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Forbes Dawson by Laura Hutchinson ATII ATT

The family home often makes up the greatest part of an individual's estate, and in many cases is the major factor resulting in inheritance tax becoming payable. Capital Taxes expert Laura Hutchinson of Forbes Dawson considers some IHT planning ideas involving the family home.The family home often makes up the greatest part of an individual's estate and in many cases is the greatest factor in taking the value of an individual' s estate over the nil rate band. Due to the recent increases in property values the high value of the family home could result in a significant amount of inheritance tax becoming payable on death. Further the home is a non-income producing asset.

For this reason, arrangements that are able to reduce the taxable value of the family home on death are attractive.

Difficulties of Tax Planning

The main difficulty arises as the individual needs to continue living in the property. Unless specific arrangements are made, the individual will have a 'reservation of benefit' in the property gifted, such that the gift is ineffective for inheritance tax purposes.

To be effective, tax planning arrangements must ensure that the Gifts With Reservation provisions (GWR) (s 102, s l02 B & C FA 1986) are not relevant.

A few of the current schemes are described below including potential problems and concerns.

Other Taxes

The major problem with any inheritance tax planning arrangement is the other taxes, specifically capital gains tax, income tax and stamp duty. Usually arrangements that are guaranteed to save inheritance tax result in additional taxes elsewhere and eliminate much of the benefit.

Tax Planning Arrangements

1. Double Trust Arrangement

This scheme allows an individual to continue to reside in the family home as a beneficiary of a settlor-interested life interest trust. The full value of the property would normally fall into the estate of the beneficiary by virtue of s49 IHTA 1984. However the Trustees borrow funds equivalent to the value of the property at the date it is sold to the trust. This borrowing is allowed as a deduction from the value of the property and reduces the value attributable to the life tenant under s49 IHTA 1984. Any increase in the value of the property from the date settled to the date of death, will form part of the beneficiary's estate.

The typical steps are as follows:

1.1 A UK domiciled and resident individual (Mr X) gifts a small amount of cash, say £1,000, into a flexible life interest trust for his own benefit. His children are included as remaindermen.

1.2 Mr X owns a valuable UK situate family home worth, say £500,000. The life interest trust purchases the home from Mr X at market value. No capital gains tax arises as it is Mr X's principal private residence and full relief is available.

1.3 The proceeds owing to Mr X are left on loan account.

1.4 Mr X creates a second trust, of which he is excluded from benefiting. The terms of this second trust are different to the first trust.

1.5 Mr X makes a gift of the loan owing to him to the second trust.

1.6 The second trust now holds a loan equivalent to the value of the property at the date it was sold into trust.

There are many issues to consider. A number of these being:

• Stamp Duty and resting on contracts. If resting on contracts is used, the Trustees of the No 1 Trust must have the right to occupy the property;

• There are complications if there is an existing mortgage on the property. In general terms the mortgagor may object to the transfer out of the donor’s estate;

• The terms of the loan must ensure that it cannot be treated as an interest in land which would fall into the rules introduced by FA 1999. Could this fall into associated operations in which case no deduction will be allowed for the debt against the value of the property?

• Does interest need to be charged on the loan?

• Ensure that the principal private residence relief is available in full on the sale to Trust No1 otherwise capital gains tax would be payable.

Capital Taxes Views

Peter Twiddy, the deputy director of the Capital Taxes Office has been quoted as saying he would like to look into the scheme, in particular at the application of s49(1) IHTA 1984 (the treatment of interests in possession for inheritance tax purposes).

At the time of writing no written comment has been released by Mr Twiddy on the specific issues. However it is clear from comments in journals that the Inland Revenue are likely to challenge the scheme.

Other Views

A number of leading Counsel have also expressed reservations on the effectiveness of this scheme, specifically relating to the terms of the lease, resting on contracts and the question of a reservation of benefit on the loan. Also concern has been raised on how a court would view the scheme particularly with their current purposive approach.

Summary

The arrangement is artificial in that the Trustees of the second trust must be content to leave their loan in place until the death of the occupier, and further to allow the loan to continue if there is a change of house.

The artificiality can be reduced if the loan is on commercial terms, but this has adverse income tax practical consequences.

As main residence exemption is preserved, there is comparatively little downside.

2. Spouse Exempt Trust (Wealth Trust)

Any transfers that are exempt transfers as described under s102(5) FA 1986, cannot give rise to a reservation of benefit. Exempt transfers include, in particular, a transfer between spouses under s18 IHTA 1984.

The 'Wealth Trust' makes use of the exempt inter-spouse transfers and ultimately creates a discretionary trust which is outside the estates of the husband and wife.

The steps are as follows:

• The donor creates an interest in possession trust for his UK domiciled spouse.

• The settlor may continue to live in the property by virtue of the spouse's interest in
possession (see notes on issues to consider). The whole value of the property should become comprised in the estate of the spouse under s18(1) IHTA 1984.

• No reservation of benefit will arise due to the transfer of value being exempt.

• The Trustees of the settlement can terminate the interest in possession at any time during the trust period. Upon the termination of the interest in possession the trust becomes discretionary in nature, under the terms of the deed.

• This termination will be a chargeable transfer of value by the spouse, equal to the value of the settled property, as the property becomes a discretionary trust. The nil rate band of the spouse will need to be available.

• For capital gains tax purposes no capital gains tax should arise as the property will have been the spouse's principal private residence during the period of her life interest (s225 TCGA 1992).

• The settlor is able to continue to live in the property as a member of the discretionary class of beneficiaries.

• Following a period of seven years from the date of the appointment onto discretionary trust, the transfer of value will drop out of the spouse's estate.

The important issues to consider are:

• The spouse must be UK domiciled otherwise the spouse exemption under s18 IHTA 1984 does not bite.

• The interest in possession trust should be left in existence for at least 6 months -the longer the better. In most circumstances, the interest in possession period should cover the end of the tax year.

• The donor should retain a part share of the property, for example could gift a 95% share and retain the remaining 5%. This would allow the donor to occupy the property, by virtue of his own holding, during the period of interest in possession.

• The choice to exercise the power of appointment is at the Trustees' discretion. There must be no predetermined exercise date entered into the deed. This should ensure that no one could argue that the exercise formed part of an associated operation (s268 IHTA 1984).

• The chargeable transfer by the spouse on the termination of the interest in possession to a discretionary trust could potentially result in an inheritance tax liability. This depends upon the value of the settled property and the availability of the nil rate band.

• It is important that the settlor does not have sole occupation of the property during the discretionary period. Otherwise the Inland Revenue are likely to argue that he has an interest in possession and the whole value of the property would fall back into his estate (s49 IHTA 1984). The risks would be reduced if he was able to occupy the property together with his other family members.

• There could be some dispute if the only other beneficiaries occupying the property under the terms of the trust are the settlor's minor children. The Inland Revenue are likely to argue that the minor children are not able to decide where they live, and they reside in the property by virtue of their parents decision only.

• Counsel have advised that the other discretionary beneficiaries should become absolutely entitled following an interval of time. The beneficiaries may then allow him to occupy the property under whatever terms they think fit.

• During the discretionary period the Trustees should be entitled to principal private residence relief under s225 TCGA 1992.

Capital Taxes Office View

Mr Twiddy stated in a recent article that the Capital Taxes Office are likely to challenge the argument that the settlor retains no reservation in the property. The Capital Taxes Office are considering whether two gifts have been made; one to the spouse which is exempt; and one to the remaindermen i.e. the children and the settlor, in which a reservation can arise.

It appears that Mr Twiddy will only take this view if the settlor determines when the interest in possession ends. If the Trustees are able to decide if and when the interest in possession is terminated, this is unlikely to be viewed as two separate gifts by the settlor.

Other Views

Counsel appear to differ in their views of this planning opportunity. Robert Venables believes the planning is effective, whereas Barry McCutcheon is concerned with the Capital Taxes office view of a number of gifts, only one of which is not subject to a reservation of benefit.

Matthew Hutton has written many articles on family home planning and seems to favour this route.

The Courts have recently found for a taxpayer in a case involving a wealth trust. The case has not yet been publicised. The Inland Revenue are to appeal against the decision.

3. Reversionary Lease

This arrangement was introduced at the time the Lady Ingram case was going through the courts. In a similar way to the Lady Ingram case, this arrangement attempts to carve out a lease. This lease is gifted to another individual. The donor continues to live in the property by virtue of owning the freehold. The lease increases in value over its lifetime, and the value of the freehold decreases exponentially. Hence, on death the value of the property held in the donor's estate should have reduced considerably.

Due to the reservation of benefit legislation introduced in 1986 and subsequent additions to the legislation in 1999, the arrangement has to be structured within the following parameters:

• The freehold should have been owned by the donor for at least 7 years (s 102A(5) FA 1986 will then not apply).

• The lease is granted to the donee to take effect at some time in the future.

• The lease must begin within a 21-year period.

• The donor has retained security of tenure until the lease falls into being.

• The lease can be structured to come into being by reference to the earlier of a certain fixed period of years, or a week after the death of the donor. This should ensure the majority of the value is attributed to the lease.

• The freehold should be left in the donor's Will to someone other than the original grantee of the lease. This should avoid any argument of associated operations.

The main downside to this arrangement is the capital gains tax implications.

The majority of value of the property will be held in the lease. On the death of the donor the uplift to market value will be available on the freehold only, as the lease is no longer held by the donor.

The donee of the lease might not ever occupy the property. On a future sale of the property, principal private residence relief will only be available in respect of the donee's period of occupation and the following three years.

One advantage over the original lease scheme (The Lady Ingram scheme), is that the lease is a long lease and therefore the base cost of the lease does not waste away over the period of the lease.

However, any sale is likely to result in a large capital gains tax liability due to the restriction of principal private residence relief, unless other planning steps are taken, e.g. using an offshore trust.

The other considerations are:

• Does the reversionary lease create any restrictions on the freedom to dispose of the property for s163 IHTA 1984? If so the value of the property is reduced for inheritance tax purposes only if consideration were paid at the time the restriction was created. Counsel have reviewed this point and do not think it should cause a problem.

• Care should be taken over associated operation issues, for example as detailed above - the freehold should not be left to the donee of the lease.

• Is possession and enjoyment of the leasehold assumed by the donee?

• Capital gains tax issues on principal private residence relief (PPR). Consideration should be given to putting both the freehold and future leasehold into trust to obtain the PPR.

• If the donor dies shortly after implementing the arrangement there will be very little value shift from the freehold to the lease and the planning will be ineffective.

• If the donor lives into the period of the lease the donor will not have any rights to occupy the property. He would need to enter into a commercial sublease, which does not fall within the reservation of benefit provisions by virtue of Schedule 20 paragraph 6 FA 1986.

Capital Taxes Office Views

The Capital Taxes Office publicly expressed its opposition to the lease schemes. However this view was subsequently amended for reversionary lease schemes that were implemented prior to March 1999 i.e. before the change in the reservation of benefit legislation in FA 1999.

The Capital Taxes Office argument is that the reservation of benefit let-out enabling land that has been held for seven years (s102A(5) FA 1986) does not apply to 'arrangements'. Mr Twiddy feels that the occupation of the property by the original owner is part of a ‘significant arrangement’. It is Counsel's view that provided full consideration was paid for the freehold when first purchased and it has been owned for seven years or more s102A(3) FA 1986 should not apply. Therefore the donor is living in the property pursuant to his ownership of the freehold. There could be problems if for example a property had passed by joint tenancy from one spouse to another on death i.e. the surviving spouse acquires one half of the property for free.

Other Views

A number of Counsel disagree with the Capital Taxes Office views on the reversionary lease arrangement. They believe there are arguments against associated operations and reservation of benefit arguments. Specifically the points raised above need to be looked at in more detail before the planning would be effective.

Further Information

For further information on Inheritance Tax planning with the famly home, contact Laura Hutchinson by telephone on 0161 245 1090, or by e-mail at laura@forbesdawson.co.uk.