unappealing to most clients, but which may be a sensible option in many cases, is simply to pay the income-tax charge.

In many cases, this will be unattractive, but take the example of a taxpayer who has a decent income, and has entered into a scheme more than seven years ago and has therefore obtained the full IHT saving by virtue of a successful PET. Particularly if the client is elderly or infirm, he or she may take the view that the IHT saving involved is sufficiently large to justify paying income tax for a number of years in order to preserve it.

Ultimately, this decision has to be taken on a financial basis: it is of little consequence whether it is IHT or income tax that is avoided (save perhaps for the fact that the former will be payable after the taxpayer has died, whereas the latter will be payable each year) and therefore if a realistic view is taken about life expectancy, paying the income tax may be a sensible (and easy) option: the lesser of two evils.

Conversely, another option is to make an election to have the relevant property charged to IHT as property subject to a reservation of benefit, pursuant to paragraphs 22 and 23 of Sch.15. The conditions for an election are that (i) a person would be chargeable to income tax for any year of assessment by reference to the relevant property; and (ii) he has not been chargeable in respect of it in any previous year of assessment. Thus a chargeable person must elect in respect of the first year in which he is (or would be) chargeable. If he opts to pay the tax for the first year, he cannot elect in relation to that relevant property thereafter. An election must be made in a manner to be prescribed by the Revenue, and by not later than 31 January of the year following the end of the year of assessment. Thus, in respect of existing schemes, the deadline for an election is 31 January 2007. This is the self-assessment deadline for the year of assessment in question. If the taxpayer has a reasonable excuse for failing to file the election on time, the Revenue may allow it to be filed out of time. In practice, the Revenue is likely to exercise such discretion sparingly (as was the case with the discretion to extend the period of six months for filing notice of a deed of variation under the old s.142(2) IHTA 1984). It should be noted that an election may be amended or withdrawn, but only during the lifetime of the taxpayer.

Therefore, if an election is to be made, it may well be prudent to delay making it until just before the deadline. If it is made early and the taxpayer dies before the deadline, there will be a charge to IHT and the election cannot be withdrawn. If no election had been made, there would merely be one year’s charge to income tax: an amount far smaller than the IHT.

The provisions governing an election raise an interesting and fundamental question in respect of the double trust scheme. That question is whether, in fact, it actually has the effect of charging the scheme to IHT at all. This may seem somewhat absurd given the purpose of the provisions. However, the wording of them is somewhat clumsy and may not serve that purpose. Paragraph 22 provides that where an election is made, the charge to income tax shall not apply, but: “The relevant property and any property which represents or is derived from the relevant property shall be treated for the purposes of Part 5 of the 1986 Act (in relation to the chargeable person) as property to a reservation, and… section 102(3) and (4) of the 1986 Act shall apply.” The difficulty that arises for the Revenue is that s.102(3) provides that: “If, immediately before the death of the donor, there is any property which, in relation to him, is property subject to a reservation then, to the extent that the property would not, apart from this section, form part of the donor’s estate immediately before his death, that property shall be treated for the purposes of the 1984 Act as property to which he was beneficially entitled immediately before his death” (emphasis added). In the double trust scheme, the relevant property (which is the property in respect of which the election must be made) is already part of the estate (by virtue of s.49 IHTA 1984). While for the purposes of the exemption under the income tax rules, the ‘excluded liabilities’ rules (arguably) prevent the exemption from applying, the concept of an excluded liability simply does not exist for GroB purposes. Thus, s.102(3) FA 1986 does not, on its face, serve to impose any charge to IHT on the relevant property. The Revenue is likely to argue either that the terms of paragraph 22 are mandatory and that s.102(3) shall apply (rather than merely ‘may’ apply if the property is not otherwise part of the taxpayer’s estate). This argument does not seem overly convincing: s.102(3) appears to mean exactly what it says.

Therefore it may be open to a taxpayer to elect and avoid the income tax charge, and for his personal representatives to argue that it does not result in an IHT charge in any event.

Another option for taxpayers who have entered into a scheme is to move out of the property. This may seem somewhat drastic, but given that the charge on land is based on the occupation of the relevant land, moving out solves that problem.

This is unlikely to be an unpalatable solution for many taxpayers, many of whom have entered into the schemes because they did not wish to ‘down size’.

For many clients, however, circumstances may well have changed, or they may fell that avoiding the tax charge is a priority. Of course, the wish of many taxpayers is to put an end to the schemes altogether, by ‘unravelling’ them. In the case of the double trust scheme, this is more easily said than done. There are usually few difficulties in appointing the property back to the taxpayer. Most (although not all) schemes involve the drafting of trust 1 in sufficiently wide terms to permit an appointment back to the settlor. However, in order to achieve the IHT saving, he is necessarily excluded from benefit under the terms of trust 2 and, as explained above, it is the existence of the debt owed to the trustees of trust 2 that causes the income-tax charge to arise (assuming that it is an excluded liability). Given that the settler is not a beneficiary, the trustees cannot simply waive or write off the debt: to do so would be a clear breach of trust.

Where the class of beneficiaries under trust 2 consists entirely of adults of full capacity, they could consent to such a course, thereby solving the breach of trust problem. Many of these trusts, however, include either minor beneficiaries or an open class, and such consent cannot, therefore, be provided. Hence, the trustees have to decide whether they are prepared to run the risk of committing such a breach. It has been suggested in certain quarters that the trustees can avoid this difficulty by appointing the benefit of the debt to an adult beneficiary who can then either waive it, assign it to the settlor or resettle it for the benefit of the settlor. No satisfactory answer has (to the writer’s knowledge) been given to the question of why such a course of action, being an appointment for the benefit of a non-object (that is, the settlor) does not constitute a fraudulent exercise of the power.

In the writer’s view, there is a clear fraud on the power if such a course of action is adopted by the trustees. It is worth noting that a fraudulent exercise of a power is void not voidable. Thus it would be open to the Revenue to assert that, in fact, the debt has never been appointed out of trust 2 at all, as the purported appointment was simply void.

The more advanced version of the appointment and resettlement strategy involved the resettlement of the debt on reverter to settlor trusts for the settlor for life, with remainder to the adult beneficiary who resettled the debt. It was thought that this type of arrangement would enable the income-tax charge to be avoided, but by virtue of reverter to settlor relief under s.54 IHTA 1984, the value of the debt would be left out of charge on the settlor’s death. This supposed ‘loophole’ will, however, be closed by the Finance Act 2006, as announced by the Revenue at the time of the Pre-Budget Report in December 2005.

If it is possible to unscramble the arrangements (that is, it is a case where the class of beneficiaries under trust 2 is ‘closed’ and consists entirely of adults of full capacity, then there was, until recently, an issue of double charging. When settling the debt on trust 2, the settlor made a PET. If the debt is waived or otherwise disposed of, the entire value of his property will again be in his estate (as the debt will no longer reduce it). Thus, if he were to die within seven years of the initial gift, there could be a charge on the PET, and a charge on the value of the property as well. This situation is now remedied by the Inheritance Tax (Double Charges Relief) Regulations 2005 (SI 2005/3441), which provide that where a person enters into double trust type arrangements and the debt is waived, released or written off (wholly or partially), and he dies (after 5 April 2005), his estate will be charged to IHT only on the greater of the amount due under the PET and the value of the property – not both.

Therefore, taxpayers who have entered into double trust schemes encounter many difficulties, not least in extricating themselves from the arrangements.

Advisers should be prepared to explain all the possible options, even those such as paying the income tax that at first may seem unpalatable, as one of them may well provide the easiest and most cost-efficient solution. For those taxpayers who feel suitably robust (or who feel that their personal representatives ought to be) there are certain options that might provide an argument that the IHT advantage may be kept without giving rise to a charge to income tax. However, a word of warning: litigation should not be undertaken lightly and, given the aim of the Revenue in introducing the charge to tax on pre-owned assets, it is a racing certainty that the arguments that have been mentioned in this article would result in the Revenue pursuing the matter before the special commissioners and the courts.

Unfortunately, so many of the questions that arise in relation to the pre-owned assets rules will remain unanswered until after the end of the current year of assessment, when the Revenue will seek to impose and collect the tax. Let the battle commence!

Editor comment: Please note this article pre-dates any Budget changes, but most existing tax planning schemes appear to remain unaffected by the Budget changes, which appear likely to be restricted to new trust arrangements excepting in the case of A&M settlements.

Richard Wilson is a barrister at 9 Stone Buildings. He can be contacted at rwilson@stonebuildings.com