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May 2005
Q:
Several years ago I entered into a “Double Trust” estate protection scheme to take my house out of IHT. I understand that this has now fallen foul of the new pre-owned assets tax. Should I elect to have the house treated as part of my estate?
A:
The government want taxpayers to elect back into paying IHT. The new POAT regime will be expensive for the Revenue to administer.
I have seen advice from professionals to the effect that making the election runs severe risks. I do not agree. In many cases it will have advantages and may preserve the intended IHT saving.
What is clear is that, if you are thinking of making the election, it is best not to do so until immediately before the latest date you can do so.
There are, however, other alternatives which I briefly set out in this article.
The double trust (lifetime debt) scheme
There were a number of versions of the double trust scheme (sometimes called the lifetime debt scheme). These were designed to protect against IHT on a valuable home.
The homeowner created two trusts:
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the first for the benefit both of himself and the rest of his family;
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the second just for the family.
The owner was entirely excluded from any benefit under the second trust.
The house was then sold to the first trust for its market value. But instead of paying cash, the trust paid by issuing an IOU (usually called a loan note).
The terms of the loan note vary in different versions of the scheme. The essential feature is that the purchase price is payable to the original owner only after his death.
The owner then gave the loan note to the second trust. That gift was structured as a potentially exempt transfer. It would drop out of IHT after seven years. Taper relief might start to provide IHT savings after just three years.
The original homeowner could still live in the home thanks to his interest in the first trust. Indeed the value of the home would still be part of his or her estate for IHT purposes. But the loan note (which would usually include a formula increasing its value) would be deductible in calculating the IHT.
There has been no attack on the IHT saving aspect of this scheme. Obviously the Inland Revenue do not like it and it is rumoured that they are beginning a court challenge to one of the early versions. Most tax experts believe, however, that the scheme, if correctly implemented, works to save IHT.
The new tax charge
The government's attack is under the new pre-owned assets tax (POAT). This takes effect from the beginning of the current tax year, 6 April 2005.
POAT imposes an income tax charge on the enjoyment of a property where IHT could be avoided by shifting ownership.
Tax is charged on an amount equal to market rent. The rent is assessed on 6 April 2005 and this figure applies in calculating the tax charge for the next five years.
Electing for GROB rules to apply
The POAT regime includes a specific right to opt for an arrangement to be within the IHT rules on reservation of benefit (GROB) when it would not otherwise be so. When this election is made (by 31 January 2007 for the 2005/06 tax year) the income tax charge does not apply.
The election may be the best answer for some who are caught by the new tax charge. It is simple.
The election may even secure the intended IHT saving because of the wording of the relevant provisions. The election brings the property within the scope of the GROB rules. But those rules say that property within the GROB rules which is in one's IHT estate anyway is not subject to an extra IHT charge. The argument is that there is no additional IHT from the GROB rules because the homeowner's life interest under the first trust puts the home within his IHT estate, even though its value is reduced by the loan note. An alternative argument is that, even if IHT is payable under the GROB rules, the taxable value is still reduced by the value of the loan note.
It is likely that the Revenue will challenge these arguments. There must be a risk that there will be future changes in the wording of the legislation governing the Regime. But the availability of these arguments means that making the election could be the best course of action.
Married couples who have jointly put the double trust scheme in place for their joint benefit have another reason to make the election. Even if the arguments outlined above fail, the election will, in most cases, only bring into IHT the half share of the home originally owned by the second spouse to die. This is because the election is itself an individual one, not one made jointly by the couple. If the couple have been well advised there will be no IHT to pay on the death of the first of them in any event.
What are the alternatives?
It is worth checking the cost of paying POAT. If IHT taper relief is already starting to give a benefit and if the original homeowner's health is deteriorating, paying POAT for a year or two is a worthwhile investment to keep the value of the home out of IHT. The problem with this is that, once 31 January 2007 has passed, the election can no longer be made. The former homeowner is stuck with paying POAT for the rest of his life.
This demonstrates, however, why nobody thinking of making the election should do so until immediately before 31 January 2007.
A more sophisticated approach has appealed to some of my clients.
- The trustees of the second trust give the loan note to the homeowner's adult children and that trust comes to an end.
- The children, after a suitable interval, and preferably after taking independent advice, settle the loan note on fresh trusts for the former owner. The trusts provide for the loan note to go back to the children in due course, taking advantage of the IHT exemption where trust funds “revert to the settlor”. Hence there will no IHT charge on the value of the loan note on the owner's death.
- Meanwhile the property is exchanged for the loan note, so clearing the debt. The home is now in the new trust fund and will go to the children on the original owner's death, with the benefit of the reverter to settlor exemption and without any IHT charge.
Finally, it is possible to unwind the scheme completely and start again. Great care needs to be taken with unwinding to ensure that there is no stamp duty land tax charge.
About the Author
Anthony Nixon is a partner in South Coast law firm Lester Aldridge. As well as being a solicitor he is a member of the Chartered Institute of Taxation, the Association of Taxation Technicians and the Society of Trust and Estate Practitioners. Anthony specialises in tax planning for private clients, particularly inheritance tax and capital gains tax, and in the law of wills and trusts. He is a well known and popular lecturer on all these subjects. Anthony can be contacted via his Bornemouth or Southampton office.
Anthony Nixon
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