Background

The explanatory notes issued with the Finance Bill 2003 stated, in relation to clause 183 (the eventual FA 2003, s 186):

“1. This clause removes a potential charge to inheritance tax (IHT) from holdings by foreign investors in UK-authorised funds. It operates for transfers on or after 16 October 2002 and applies to the holdings of non-UK domiciled investors or their trusts in authorised unit trusts and open-ended investment companies. . . . .

8. This clause is one of two measures to boost the competitiveness of UK-authorised funds announced by Treasury press notice (105/02) dated 16 October 2002. From that date, holdings by non-UK domiciled investors or their trusts in authorised unit trusts and open-ended investment companies will not be chargeable to IHT.”

So far, so good.  But consider this example.

Example

Sheila, who comes from a wealthy Australian family, had been working in London for a couple of years (after spells in the US and elsewhere in Europe) when at the end of January 1994, on advice, she created an excluded property settlement – which she chose to locate in Jersey – to look after assets worth some £10 million which she had just inherited on her father’s death.  The trust was formed on a discretionary basis.

A little while later Sheila met and married George, whose roots in England go back many generations.  Before long, Sheila accepted that she would never persuade George to travel much, let alone move abroad; and when they started a family she realised that she, too, had fallen in love with England and could not see herself leaving even if she ever split up with George.

The trustees knew that the timing of inheritance tax charges in a discretionary trust was, if not entirely controllable, at least predictable, and were not particularly bothered about holding UK investments directly at trust level because they knew that they could arrange for the trust to be wholly invested outside the UK (and thus to be excluded property) around the time of a ten-yearly charge.  This course was seen as preferable to using an underlying holding company, which would build up a second layer of CGT exposure in the longer term.

Once FA 2003 had been enacted, the trustees’ attention was drawn to the changes made by section 186, and specifically to the new IHTA 1984, s 48(3A) which it introduced.  That subsection reads:

“(3A) Where property comprised in a settlement is a holding in an authorised unit trust or a share in an open-ended investment company—

(a) the property (but not a reversionary interest in the property) is excluded property unless the settlor was domiciled in the United Kingdom at the time the settlement was made, . . . .”

The trustees were aware that a ten-yearly IHT charge would fall due in 2004 on the trust’s UK assets, and were already considering the best course to minimise the charge.  The new exemption seemed the answer to the problem – instead of going out of the UK market for a time, they could merely switch from directly-held stocks to suitably-chosen collective investments, and retain the percentage exposure to the UK market that their asset allocation strategy required.  Fortunately the stock market had only just recovered from the downs of the previous few years and the inbuilt gains in the UK section of the trust portfolio were not large; so between November 2003 and early January 2004 they reinvested in this way to the tune of some £4 million.  By the time the ten-year anniversary arrived, the whole trust fund was excluded property, either in AUTs and OEICs or in overseas assets.

So where’s the problem?

Although they probably did not realise it, the trustees’ reinvestment programme has triggered an IHT charge of around £228,000.

The previous UK investments (and their sale proceeds in the hands of the brokers who carried out the reinvestment) were relevant property; the new UK collective investments were excluded property.  Excluded property is not relevant property: IHTA 1984, s 58(1)(f).  So the settled property in question ceased to be relevant property on being invested into the AUTs and OEICs.  IHTA 1984, s 65(1)(a) imposes an exit charge “where the property comprised in a settlement or any part of that property ceases to be relevant property (whether because it ceases to be comprised in the settlement or otherwise)”.  The assumed transfer used to calculate the rate, under IHTA 1984, s 68 (as there had not yet been a ten-year anniversary at the time of the exit charge), is the entire value of the trust fund immediately after it had been settled: see s 68(5)(a) and (c); and 39 complete quarters had elapsed by the time the charge arose, giving a rate chargeable of fractionally over 5.7%:

A botched reform?

When the CTT rules for discretionary trusts were being recast in 1982, introducing the concept of a charge on property ceasing to be relevant property, responses to the December 1981 consultation pointed out that this would impose a charge every time UK property was moved or reinvested abroad, where the settlor had been domiciled outside the UK.  As a result, the rule now embodied in IHTA 1984, s 65(7) was included in FA 1982.  That subsection reads:

“Tax shall not be charged under this section by reason only that property comprised in a settlement ceases to be situated in the United Kingdom and thereby becomes excluded property by virtue of section 48(3)(a) above.”

The good sense implicit in this rule should have been reproduced for holdings in AUTs and OEICs when the excluded property definition was being extended by FA 2003.  That it was not represents a potentially serious tax trap, which once realised will remove the incentive to use UK collective investments for which the fund management industry had lobbied.  There must be a case for an early amendment to cure it, possibly even – dare one suggest – on a retrospective basis.

A senior HMRC official has since confirmed that such a rule ought to have been included to achieve the intended policy satisfactorily, but, regrettably, he did not foresee a realistic prospect of legislative correction.

This article was first published in Private Client Business, [2007] Issue 1, and is reproduced with kind permission of Sweet & Maxwell

Article Added Friday, 01 June 2007 | 2163 Hits

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