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Tolley's Practical Tax by Donald Drysdale

Donald Drysdale revisits this subject as taxpayers become liable to self assess the new charge.

Introduction

This article attempts to fulfil three purposes.

First, it offers an overview of the pre-owned assets (POA) tax regime in very broad terms in the hope that this may assist practitioners. It may possibly help them explain the new tax charge to their clients if they have not already done so. The overview is aimed particularly at taxpayers who may be exposed to the tax even though they have not engaged in any deliberate attempts to avoid inheritance tax.

Second, the article provides a brief update on recent events in the development and interpretation of the POA legislation.

And third, it identifies a number of important practice management issues raise by POA.

The views expressed herein are those of the author, and not of any professional body or other organisation. Reliance on these views is at the reader’s own risk.

An overview of the Pre-Owned Assets charge

The POA charge was introduced by FA 2004 to combat artificial inheritance tax avoidance arrangements by imposing an income tax charge in certain circumstances. It applies with effect from 6 April 2005, so 2005/06 tax returns are the first to be affected by it. The legislation is to be found in FA 2004 Schedule 15 and related Regulations.

A charge under this new POA regime may arise by virtue of transactions that occurred or circumstances that existed as far back as 18 March 1986. While most POA charges will fall on taxpayers who have entered into contrived schemes to reduce their exposure to potential inheritance tax liabilities, some will be triggered by innocent financial arrangements which had no particular tax avoidance motive. In a relatively small number of cases, such charges may fall disproportionately on taxpayers who least expect them.

Since 1986 the inheritance tax rules have included the concept of ‘gifts with reservation of benefit’, and an individual making such a gift but continuing to enjoy the benefit of the property in question must include its value in their estate for inheritance tax purposes. The new POA income tax charge will often arise where an individual has disposed of assets or divested themselves of value in such a way that they continue to benefit from them, but in circumstances which fall outside the reservation of benefit rules – a result which was sought as a deliberate ploy by certain schemes designed to avoid inheritance tax. The circumstances giving rise to a POA charge may also arise as a consequence of entirely innocent and practical financial arrangements between individuals or within families. For example, a taxpayer may have helped a relative to acquire a house and the taxpayer subsequently stays there. A charge may also be triggered by arrangements made, typically in connection with the financing of property in joint occupation, by relatives or unmarried couples (or unregistered same sex couples) who do not enjoy the tax reliefs available to spouses or civil partners.

POA charges may arise in respect of land or chattels. Where an individual occupies land or possesses or uses chattels, and they used to own the property in question or other property from which it was derived (the ‘disposal condition’) or they helped someone else acquire it by contributing to its acquisition (the ‘contribution condition’), they may be liable to income tax each year on a notional measure of the benefit they receive. The value of the occupation of land is measured by reference to annual rental values, and possession or use of chattels by reference to a notional 5% interest rate on their capital value.

POA charges may also arise in respect of settled intangible property. Where an individual is in a position to be taxed under the settlements legislation (formerly ICTA 1988 s 660A et seq and now to be found in ITTOIA 2005 s 619 et seq) by virtue of their own (but not their spouse’s or civil partner’s) position as a potential beneficiary of any settled intangible property, they may be liable to income tax each year on a notional benefit, whether or not they actually receive any benefit from the settled property. The amount chargeable on such settled property is also calculated by reference to a notional 5% interest rate on capital value.

For the purpose of computing POA charges, relevant land or chattels must generally be valued every five years, while intangible property must be valued annually. Certain transactions are treated favourably by being ‘excluded’ when considering exposure to the charge on land or chattels. These include a disposal of the taxpayer’s whole interest in a property either to an unconnected person at arm’s length or to a connected person but on arm’s length terms, certain gifts to the taxpayer’s spouse or civil partner, and disposals within certain inheritance tax exemptions (maintenance of family, annual exemption or small gifts exemption) but not within others (eg gifts in consideration of marriage). For the purpose of the contribution condition only, outright gifts of money are also excluded if made either before 6 April 1998 or at least seven years before the earliest date on which the taxpayer could satisfy that condition.

Separate from the exclusions, certain other situations are ‘exempt’ from the charge on land, chattels or settled intangible property. Most importantly, exemption applies where the property in question is within the taxpayer’s estate for inheritance tax purposes or treated as such under the reservation of benefit rules, or would be subject to a reservation of benefit but for the fact that it falls within certain prescribed provisions.

These provisions include those relating to gifts to certain privileged donees such as charities, political parties or employee trusts; land or chattels where the taxpayer pays full consideration for his occupation or possession; shared occupation qualifying for relief from inheritance tax; and other specific reliefs.

Exemption from the charge is also available for certain ‘equity release’ arrangements. This is achieved by exempting part disposals of land or chattels at arm’s length between unconnected persons, and certain other part disposals such as might be expected at arm’s length between persons not connected with each other.

Aggregate chargeable amounts of less than a de minimis exemption limit (£5,000 in 2005/06) are exempt, but those above this limit remain fully chargeable. Where sums remain chargeable, they can be reduced (in the case of land or chattels) by payments which the taxpayer has made for their use, but only in certain stringent circumstances.

Special provisions deal with taxpayers who are not domiciled in the UK or not resident here. There is no POA charge on an individual for a year of assessment during which he is not resident in the UK. A UK resident who is treated as domiciled outside the UK will only be subject to the POA charge on relevant property situated within the UK, and property that is ‘excluded property’ for inheritance tax purposes is disregarded.

Taxpayers liable to the POA charge on any property may opt out of paying the resultant income tax by making a one-off election which obliges them instead to treat the property as though it were subject to a reservation of benefit. This exposes them to inheritance tax on the property unless their occupation, possession or use ceases at least seven years before death. For any property falling within the scope of a POA charge within 2005/06, the last date for making such an election is 31 January 2007 – the same as the deadline for submission of the tax return. Late elections will be accepted only in cases where a reasonable excuse for lateness can be established.

Remember, the POA charge applies by reference to transactions and circumstances that have existed on or after 18 March 1986 – the date on which the concept of ‘gifts with reservation of benefit’ were introduced for inheritance tax purposes. This means that taxpayers have to look back as far as that date in considering whether they have an exposure to the new charge.

Recent POA developments
Those who have attempted to study the POA provisions in depth and understand the scope of the charge will be well aware that it is a minefield of considerable complexity. As we go to press, there is widespread concern among tax practitioners that HMRC has not yet published a revised version of its ‘technical guidance’ on POA, even though it has been promising to do so for several months. HMRC’s existing guidance can be viewed at http://www.hmrc.gov.uk/
poa/index.htm, but doubts remain about how various transactions and circumstances may be viewed in the context of the POA regime.

In the meantime attempts have been made to clarify some areas of doubt relating to the POA charge. Particular credit is due to the Society of Trust and Estate Practitioners, the Chartered
Institute of Taxation and the Low Incomes Tax Reform Group, who jointly submitted questions to HMRC on a number of technical issues. These questions, and the answers which they drew from HMRC, were published in March 2006 and can be found at www.tax.org.uk/showarticle.pl?id=3839. HMRC has provided guidance on the interaction between the disposal and contribution conditions, and has confirmed that there are circumstances in which both conditions might apply – for example, where the taxpayer has gifted property other than cash, and the donee has sold this and applied the proceeds in acquiring the relevant property. The legislation provides that, in such a case, only the higher of the two charges will apply.

HMRC has suggested that the contribution condition does not depend upon there being an element of bounty, but this remains unclear. In relation to the settlements legislation the courts have interpreted the ‘provision’ of consideration as connoting some element of bounty, and it appears arguable that such an interpretation should also be applied for POA, with the effect that the contribution condition might not be satisfied if it could be shown that there was no element of bounty involved in the alleged contribution. There is relatively little guidance available on whether (and if so, how) a loan might be regarded as a contribution for POA purposes. The taxpayer may have assisted in the acquisition of relevant property by providing a loan on commercial terms; alternatively, a loan may have been provided interest free or at a rate lower than arm’s length, or on terms which allow generous or indefinite repayment terms. HMRC has indicated that a loan on truly commercial terms and conducted in a truly commercial way should not be treated as a contribution.

Where this does not apply, it remains unclear how a contribution made by way of loan would be measured – eg by reference to interest foregone and/or capital value. There appears to be a particular risk that the face value of a loan left outstanding indefinitely would be regarded as a contribution.

There have been discussions about the POA treatment of property owned by companies. In such circumstances, the taxpayer’s estate may include either shares representing the full value of the relevant property, or shares to a nominal value plus a loan that has funded the purchase of the relevant property. HMRC argues that such a loan would not be property that derives its value from the relevant property, and this could have possible adverse POA consequences.

The provisions requiring five-yearly valuations of land or chattels subject to POA have caused concern. These pose a particular threat to taxpayers where the value of relevant property declines but the measure of value established for POA purposes remains unchanged until
the next five-year anniversary. HMRC has confirmed that, where there is a substitution of property (eg where the taxpayer moves house with the result that the relevant land is replaced by a property of lower value), a new valuation should be obtained and used for the remainder of the current five-year cycle.

In considering the POA treatment of settled intangible property, the definition of relevant property is property which is or represents property which the taxpayer settled. Where funds are settled and later invested unwisely, the trustees may find themselves left with a mixture of assets and liabilities, and HMRC has confirmed that it is the net value of the trust fund that would be taken into account for POA purposes.

Practitioners seeking to keep abreast of estate planning techniques have become accustomed already to the need to consider potential exposure to POA charges and how to avoid them. The proposed changes in the rules on inheritance tax for trusts, contained in
Finance Bill 2006 and the subject of much current controversy, will (if enacted) add a new dimension to estate planning by substantially shifting the balance of advantage away from traditional uses of trusts. New planning techniques will evolve, and in developing and applying these practitioners will need to take full account of the POA regime.

The Finance Bill also contains a new measure (at clause 80) designed to counter tax avoidance by denying an existing POA exemption where a taxpayer disposes of an asset, continues to enjoy it, and is given an interest in possession in it which would escape inheritance tax on death under the ‘reverter to settlor’ rules.

Practice management issues

Now that 5 April has passed, tax practitioners are gearing up for a new personal tax return season. Self assessment returns for 2005/06, the first to be affected by the POA regime, had been expected to contain a new question about deemed income subject to tax under the POA rules.

Astonishingly, this has not happened. In what has become an extreme stealth tax, the tax return makes no reference to the new charge; instead, taxpayers are expected to declare their exposure to this invidious new charge in response to Question 13 – ‘Did you receive any other taxable income which you have not already entered elsewhere in your Tax Return?’

This situation is far from satisfactory. The ‘benefits’ falling within POA are certainly neither ‘income’ nor ‘received’ in a conventional sense, and no ‘deemed income’ of any kind is referred to in the list of examples of other taxable income shown in HMRC’s Tax Return Guide notes on Question 13. Taxpayers who read these notes and follow HMRC’s reassuring advice – ‘If not applicable, go to Question 14’ – will therefore miss the brief explanation of the POA regime and will remain blissfully unaware of their obligations.

When asking clients for 2005/06 tax return information, agents may face an uphill struggle trying to explain the intricacies of the POA charge. After all, the charge has been with us for more than a year and, as explained above, at the time of writing HMRC has still not managed to update its preliminary ‘technical guidance’, which was originally published in March 2005 and long since recognised as woefully inadequate.

Practitioners will want their clients to inform them of transactions or circumstances likely to give rise to a charge, bearing in mind that these may relate to events as far back as 18 March 1986. A particular problem is that firms may have been given such information already without knowing it. Imagine that in 1988 client X had informed Y, who was then a partner or employee of the firm, of circumstances (perhaps a disposal, gift or loan) which had no immediate tax impact but might now trigger a pre-owned assets charge. Possibly the information was not even noted at the time, or maybe it was and the file was subsequently destroyed in accordance with prudent routine procedures. Perhaps X is now elderly and
has no clear recollection of the circumstances in question, and Y may have retired or even died. Nonetheless the firm was previously given the information it now requires.

Bearing this in mind, agents may wish to ask for information to be notified again if it has now become relevant to the new charge. They may also decide to review clients’ files for the most recent years or ask specific questions aimed at identifying circumstances that are thought most likely to create a charge. The terms of engagement letters might also be revised to clarify clients’ responsibilities for providing relevant information.

Although not acknowledged in any of the guidance yet issued by HMRC, there may be circumstances in which a taxpayer exposed to a POA charge may have no right of access to details of third party transactions having a material bearing in their tax liability. This can happen because the POA charge is imposed by reference to assets owned by third parties, with provisions for tracing through to substituted assets. Practitioners should be alert to such situations, and ready to discuss with their clients (and perhaps HMRC) what remedies might be available.

The POA charge is an income tax levy imposed to counter avoidance of inheritance tax, which is a capital tax. It is therefore HMRC’s Capital Taxes Office to which taxpayers or practitioners should turn if they require information on POA, by telephoning the Probate and Inheritance Tax Helpline on 0845 30 20 900.

Conclusions

It is disturbing that ordinary taxpayers and their agents may face extreme and costly difficulties as a direct result of inappropriate Government fiscal policy. It is also a matter of serious public concern that unrepresented taxpayers, particularly those not subject to the full self assessment procedures, may remain unaware of their exposure to this complicated new tax – at least until such time as omitted liabilities may catch up with them on a later enquiry, when the time limit for electing out of the POA regime may have long since expired.

POA must rank as one of the most obscure and unsatisfactory parts of the UK personal tax regime. However, the uncertainty it creates is far from unique. Taxpayers face comparable difficulties in complying with other aspects of tax – notably the settlements legislation, IR35, employee-related securities, and now the prospective new inheritance tax regime for trusts; the list goes on and on. It is a sad reflection on our tax system that honest taxpayers increasingly perceive the excessive complexity of the regime as a deliberate ploy by Government to extract the maximum amount of tax from ordinary citizens.

Donald Drysdale CA CTA (Fellow) TEP

Donald Drysdale, a former KPMG partner, is Assistant Director of Tax at ICAS

The above article was first published in Tolley's Practical Tax, 12/05/2006, and is reproduced with the kind permission of LexisNexis UK.