Malcolm Gunn FTII, TEP, Consultant with Squire, Sanders & Dempsey, gives his forthright view of the income tax charge on the charge to income tax on benefits received by the former owner of property, otherwise known as 'Pre-Owned Assets Tax'.

Malcolm Gunn

 To my mind, this tax is one of the most pernicious imposts ever introduced.  It is largely a tax on the elderly and it is purely vindictive in nature.  No matter what the Government says, it is retrospective, applying to structures set up as far back as 1986 and which ever since have been commonly thought as being benign.  Yes, there was an escape route built into the legislation in the form of an election out of the tax and back into inheritance tax, but in the great many cases this escape route is completely useless.  I have cases of elderly people made ill with worry about the introduction of this tax and I confidently predict that many others ought to be worrying, but they currently have no idea at all that the Government has both moved the goal posts and changed the existing scoreboard all at the same time, whilst setting a Sword of Damocles over their heads.

Gladys

 This lady in her mid-eighties contacted me last spring.  In her case she went in for an “Ingram” type scheme over her home early in 1999.  She now has a twenty year lease over her home which has run for seven years to date and she gave the reversionary interest to a trust for her children.  Her income is very low, being state pension and a small occupational pension but very little else.  She discovered the introduction of pre-owned asset tax from reading a Sunday paper. 

Since she cannot afford to pay the new tax out of her income, why does she not simply make the inheritance tax election?  The answer is obvious to anyone operating in this field but apparently not to Treasury Ministers.  Making the election in these circumstances will ultimately bring about financial disaster: both capital gains tax and inheritance tax will be payable on the value of the property (less a very low base cost in the case of the capital gains position) – all this to save the pre-owned asset tax.

So the best plan is to pay the tax but she cannot do that either, nor can she borrow on the home to pay it because she only has a short lease.  Nor can she unscramble the scheme since she is excluded from benefit from the trust.  Now you see why I rant at my television screen from time-to-time.  HMRC must be aware of this situation but so far it seems to have closed its eyes to the problem.  If that is an acceptable way to run a tax system, then there is not much hope for any one.

Can anything be done for Gladys?  The best solution seems to be for the children to assign their interests under the trusts back to their mother.  This puts the reversionary interest back in the mother’s estate for inheritance tax purposes but, following the Finance Act 2006, pre-owned asset tax will still be due; in other words both inheritance tax and pre-owned asset tax will apply which must be nonsensical since the latter is a tax designed specifically for those who have avoided the former.  This problem is however solvable; Gladys must elect into inheritance tax as well and then she is finally rid of pre-owned asset tax.

This does not get her out of all capital gains tax problems, but it goes a long way and it seems to be the best which can be done.

Arthur

Arthur’s Ingram Scheme worked in a slightly different fashion.  He gave the reversion to the lease direct to his children and subsequently they decided to put it into trust for Arthur on “revertor to settlor trusts” in order to preserve the capital gains tax exemption on his death.  So it was a trust for Arthur during his lifetime and then the children for six months and thereafter for the children absolutely.  This was always thought a neat scenario which preserved the inheritance tax exemption and also gave capital gains tax exemption, whilst by stroke of good fortune also not being within pre-owned asset tax when it was introduced.  Also we were confident that if there would be any change to the rules, it ought not to affect an existing trust.

This year’s Finance Act has blown this planning sky high.  The inheritance tax exemption has gone because the property no longer reverts to the estate of the settlors on the death of Arthur, pre-owned asset tax now applies to these trusts and only the capital gains tax exemption remains.  I have cases of this type and they now need urgent attention.  If the children are now given an absolute interest on the death of Arthur, in place of the six month trust in their favour, the inheritance tax exemption will be restored, but capital gains tax on the property will be back on the agenda.  Also this alteration does not help with pre-owned asset tax. 

Unscrambling Arthur’s scheme may be easier if the trust permits the reversionary interest to be appointed out to him but there will still be capital gains tax issues to examine on this appointment. The reversionary interest in the trust will probably not qualify for capital gains tax exemption under Section 225 TCGA 1992.

Alfred’s Scheme

Alfred went in for one of the double trust schemes, by which his home was sold to a trust which had no money so it had to owe him the purchase price.  That debt was given away to another trust for the benefit of his children.

This scheme is within the scope of pre-owned asset tax on the basis that the value of the house cannot be counted in as part of the taxpayer’s estate to the extent of the amount of the associated debt.  (There are good arguments against this interpretation of the legislation but it is generally assumed that the courts would not be sympathetic to them).

These schemes are generally now being unscrambled.  The inheritance tax election can be made so as to escape from pre-owned asset tax, but there are doubts about the affect of the election and to some extent one is relying on Revenue guidance; as we now know, it is dangerous to rely on anything the Revenue publishes.  Also if Arthur’s widow Alice survives him, the election will cause inheritance tax to be payable on his death in respect of the scheme, without the benefit of the spouse exemption.

Unscrambling these schemes is fraught with its own problems.  Generally there will either be a breach of trust by the trustees or fraud on the power issues.  The best solution is for Arthur to introduce new cash into the structure so that some of the liability to the children’s trust is paid off, thereby reducing the amount on which pre-owned asset tax is payable to below the £5,000 limit.  This preserves the benefits of the scheme and escapes from the new tax charge.  However, Arthur may not have sufficient cash to do this.

Generally

This is not the first time existing structures have been attacked by new legislation in recent years.  The principle to follow now is that if a tax saving cannot be achieved straight away, then you should not lock yourself into an irreversible scheme which will only produce tax savings in years to come.  In my view, this applies to anything including child trust funds and personal pension schemes.  We are now in unchartered territory where new tax charges, or new and unwelcome rules, may be introduced onto anything already set up; we have already seen this several times with pension funds.  We will undoubtedly see it with other benign, or tax approved, structures in the future. Welcome to a world where you are expected to pay your maximum tax liability in full, without any postponement, or you will be lined up with tax evaders.

Article Added Tuesday, 02 January 2007 | 3855 Hits

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