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Capital Tax Review by Matthew Hutton, MA, CTA (Fellow), AIIT, TEP

Matthew Hutton MA, CTA (fellow), AIIT, TEP author of Capital Tax Review, comments on the Pre-Owned Assets Technical Guidance issued by the Inland Revenue (now HM Revenue & Customs) on 17 March 2005

Context

This 25-page document comprises both a description of FA 2004 Sch 15 (and, indeed, something of a technical commentary on it – not unuseful in itself) and an explanation of the meaning of some points of uncertainty. The following picks up a number of the more interesting points.

The contribution condition

The wide scope of the contribution condition is noted. Where the chargeable person provided all or part of the consideration for the purchase of property by another person, who then sold the property and used the proceeds to purchase the land occupied, or the chattel used, by the chargeable person, the contribution condition is satisfied, unless it qualifies as an excluded transaction. Of course, we all know that: the problem is, how far does the indirect provision condition go in practice? No guidance is given here.

Exemption: co-ownership and full consideration

The exemptions in para 11 are set out. Interestingly, when referring to the co-ownership exemption, it is stated that the share transferred by the donor to the donee(s) who together continue to occupy, paying their share of household expenses, is ‘usually 50%’. Does this amount to implicit Revenue acceptance that unequal proportions of ownership can satisfy the test – subject to getting the evidence for payment of expenses right (see CTR Issue No 9 Item 13)?

The full consideration exemption in para 11(5)(d) is fairly stated to apply both to land and to chattels – but without comment on current views within Inland Revenue Capital Taxes that the levels of consideration historically adopted in chattels licensing arrangements do not satisfy the full consideration test. This subject can be expected to develop over coming months.

The election into Inheritance Tax

The election is to be made on Form IHT 500, found elsewhere on the website, together with guidance on completion. A late election (that is after the 31 January following the tax year when the Sch 15 conditions are first satisfied) will be accepted in the event of reasonable excuse, of which various examples are given:

• The election lost or delayed in the post (by an unforeseen event which disrupted the normal postal service, eg fire or flood at the relevant Post Office or prolonged industrial action).

• Loss of the chargeable person’s financial records or other relevant papers – subject to evidence of the circumstances.

• Serious illness of either the chargeable person or his close relative or partner – again, subject to the circumstances.

• Bereavement shortly before the relevant filing date, so long as the necessary steps had already been taken to have the election ready on time (as with the previous cases).

Generally, an excuse will be reasonable only if some event beyond the taxpayer’s control prevented him from sending the election to the Revenue by the relevant filing date. If the chargeable person can manage the rest of his private or business affairs during the period claimed to be covered by the reasonable excuse, the Revenue are unlikely to accept that the person was otherwise prevented from delivering the election on time!

Domicile/residence issues

The commentary does little here to add to the bare provisions of para 12. There is a long-standing and unresolved debate with Inland Revenue Capital Taxes (in which I remember participating as Chairman of the CIOT’s Capital Taxes Sub-Committee back in 1997/98) as to whether an addition to an excluded property settlement at such time as the transferor had become actually or deemed domiciled in the UK creates a separate chargeable settlement for IHT purposes. The Revenue have always taken the view that it does - and that view is restated here.

Tracing and contributions

It is well known that the GWR tracing provisions in FA 1986 Sch 20 para 2 do not apply where the original gift is cash, except where the transaction can be shown to be a GWR by associated operations of the purchased property. But of course, ‘what’s sauce for the goose is sauce for the gander’, and the GWR tracing rules do not apply to the POA charge. Accordingly, subject to the exclusions and exemptions, there could be a POA issue with cash traced into other property.

Reasonable attribution

For some time now practitioners have been looking for guidance on how the reasonable attribution rules for both land and chattels are applied. In a case where (a) the taxpayer has either disposed of property and all or part of the disposal proceeds were used to acquire all or part of the relevant property or (b) he has contributed any of the consideration (directly or indirectly) to acquire the relevant property, the proportion of the value of the relevant property which can be reasonably attributed to the property originally disposed of or to the consideration provided needs to be calculated. How do you do it? Section 4.3 of the Technical Guidance is disappointing in the extreme, referring simply to the need to make a reasoned judgment on the basis of the facts: the value of the land disposed of and its ultimate sale price, the consideration provided and the independent financial resources of the recipient.

Just one example is given. The chargeable person transfers land to another who later sold the land and used the proceeds to purchase a second property which the chargeable person occupies. If the land was valued at £100,000 at the date of transfer, sold for £300,000 and the new property purchased for £150,000, the Revenue would consider it reasonable to treat the whole value of the new property to be attributable to the property originally disposed of. If the value of the new property exceeds the proceeds received from the sale of the original property, the proportion of the value reasonably attributable to the original property will be reduced [but how?]. The value reasonably attributable to the new property cannot exceed the final value of the property originally disposed of.

Full or part consideration

Again, Section 4.4 of the Technical Guidance refers to the application of the full consideration let-out in para 11(5)(d) for both land and chattels, so as to disapply the POA charge. What happens if either less than full consideration is paid from the outset or an initial full consideration falls over time below market rates? A GWR will arise from the date when full consideration ceases to be paid. Provided that para 11(5)(a) applies, there will be no POA charge.

Occupation/possession

Occupation of land required for a POA charge is construed quite widely. A person would, for example, be regarded as in occupation not only if resident in the relevant property, but also if he used it for storage or had sole possession of the means of access and used the property from time to time. It is expressly confirmed that a person is not regarded as occupying a property from which he receives rent from the actual occupier.

If occupation or use is only very limited in nature or duration it may not be caught by para 3: each case will ultimately be decided on its own facts or circumstances. The Revenue specifically apply their November 1993 interpretation of occupation in the context of the GWR regime (RI 55).

Similar considerations apply to the possession or use of previously owned chattels.

‘Substantially less’

Property is exempt from POA if it is included in the chargeable person’s estate for IHT purposes or is subject to the GWR provisions. Also, if other property which derives its value from the relevant property is included in the estate or subject to a GWR, nor will the POA charge applied. However, if the value of that derived property which can be reasonably attributed to the relevant property is ‘substantially less’ than the value of the relevant property, only that proportion of the value of the relevant property which can be reasonably said to be included in the estate is exempted from POA.

By analogy with the CGT taper relief rules, the Revenue would regard a reduction in value of less than 20% as not ‘substantially less’ for purposes of Sch 15 – subject, however, to the circumstances of any particular case.

Where the ‘substantially less’ rule does apply, the appropriate chargeable amount for purposes of Sch 15 will be reduced by a ‘reasonable proportion’ to take into account the property in the estate.

Reversionary lease schemes

An example in the Appendix of a reversionary lease scheme confirms the Revenue’s view that, for schemes effected on or after 9.3.99, GWR applies. This is on the basis that the lessor’s continuing occupation of the property is considered to be a ‘significant right’, within FA 1986 s102A. This is not generally accepted by the professions – although of course, if not a GWR, there will be POA.

Death: the debt or charge scheme

An example of the debt scheme is given in the Appendix. There will be no POA issues, either because the widow did not satisfy the disposal conditions or, had she provided her late husband with all or part of the consideration, the contribution condition would not apply (as it would have been an excluded transaction under para 10(2)(a)). However, in the latter scenario there would be a disallowance for the debt on the widow’s death under FA 1986 s103.

The double trust scheme

Comment in the Appendix applies the POA regime to a scheme where the house is now valued at £500,000 and the debt at £400,000: only the net value of £100,000 attracts IHT. The excluded liabilities rules in paras 11(6) and (7) ensure that the para 11(1) exemption covers only the excess over the excluded liability, in this case, £100,000. The remaining part of the house will be subject to POA, in this example 80% of the appropriate rental value.

What the Technical Guidance does not say is that the excluded liabilities rules apply only if the creation of the liability and the transaction under which the person’s estate came to include the relevant property are ‘associated operations’ within IHTA 1984 s268. In many cases, of course, they will be associated operations – thought not necessarily. Careful analysis of each client case is required.

Insurance policies

ABI press releases in Autumn 2004 and subsequent Revenue comment confirmed that, in the Revenue’s views, a number of common insurance-based IHT mitigation arrangements were not caught by POA (see, for example, CTR Issue No 9 Item 7). The Appendix to the Technical Guidance refers only to discounted gift schemes and to gift and loan arrangements in this context.

Under a discounted gift scheme, there is a gift into settlement with certain ‘rights’ retained by the settlor, eg a series of single premium policies maturing (usually) on successive anniversaries of the initial investment or on survival, reverting to the settlor (if alive on maturity), or the settlor carves out the right to receive future capital payments if alive at each prospective payment date. GWR does not apply. Because the rights are held on bare trusts for the settlor, it is not property within para 8, at least in the straightforward case. In more complex cases where the settlor’s retained rights or interests are themselves held on trust, that would normally be construed as being a separate trust of those benefits in which the settlor had an interest in possession and so with no POA charge, given para 11(1). Even if (in less common cases) para 11 did not apply so as to exempt the case from charge completely, any POA charge would apply by reference to the value of the rights held on trust for the settlor, not by reference to the value of the underlying life policy.

Under the gift and loan arrangement, the settlor makes a policy which he settles on trust for the benefit of others. A substantial interest-free loan made to the trustees is repayable on demand. The trustees use the loan to purchase more policies and make partial surrenders each year to pay off part of the loan. This arrangement is not a GWR. The settlor is not a beneficiary of the trust itself and the making of the loan does not constitute a settlement for IHT purposes. There will be no POA charge.

The third category of insurance policies mentioned in the Appendix is ‘business trusts (or partnership policies)’. Here a partner in a business effects a life assurance policy subject to a business trust of which the partner is a potential beneficiary. Provided the arrangement is commercial, it is not a GWR. However, the trust is a settlement of IHT purposes and there will be a POA charge under para 8.

The above said, business trusts (or partnership policies) were by Revenue statement made on 1.4.05 expressly taken out of charge under para 8, provided that the life assured does not retain a benefit eg in the form of the ability to cash in the policy during lifetime. In such latter case, even if there is no GWR (because the arrangement is on commercial terms), the para 8 POA charge will apply.

Comment

While the above is useful and interesting as far as it goes, the guidance will by no means cover all the nitty gritty problems that arise in practice, for example the application of the ‘reasonable attribution’ principle. As with all self assessed taxes, an element of judgment remains to be exercised by the taxpayer, on the basis of professional advice, eg as to whether he does occupy the land or possess the chattel within the meaning of the regime.

More Information

The above article has been taken from Matthew Hutton’s Capital Tax Review, a quarterly update for professional advisers of private clients. For more information, visit http://www.taxationweb.co.uk/books/capital_tax_review.php.

Matthew Hutton
April 2005

About the Author

Matthew Hutton is a non-practising solicitor (admitted 1979), who has specialised in tax for over 25 years. Having run his own consultancy (latterly through Matthew Hutton Ltd) until 30th September 2000, he now devotes his professional time to writing and lecturing.