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Mark McLaughlin CTA (Fellow) ATT TEP looks at the inheritance tax 'gifts with reservation' rules and their interaction with 'pre-owned assets'

Inheritance tax (IHT) has not been with us for very long compared with the other direct taxes, having been introduced in Finance Act 1986 to replace capital transfer tax. Anti-avoidance legislation dealing with 'gifts with reservation' (GWR) was also introduced in FA 1986, to prevent taxpayers from 'having their cake and eating it'. The GWR legislation can be found in FA 1986, ss 102–102C and Sch 20. Without the GWR rules, an individual could make a potentially exempt gift of an asset, but continue to have the use and enjoyment of that asset; after seven years, the property would be exempt from IHT.

IHT planning schemes quickly evolved to circumvent the GWR rules. This resulted in an extension of the GWR provisions in FA 1999, dealing with arrangements involving interests in land and effective for disposals made on or after 9 March 1999. However, much IHT planning continued to revolve around the donor gifting assets but continuing to benefit from them. The Government finally lost patience with such arrangements, and introduced as a deterrent, in FA 2004, an income tax charge on 'pre-owned assets' (POAT). This article considers the background to, and practical implications of, the GWR regime, and outlines its interaction with POAT. All statutory references are to FA 1986 unless otherwise stated.

The effect of a gift with reservation

A GWR is, broadly, a gift of property made by an individual on or after 18 March 1986, whereby either the recipient does not enjoy possession of the gifted property, or the donor continues to enjoy or benefit from it; if there is a reserved benefit within seven years of the donor's death then the gift is caught by the GWR rules (s 102(1)). The effect is that the gifted property is treated as part of the donor's estate for IHT purposes. This could result in the same gift being taxed twice. However, there are provisions which provide relief in those circumstances (s 104; Inheritance Tax (Double Charges Relief) Regulations, SI 1987/1130).

If the reservation of benefit ends during the donor's lifetime, the gift is generally treated as a potentially exempt transfer (PET) at that point, which is subject to IHT on the donor's death within seven years (s 102(4)). In the case of an interest in settled property subject to the 'old' (pre-FA 2006) treatment of interests in possession, the lifetime termination of such an interest is treated as a gift for GWR purposes (s 102ZA). Without this provision, the termination would be a transfer of value but not a gift, and the beneficiary could continue using the property without the GWR rules applying.

The term 'gift' in the context of a GWR can include a sale deliberately made at undervalue. HMRC considers that the rules only apply to the undervalue proportion, unless the 'sale' is in reality a gift of the whole property with a reserved benefit (see HMRC's inheritance tax manual at IHTM14316). This is perhaps a generous interpretation of the rules, since it could be argued that any gift element is sufficient to taint the whole property.

GWR 'let-outs'

There are certain exceptions and exclusions from the GWR rules.

(a) Gifts made before 18 March 1986

Such gifts cannot be the subject of a GWR, even if a benefit was reserved after that date (s 102(1)). For example, a pre-18 March 1986 discretionary trust in which the settlor has continued to retain a benefit will not be caught unless further gifts are settled on or after that date.

(b) Gifts subject to specified IHT exemptions

The GWR rules do not apply if the gift was subject to certain IHT exemptions listed in s 102(5), most notably the spouse or civil partner exemption (except in certain cases where specific anti-avoidance provisions apply in s 102(5A–(5B)); the 'small gifts' exemption; and gifts in consideration of a marriage or civil partnership. However, gifts subject to the annual exemption or the 'normal expenditure out of income' exemption can be GWRs.

(c) Full consideration

There is a specific 'full consideration' let-out in relation to the continued occupation of land or the actual enjoyment of chattels (s 102B(3)(b); Sch 20, para 6(1)(a)). However, care should be taken with gifts of other assets, as HMRC considers that there is still a reservation of benefit even if the donor gives full consideration (IHTM 14336). 'Full consideration' should be negotiated at arm's length between the parties, and separate professional valuations obtained where practical. Full consideration must also be maintained throughout the relevant period, eg. regular rent reviews should be undertaken in respect of land and buildings.

(d) Gift of an interest in land

The gift of an undivided share of an interest in land (from 9 March 1999) is not a GWR if either of the following conditions is satisfied:

• the donor does not occupy the land, or occupies it to the exclusion of the donee for full consideration (eg. a full market rent, but bear in mind the income tax implications of property income) (s 102B(3)); or
• the donor and donee both occupy the land, and the donor receives no (or negligible) benefit from the donee in connection with the gift (s 102B(4)).

The second exception, although introduced with effect from 9 March 1999, is based on a statement by a Treasury minister during the Finance Bill debates (Commons Hansard 10 June 1986, col. 425). It means that if say, a father gifts an interest in his house to his daughter who also lives there, no GWR arises provided that the daughter pays no more than her own share of household expenses. There is no problem if father continues to meet all the expenses. However, difficulties may arise if (say) a 90 per cent per cent share is gifted; HMRC could argue that 'joint occupation' means that no more than 50 per cent can be gifted (see IHTM 14332). Ownership in equal shares may therefore be the preferred route, if practical.

(e) Provision for old age, infirmity etc

The donor's occupation of gifted land is not a GWR, broadly, if it represents reasonable provision for his care and maintenance due to old age, infirmity etc, and results from unforeseen changes in circumstances (eg. a sudden serious illness), and the donee is a relative of the donor or of his spouse or civil partner (s 102C(3), Sch 20 para 6(1)(b)). The 'reasonable' test is subjective, and whether it is met depends on the circumstances.

(f) 'De minimis' benefits

There is no GWR if the property is enjoyed to the exclusion, or virtually the entire exclusion, of the donor (and there is no benefit) during the relevant period (s 102(1)(b)). There is no definition of 'virtually' in the legislation. However, HMRC accepts that limited benefits can be provided to the donor without invoking the GWR rules. Examples of 'de minimis' benefits include the following:

• a house which becomes the donee's residence, but where the donor either (i) later stays for no more than two weeks each year in the donee's absence, or (ii) stays with the donee for less than a month each year; or
• temporary, short-term stays in a house the donor had previously given away, eg. while the donor recovers after medical treatment, or the donor looks after the donee convalescing after medical treatment, or while the donor's home is being decorated; or
• domestic visits to the house (eg for babysitting the donee's children).
  

Revenue Tax Bulletin 9 (November 1993) and HMRC's inheritance tax manual at IHTM14334 provide further examples. However, the extent of the donor's benefit should be constantly monitored, to ensure that the benefit does not escalate into something more significant which might constitute a GWR.

(g) Deeds of Variation

The GWR rules cannot apply if the disposition is a made by an instrument of variation of a will (within IHTA 1984, s 142). For IHT purposes, the variation is treated as having been made by the deceased person whose estate is the subject of the variation, not the legatee under the will.

Example

Mr Smith dies leaving all his estate to Mrs Smith, who varies the will within two years by an instrument of variation within s 142 such that the property becomes held on a discretionary trust for the benefit of Mrs Smith and her adult children. The variation is treated as made by Mr Smith. On the death of Mrs Smith there will be no reserved benefit subject to the GWR rules.

(h) Excluded property

The non-UK situs assets of a non-UK domiciled person are 'excluded property' (IHTA 1984, s 6(1)), which are not subject to the GWR rules (but see 'GWR and deemed domicile' below).

The pre-owned assets charge

This income tax charge was introduced in response to certain IHT planning arrangements with effect from the 2005/06 tax year, although it applies with retroactive effect from 18 March 1986. Broadly speaking, an income tax liability may arise where a person (i) occupies land that he has disposed of, or (ii) has contributed (directly or indirectly) part of the consideration given by another person for the acquisition of the land.

There is an exemption from the POAT charge if the GWR provisions apply in the following circumstances (FA 2004, Sch 15, para 11(5)):

• the property is treated for IHT purposes as subject to a reservation;
• there would be a GWR but for the gift being an exempt transfer (see (b) above);
• the gift of an interest in land would be a GWR but for the 'sharing' exclusion in s 102B(4) (see the second bullet point in (d) above); or
• a GWR would arise but for the exclusion for old age, infirmity etc, as outlined in (e) above.
  

In addition, there is no POAT if an election is made to effectively 'opt out' of the income tax rules and for the gifted property to be treated as a GWR for IHT purposes (FA 2004, Sch 15 para 21). The election could result in a double IHT charge, if an election was made and the taxpayer died within seven years of the gift. Regulations were therefore introduced to prevent a double IHT liability (ie. on the original gift and the GWR). Only the higher amount of tax is charged to IHT (Charge to Income Tax by Reference to Enjoyment of Property Previously Owned Regulations, SI 2005/724, reg 6).

Practical situations

Trusts — avoiding a GWR

Can the settlor of a trust also be a trustee? As a matter of trust law, and for GWR purposes, there is normally no objection to the settlor (or a spouse or civil partner) being one of the trustees. In spite of case law to suggest otherwise (Oakes v Commissioner of Stamp Duties of New South Wales [1954] A.C. 57), HMRC accepts that the settlor can receive remuneration for his duties as a trustee without constituting a GWR, so long as it is not excessive.

However, what is the position if the settlor gifts shares in the family company to the trust, acts as a trustee and is also a paid director of the company? The gift of shares of itself does not constitute a GWR. HMRC accepts that the continuation of reasonable commercial arrangements entered into before the gift does not constitute a GWR, provided that the benefits were not linked to or affected by the gift in any way. However, HMRC may challenge a new remuneration package as a GWR 'by contract or otherwise' if the gift was taken into account as part of the arrangements (IHTM 14394-5).

The settlor's spouse or civil partner may be a potential beneficiary of a discretionary trust. This does not of itself constitute a GWR. However, the settlor should be specifically excluded from benefiting under the trust, and care should be taken to ensure that the settlor cannot share in any distribution or benefit received by the spouse or civil partner as a trust beneficiary.

The GWR and deemed domicile

As mentioned, the excluded property of a non-UK domiciled individual is not subject to the GWR rules. Conventional IHT planning for non-domiciliaries hitherto often involved gifting foreign assets into trust before the settlor becomes treated as domiciled in the UK for IHT purposes under the '17 years out of 20' rule in IHTA 1984, s 267. However, HMRC guidance on this subject is rather confusing. The Inheritance Tax Manual says at IHTM 14396:

'Foreign property settled by a settlor with foreign domicile remains excluded property if the reservation continues up to the settlor's death, even though the domicile may have changed between those dates.'

So far, so good. However, the guidance then provides an example of an Australian domiciled donor who puts foreign property into a discretionary trust under which he is a potential beneficiary. He has become domiciled in the UK by the time of his death. The guidance states: 'The property is subject to a reservation and is therefore deemed to be part of the donor's death estate.'

In the above circumstances, if the settlor ceased to be a potential beneficiary of the 'excluded property trust' during his lifetime, this was commonly thought not to constitute a deemed PET even if the individual subsequently became UK domiciled. However, in HMRC's view it is 'arguable' that the release of the GWR would have been a PET. IHTM 14396 goes on to say: 'In effect, the property ceased to be excluded property at the time the reservation was released. The release would thus have triggered a charge which would not have arisen had the release not been made.'

Why does HMRC's guidance appear to contradict itself? One explanation is that changes were made in anticipation of a potential overhaul of the tax laws affecting domicile a few years ago, which never materialised. What is not in dispute is that assets added to an excluded property trust after the settlor has become UK domiciled will not themselves be excluded property (Revenue Tax Bulletin 27, February 1997).

Tracing gifts

Anti-avoidance provisions within the GWR regime ('substitutions and accretions') concern the 'tracing' of gifts. These rules broadly apply where the donee does not retain the gifted property until the donor's death, or until the benefit ends (Sch 20, paras 2–4).

The tracing rules do not apply to absolute gifts of cash. However, suppose that father make a cash gift of £200,000 to his daughter, which she uses to buy her father's house (also worth £200,000), and allows him to occupy rent-free until his death. In HMRC's view there would be a GWR of the house by means of associated operations (IHTA 1984, s 268, see IHTM 14372). The tracing provisions can also catch other property. For example, gifts of shares extend to bonus and rights issues as well. There are also fairly complex tracing rules for settled property (Sch 20, para 5), which are outside the scope of this article.

There is a specific tracing rule for POAT purposes in respect of cash, in addition to the general 'contribution condition' for land and chattels. However, this cash tracing rule only permits the tracing of such gifts made in the seven years before the donor was otherwise first caught by the POAT rules in respect of land or chattels (FA 2004, Sch 15 para 10(2)(c)).

The big picture

There are also GWR rules affecting insurance policies, business and agricultural property and settlements. When giving IHT advice to clients, practitioners must consider the implications of gifts and legacies not only for IHT purposes, but also for income tax (POAT) purposes, in addition to any capital gains and other tax and non-tax (eg. legal or commercial) implications that may arise. All in all, IHT planning is not for the faint hearted!

The above article was first published in Tolley's Practical Tax on 3 August 2007.