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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 highlights some potentially strange effects of the pre-owned assets income tax regime.

Context

A characteristically excellent article by Emma Chamberlain puts forward a number of examples which illustrate certain curious effects of the application of the regime. These examples, numbered 2 – 7, use Rose and Tom who have lived together for some years as co-habitees. They are not connected persons, but Rose spends her weeks in London and her weekends in Oxford with Tom.

Example 2: Gifts of cash

In 1999, Rose gave £200,000 cash to Tom. Tom uses all the cash to buy a house in Oxford for £400,000, the rest being funded by commercial borrowing.

For IHT purposes, Rose makes a potentially exempt transfer. It is accepted by HMRC that there is no GWR on the cash gift provided the gift to Tom is not conditional on him buying the house. The tracing provisions do not apply (see FA 1986 Sch 20 para 2).

For POA purposes, the contribution condition has been satisfied. Rose has provided consideration for Tom which is used by him to fund the purchase. It is not an excluded transaction because the gift was after 5.4.98 and she occupied the Oxford house within seven years of the cash gift. Rose pays income tax on half the market rent, since half the purchase price was funded with her contribution.

Note that even if Rose and Tom have subsequently married, this does not then protect the transaction. Rose still pays POA tax. Hence the diligent accountant must ask his clients whether they gave cash to a spouse for the purchase of a house prior to the date of any marriage and, if so, when.

Example 3: Gifts of cash – joint purchase

In Example 2, the POA problem arises because Rose has satisfied the contribution condition and does not fall within any of the exemptions or exclusions. Contrast the position in Example 3 if the property is jointly purchased.

Rose gives £200,000 cash to Tom. Rose and Tom then buy a house jointly for £400,000 two years later and share occupation.

The gift of cash by Rose is a PET. There is no GWR on the principles outlined above.

In contrast to Example 2, it is thought that there is no POA charge provided that Tom continues to occupy the house with Rose [and, say, they share expenses]. The wording in para 11(8) is very unclear, but appears to require one to assume that Rose has in fact given an undivided share in land to Tom, otherwise the reference to (c) in para 11(8) would have no meaning. Hence if donor and donee are in joint occupation, they are protected from the charge because they are deemed to satisfy the co-ownership exemption within FA 1986 sI02(B)(4).

Example 4: Gifts of land – whole house

Rose gives the whole house she owns to Tom and they both occupy it.

This is clearly a gift caught by GWR. Therefore there is no POA charge because Rose is protected under para 11(5)(a).

Example 5: Gifts of land - share of house

Rose gives a share of a house she owns to Tom and they both occupy it.

There is a gift for IHT purposes but, while Tom occupies with Rose and pays no more than his share of the expenses, there is protection from the GWR provisions under FA 1986 sI02B(4) (co-ownership exemption). If Tom moves out, a GWR will arise.

While Tom is in occupation there is no POA charge because para 11(5)(c) confers protection: the disposal satisfies s102B(4). If Tom moves out, there is still no charge because Rose is protected under para 11(5)(a) - she is caught by the GWR rules, so there is no need to charge her to income tax as well.

All of this has a certain logic and is in keeping with the principle that POA tax should only be payable where IHT is being avoided contrary to the intention of Parliament.

Example 6: Loans

Rose lends cash to Tom and Tom buys a house for Rose and Tom to live in.

There is no IHT event assuming the loan is repayable on demand. The value of the loan is an asset of Rose's estate and subject to IHT on her death.

HMRC take the view that the contribution condition may have been satisfied because a loan constitutes the provision of consideration and therefore POA tax is due. A COP 10 letter suggests that both commercial loans and interest-free loans are caught. Has Rose in fact 'provided' anything within the meaning of the contribution condition? In the context of other income tax provisions such as the old Part XV settlement provisions, 'provide' has been held to connote some element of bounty; see CIR v Leiner 41 TC 589 and CIR v Plummer [1979] STC 793. On that basis, if the loan is commercial, no bounty has been given.

If Rose's loan is interest-free, is the provision of funds the whole loan or merely the interest-free element? Or could one argue that nothing has been provided by Rose as such, since it is Tom who provides the consideration by his promise to repay Rose? At present, HMRC certainly seem to consider that interest-free loans are caught. Securing the loan on the property does not in their view mean that the loan derives its value from the land and hence Rose is not protected under para 11(1).

Example 7: Sales

Rose sells part of her house to Tom.

If the sale is at full value, there is no IHT issue. There has been no diminution in Rose's estate and, since there is no gift, the GWR provisions are irrelevant.

For POA purposes, if the sale is at full value it is protected under Regulation 5 since cohabitees are not connected persons. If, however, Rose was Tom's mother and the sale took place after 6 March 2005, POA tax is payable even if Rose retains the cash and pays tax on the interest from it. This is because they are connected persons.

If the sale is at an undervalue, the position is more difficult. For IHT purposes, a sale at an undervalue involves some element of gift and therefore potentially a GWR. Arguably the GWR is in the undervalue element only rather than in the whole property (see HMRC Manual which adopts this approach, although this is open to question). One might then say that such a disposal of part is protected from a GWR under FA 1986 sI02B(4) (co-ownership protection) while Tom is in occupation, because Rose has disposed of a share in land and they both occupy it.

For POA purposes, there should be no income tax charge on the element of undervalue if it is subject to a GWR as a gift or would be but for the co-ownership protection: see paras 11(5)(a) or (c). However, POA tax is arguably payable on the cash received by Rose whether or not she retains such cash. The non-exempt sale provisions do not apply to sales of part and the basic disposal condition is satisfied. So the position is the exact opposite of Example I (sales of whole at an undervalue).

Compliance issues

In Example 6 it seems to make no difference whether Rose and Tom share occupation or own the property jointly – nor indeed would it technically help if Tom were to repay Rose or if they were later to marry: the contribution condition has still been satisfied. Also, loans made since 17.3.86 can be caught, since loans are not outright cash gifts and can therefore never attract the seven year exclusion in para 10(2)(c).

The moral seems to be that a tax adviser should ask all his clients whether any loans were made between members of the family, including loans between husband and wife prior to marriage. But why do HMRC want to tax such transactions even if the loan is interest-free? After all, the loan is taxed as part of Rose’s estate on her death. If the loan is written off by Rose (which is presumably what worries HMRC), the POA legislation may be wide enough to catch such a transaction already or, if not, it can easily be amended.

In the interests of facilitating self assessment, the hope is that HMRC modify their current position. Loans are common not only between cohabitees but also between other family members. Consider for example elderly mother who loans cash interest-free repayable on demand to her daughter to buy a house in which the daughter and the family live and Mum later moves in. The loan is taxed on Mum’s death: why should she also have to pay POA while she is alive? It is hard to see why this transaction should be taxed so much more adversely than Mum giving a share of her house to her daughter with everyone in joint occupation: this saves IHT and avoids POA!

Example 7 demonstrates the complex position on sales of an undervalue or sales of part.

An unnecessary tax

The above are common transactions often not done for IHT mitigation reasons but to facilitate living arrangements between family members. The Government urgently needs to review policy in this area.

(Taxation 19.1.06 p375, article by Emma Chamberlain)

Comment

Example 6: Loans - notwithstanding the reference to the need for bounty within the old Part XV Settlement provisions for income tax, I understand that HMRC take the view that the meaning of ‘settlement’ for POA purposes follows the IHT definition, for which of course no bounty is required. However, it appears that most recently HMRC have said that with a loan which is on demonstrably commercial terms (ie exactly the same as would be offered by a commercial lender) the contribution condition has not been satisfied.

The main point at this Item is to underline the fact that the POA regime so often operates counter-intuitively – and indeed the need for compliance purposes to ask some possibly unusual questions of clients: see for example the last sentence of Example 2 above.

April 2006

Matthew Hutton MA, CTA (fellow), AIIT, TEP

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.

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.

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