Enter Your E-mail

Taxation by Mark McLaughlin CTA (Fellow) ATT TEP

Mark McLaughlin CTA (Fellow), ATT, TEP examines important recent changes affecting capital gains tax main residence relief in the second part of a two-part article (see ‘Gift Rapped’).The second article of this series of two, looks at the changes to the operation of capital gains tax only or main residence relief made in the FA 2004 in response to what the Government perceived as unacceptable tax planning. (All references are to the Taxation of Chargeable Gains Act 1992, unless otherwise stated.)

Another breakdown …

A further ‘tax avoidance’ arrangement to which the Government objected was designed to make use of gifts relief under s 260 (i.e. for gifts on which inheritance tax is chargeable, in this case transfers to a discretionary trust) and private residence relief (under s 225 , for only or main residences occupied under the terms of a settlement) to ensure that gains on second homes were realised free of CGT.

For example, John Smith owned a second property (a bungalow bought as an investment) standing at a considerable gain. The bungalow was transferred to a discretionary trust in which the beneficiaries included his three adult children. The gain was held over under s 260. The trustees have the power to allow a beneficiary to occupy the property. One of those beneficiaries, Jane, took up occupation as her only or main residence. On a future sale of the bungalow, before 10 December 2003, the whole gain, including the held over gain, would be subject to a claim for exemption under s 225.

Further repairs

The relief restrictions ( s 226A , as introduced by FA 2004, s 117 and Sch 22 ) are designed to block private residence relief in most cases on the disposal of a residence from 10 December 2003 by an individual or settlement trustees, if the property’s base cost has been reduced following one or more s 260 holdover claims on its earlier disposal. This means that a s 260 claim by trustees on the transfer of a property to a beneficiary prevents private residence relief being claimed by the beneficiary on a future disposal, or vice versa. Any future gain from the individual’s or trustees’ period of ownership is also denied private residence relief, including the held over gain element.

The rules are retrospective in the sense that they apply whether the earlier (s 260) disposal was before or after 10 December 2003, although there is transitional relief in the former case. Given that a s 260 claim can be made up to five years from 31 January following the tax year of disposal ( TMA 1970, s 43 ), the effect of s 260 claims on private residence relief is broadly that:

• Private residence relief is not available to an individual who makes a s 260 claim relating to an earlier disposal on or before a later disposal of the residence, or to trustees who make a s 260 claim for an earlier disposal on or before a private residence relief claim on its later disposal.

• Private residence relief is treated as never having applied to individuals who make a s 260 claim after a disposal of the residence. The same applies for trustees who claim relief under s 260 after making a private residence relief claim on its later disposal.

However, a s 260 claim on the earlier disposal can be revoked, in which case it is treated as never having applied and private residence relief becomes available (s 226A(6)). Declining to make a s 260 claim, or revoking an earlier one, may be worth considering if the gain since the transfer into trust has already exceeded the original held over gain, or is expected to exceed it. This assumes that the settlor is content to bear the CGT liability on the property transfer – after all, it is sometimes said that ‘a tax deferred is a tax saved’!

In line with the relaxation in the gifts relief restriction mentioned above, there is an exception from the private residence restriction in s 226A on a later disposal by trustees who have elected for TA 1988, s 691(2) to apply in respect of maintenance funds for historic buildings for the tax year in which the relevant earlier disposal was made ( s 226B ).

Unsatisfactory?

There are elements of the relief restrictions which, to say the least, are unsatisfactory. For example, the denial of private residence relief affects not only the gain held over on the earlier disposal, but also any increase in value of the property up to the later disposal. Would it not perhaps be fairer for the private residence relief restriction to apply to the original held-over gain only? It would be a welcome development to see this issue addressed in the next Budget.

In addition, unlike the gifts relief rules, there is no exception from the private residence relief restriction in relation to disabled trusts. The Revenue explains in the explanatory note to Finance Bill 2004 that:

‘… IHTA 1984, s 89 provides that a beneficiary of such a settlement has an interest in possession of the settled property. And this means that any transfer to the trustees of such a trust is a potentially exempt transfer for IHT purposes, and cannot, therefore, fall within the scope of TCGA 1992, s 260.’

However, what about the trustees of discretionary trusts for disabled persons, where the terms of the trust deed fail to satisfy the IHT conditions for disabled trust status, either deliberately, e.g. for estate planning purposes, or inadvertently? This is perhaps another issue that could be addressed by the Chancellor in his forthcoming Budget.

Some relief

Transitional rules provide for a measure of private residence relief on a later disposal, if the earlier (s 260) disposal was made before 10 December 2003 (FA 2004, Sch 22 para 8). The effect is that relief is available for periods before that date. This is achieved by treating the period from 10 December 2003 to the date of disposal as a period of non-occupation. Unfortunately, this includes all or any part of the last 36 months’ ownership falling within that period, for which relief is normally available under s 223(1) (see Example 1 ).

Example

Bernard owns a second property which has never been occupied as his only or main residence. On 1 April 1998, he transferred the property to the trustees of a discretionary trust, the beneficiaries of which include his adult children Sharon and Martin. Bernard and his wife are excluded from any benefit. Bernard claims relief under s 260, holding over the gain of £125,000. One of the beneficiaries, Martin, is allowed to occupy the property as his only or main residence under the terms of the settlement between 1 April 1998 and 10 March 2006. Martin moves out on 10 March 2006, when the trustees sell the property, realising a gain of £400,000 after allowable costs net of the £125,000 held over gain.

Private residence relief is not available to exempt the full gain, due to the earlier gifts relief claim. However, transitional relief is available. The trustees’ period of ownership was 2,900 days. Private residence relief applies to the period 1 April 1998 to 9 December 2003, i.e. 2,079 days. The trustees are entitled to relief of £286,759 (£400,000 x 2,079/2,900). The remaining gain of £113,241 (£400,000 - £286,759) is chargeable, including that part of the final 36 months’ ownership falling after 9 December 2003, and an element of the original held-over gain, subject to non-business asset taper relief and the trustees’ annual exemption, if available.

While any relaxation in the private residence relief restriction is welcome, there is still an element of retrospection, as the time-apportioned gain will include a proportion of the gain held over from the earlier disposal. Future growth in value of the property will also be taxable, which means that the potential gain on a subsequent disposal increases as long as the property is held and values continue to spiral.

An important point on private residence relief generally is that trustees wishing to avail themselves of the relief on a disposal of the only or main residence of a beneficiary entitled to occupy it under the terms of a settlement must make a claim for private residence relief, in respect of property disposals from 9 December 2003 (s 225).

Not all bad news!

At least FA 2004 gave statutory effect to Extra-statutory Concession D5 concerning only or main residence relief for property held by personal representatives, through the introduction of a relief claim under s 225A for disposals from 10 December 2003. The relief is available for the disposal of what was the only or main residence of one or more legatees both immediately before and after the deceased’s death. ESC D5 required that the individual(s) must be entitled to all or substantially the whole of the house proceeds. S 225A helpfully replaces the term ‘substantially the whole’ with a 75% test for net disposal proceeds. However, given that the property is subject to market value uplift on death in any event (s 62(1)), the relief is perhaps of limited application in many cases.

Mark McLaughlin CTA (Fellow) ATT TEP
March 2005

Mark McLaughlin is Editor of TaxationWeb. This article was first published in ‘Taxation’ on 10 March 2005, and is reproduced with kind permission of Lexis Nexis UK