Peter Vaines of Squire Patton Boggs reflects on the new IHT rules for loans, a case on penalties won by the taxpayer, and the problem with "insufficiency of funds" for late payment of liabilities.
IHT and Deduction of Liabilities
It may be remembered that one of the changes in 2013 was a restriction to the deduction of liabilities for Inheritance Tax purposes. This issue seems to be causing widespread problems.
The general rule in IHTA 1984 s 162 (4) is that where a liability is charged on particular property, the liability reduces the value of that property for Inheritance Tax purposes.
However, last year this rule was modified and a deduction now depends on how you spend the borrowed money. If you borrow money to invest in business property (or agricultural property) which qualifies for 100% relief, a deduction will no longer be allowed for such borrowings against other assets. The borrowings can only be deducted from the assets which were acquired with the money. The effect of this is to eliminate any effective deduction for the borrowings.
Another new rule applies to liabilities which have been incurred to finance property which is excluded from inheritance tax. (This will mainly affect non doms, because it is comparatively rare for UK domiciled individuals to have excluded property.) So borrowing money charged on a UK property and depositing that money abroad will disqualify that borrowing from any deduction against the UK property. It is perhaps arguable that if an individual borrows money charged on his UK property and that money is merely sitting in a bank account outside the UK pending investment, the borrowings have not been incurred to acquire or finance excluded property. However, HMRC take the view that the money on deposit is excluded property, the borrowing was incurred directly or indirectly to acquire the deposit so it is therefore disqualified.
One can understand the logic behind the proposals but I can see serious practical difficulties here. The fact that HMRC may not allow a deduction for a liability does not mean that the liability does not exist. Accordingly, a situation could easily arise where somebody has a net estate of zero because he has significant debts. If you ignore the debts he would have a substantial chargeable estate on which IHT would be payable. This is a pure fiction; the estate is zero and although HMRC can have a deeming provision to create a tax liability, there is no deeming provision to provide the money to pay it.
An amendment was made so that the new rules only apply to loans taken out after 5 April 2013. That was obviously welcome but unfortunately it applies only to loans taken out to acquire business property or agricultural property – it does not apply to loans attributable to financing the acquisition (or enhancement) of excluded property. Accordingly, all those foreign domiciled individuals who (years ago) reduced the value of their UK property by loans will find that the loans are now disqualified from an inheritance tax deduction and the gross value of the UK assets is now exposed to Inheritance Tax.
The retrospective nature of these provisions creates a significant problem for people who have had settled arrangements for many years (including trustees who may now be unexpectedly exposed to the
ten year charge) and some serious attention will now be necessary to reconsider all those arrangements.
Penalties
The case of R Gardiner v HMRC TC 3550 is interesting on a number of levels. It also seems to give a clear indication about HMRC's approach in penalty cases. Mr Gardiner and his family entered into a tax scheme to shelter a capital gain they had made on the disposal of some shares. The details do not really matter but it seemed to have similarities with the case of Drummond v Revenue & Customs Commissioners [2009] EWCA Civ 608 which the Court of Appeal held was ineffective. As a result of the Court of Appeal's decision, the taxpayer accepted that the tax was due and paid up.
However, despite the fact the taxpayers took detailed professional advice and it needed the Court of Appeal to determine whether the scheme worked, HMRC argued that the taxpayers had been negligent in submitting their tax returns on the basis that it did work. Accordingly they imposed penalties.
The argument of HMRC was very similar to that in Litman & Newall v HMRC [2014] UKFTT 089 (TC), that no reasonable person could have concluded that the arrangements were carried out properly and that the weaknesses were such that they should have been appreciated by the taxpayer.
This argument puts the taxpayer in a very difficult position. How far is the taxpayer expected to understand a complex arrangement and how obvious do the weaknesses in the scheme have to be (both technically and by way of documentation), for them to be exposed to a penalty? And what if he does have concerns about the technicalities and the documentation and makes specific enquiries of the advisers who assure him specifically that everything is OK?
I don't not need to put too many eyes of newts and toes of frog into my cauldron to foresee that if the taxpayer is supposed to fulfil some conditions (like carrying on a trade or working for a specific number of hours) and he knows he has not done so, then the risk of a penalty arises. I have a feeling we are going to see a lot more of this argument.
However, the most extraordinary thing about the case of Gardiner is how this point ever got to Court at all. HMRC were claiming that the taxpayer had been negligent and therefore liable to a penalty. The onus of proof was on them - but they did not put forward any evidence. The tribunal naturally allowed the taxpayer's appeal.
I simply cannot understand this. You can understand an unrepresented taxpayer turning up to the Tribunal not appreciating that the onus of proof is on him and being unclear about the nature of evidence. But surely not HMRC. How can they take the taxpayer to the Tribunal (at considerable expense) and then adduce no evidence at all in support of their allegation?
It is not as if this is the first time. In the case of Trustee of the de Britton Settlement v HMRC TC2524, HMRC imposed a penalty for the late submission of a tax return and pressed the penalty to the Tribunal but without any evidence whatsoever in support of their case. It is hardly surprising that the penalty was set aside by the Tribunal in that case as well. Given that costs are not awarded to the Appellant before the First Tier Tribunal, this approach imposes a serious burden on the taxpayer which is surely wrong.
Reasonable Excuse : Insufficiency of Funds
I have previously made reference to the case of Stephen Brand v HMRC TC 2434 (see Postal Delays and Reasonable Excuse) in which the Tribunal took a sympathetic view of the financial situation of Mr Brand and concluded that the insufficiency of funds which caused him to be late in making payment was attributable to events outside his control. This is important because in the penalty regime set out in the Finance Act 2009, the following phrase appears a number of times:
“An insufficiency of funds is not a reasonable excuse unless attributable to events outside the person’s control”.
HMRC take the view that cashflow problems are part of the normal cycle of business which need to be managed as part of the day to day operations. However, they acknowledge that there can be unforeseeable events outside the taxpayer’s control that will create a severe cash shortage which cannot be managed.
This issue arose again this month in the case of Anaconda Equipment International Limited v HMRC TC 3521. The company’s business was the manufacture of conveyor systems and engineering equipment for the construction trade. The company seemed to be managing their cashflow position but their bank had reduced their overdraft facility by two thirds and insisted on a further monthly reduction. This made their cashflow position significantly worse and they had no alternative but to refinance – and that obviously took a little while. In addition, the company lost two big clients which accounted for approximately 67% of their turnover.
HMRC said that the taxpayer was a habitual late payer with a history of poor compliance, but the Tribunal looked at this appeal on its merits.
The Tribunal concluded that the reduction in turnover and the substantial reduction of the overdraft facility were events entirely outside their control and constituted a reasonable excuse for the late payment.
By a strange coincidence, a week later the case of Paragon Precision Engineering Limited v HMRC TC 3542 was published. This involved an appeal on the same grounds – an insufficiency of funds. However, this was much more difficult because it was a VAT case, and the rule for VAT is considerably worse. VAT Act 1994 s 71(1)(a) says:
“An insufficiency of funds to pay any VAT due is not a reasonable excuse”.
There is nothing here about events outside the taxpayer’s control. Accordingly, this looked completely hopeless. However, the taxpayer had an argument based on proportionality. They claimed that the Tribunal could strike down penalties which were clearly out of all proportion to the default. This approach has previously been supported by the Upper Tribunal who said that in appropriate cases it is possible to conclude that the penalty is so disproportionate that they would be entitled to substitute their own view of what is fair for the penalty which Parliament has imposed. However, this power should rarely be used because “the Tribunal should show the greatest deference to the will of Parliament when considering a penalty regime”.
Applying this to the circumstances of Paragon, the Tribunal did not think that the penalty was disproportionate - but they suspended their decision for 21 days to give the taxpayer the opportunity to provide further evidence regarding their financial affairs to demonstrate the lack of proportionality.
We may never know whether they were able to do so - but the mere possibility opens up an interesting further defence to the taxpayer in what looked like a hopeless case.
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