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TaxationWeb by Laura Hutchinson ATII ATT

A valuable form of relief from Inheritance Tax is potentially available to farmers and landowners. Tax Specialist Laura Hutchinson ATII ATT of Forbes Dawson explains the opportunities and complexities of Agricultural Property Relief.

Introduction

Agricultural land and property (‘agricultural property’) will probably make up the greatest part of a farmer’s estate upon death. Fortunately, a relief against inheritance tax on these assets is available in the form of Agricultural Property Relief (APR).

Unfortunately the legislation affording the relief is complex, and the availability of the relief sometimes relies on precedents of recent Court cases.

Despite the complexity, the relief when available is generous and can reduce the value of agricultural land chargeable to inheritance tax to nil. For this reason it is important that anyone owing agricultural property structures their affairs to attract the maximum relief available.

This article attempts to explain the intricacies of the current inheritance tax regime and the complexities of Agricultural Property Relief.

The topics covered include:

1. General rules of APR

Conditions to qualify as APR
Period of ownership

2. Taxation implications of how the land is held

In a farming company
Under a tenancy
Under a license

3. Availability of APR on a farmhouse

The tests of whether a property is a farmhouse
Agricultural value of a farmhouse

4. Inheritance tax planning

Reasons to make lifetime gifts
Tax implications of death within seven years of a gift
Reinvestment into further APR assets
Interaction of APR with Business Property Relief (BPR)
Will planning

1. GENERAL RULES OF APR

Conditions to Qualify for APR

To attract the relief two conditions must be satisfied.

1. Firstly the land must be ‘occupied for the purpose of agriculture’

This incorporates general farming, rearing of animals (including horses on a stud farm), and using land for grazing, providing the owner is responsible for the upkeep of the land.

2. Secondly, it must be agricultural property, as defined by the Inheritance tax Act.

Agricultural property includes UK land, buildings used as farm buildings, and cottages and farmhouses of a character appropriate to the land. Land outside the UK will not attract the relief but should be eligible for BPR. The availability of the APR on farmhouses can be complex and is discussed in more detail later on in the article.

An owner of agricultural property used for the purposes of agriculture can claim 100% relief against the agricultural value, provided any of the conditions below are satisfied:

- The owner has right to vacant possession within 12 months (an extra statutory concession F17 extends this period to 24 months for land under a tenancy, but not a license), or

- The property is let on tenancy beginning on or after 1 September 1995 or

- If the owner has been beneficially entitled to the interest in the land since March 1981, and had he made a transfer of value before that time, would have attracted the full relief under the old ‘working farmer’ rules. The owner must also not have had rights to vacant possession within 12 months

Transfers of any other agricultural property attract relief at 50% only.

Relief is available only against the agricultural value of the property, which in many cases, for instance farmhouses, can be different to the open market value. The value of agricultural property is often lower than the open market value as the agricultural value assumes use is restricted to agriculture only.

Period of Ownership

To obtain the relief the property must be held for a minimum period. There are two periods of ownership relevant to the 100% relief:

1. A minimum 2 year period for the owner farmer; and

2. A seven-year minimum period for the owner of property let out on a tenancy

The period required to qualify for full relief differs in certain circumstances where property is received on death and subsequently transferred, or when an individual who has been recently received agricultural property dies.

2. TAXATION IMPLICATIONS OF DIFFERENT WAYS LAND IS HELD

Farming Company

The land may be owned through a farming company rather than an unincorporated business.

Shares in an agricultural company attract 100% relief if the transferor has a controlling shareholding (over 50% of voting rights). To attract the full relief the company must have occupied the property for the purposes of agriculture throughout a period of two years before the transfer of the shares. And in a similar rule that applies to an individual, 100% APR is available on the shares, if the company has owned the land and it, or another, has used it for agriculture, throughout a period of seven years before the transfer. This effectively covers the scenario of the company leasing its land to be farmed under a tenancy.

Where the shares have been acquired as consideration for agricultural land, the shares are deemed to stand in the shoes of the original property in calculating the period of ownership, and in ascertaining whether the original property is still held on death (important for replacement property – explained later).

Tenancies

Another more common way of holding farmland is under a tenancy, where the owner lets out his land for others to farm. In many circumstances this is an informal tenancy between family members to pass the benefit of the land down a generation. In other cases the tenancy is granted to established farmers to enable the owner to receive a regular income from the land.

There are many different types of tenancies, the main differences arising from the time they were implemented. The old style tenancies prevented the right to vacant possession and hence restricted the availability of APR to the owner. In the majority of cases only 50% relief would be available on a transfer.

In 1995 the Agricultural Holdings legislation introduced new tenancies known as ‘farm business tenancies’. These were created specifically to ensure the landowner did not lose out on APR. These tenancies attract 100% APR provided the land has been held by the owner for the required 7 year period.

To qualify as a farm business tenancy the property must be farmed for the purpose of a trade or business throughout the term of the tenancy. The property must also be used for wholly or primarily agricultural purposes.

The granting of a tenancy will not constitute a gift of any value for inheritance tax effect provided three conditions are satisfied:

- The tenancy is granted for agricultural purposes, and
- It is granted for full consideration, and
- The land is in the UK or the Isle of Man

Whether the owner is entitled to APR on his land, depends upon the tenant farming the land under the guidelines provided. The tenant must, under the terms of the tenancy, only occupy the land for agricultural purposes. However, if, as in the case of Wheatley and Another (Executors of Wheatley deceased) v Commissioners of Inland Revenue, the Court found that the activities did not constitute agricultural purposes, and the APR was not available to the owner of the land. Any compensation payable by the tenant for breach of contract would be insubstantial to the inheritance tax payable as a result of the loss of APR.

Clearly with the increased reliefs available there will be a strong temptation to replace existing tenancies with the new farm business tenancy.

Surrender of an Existing Tenancy

Unfortunately there are tax consequences of replacing a tenancy, including stamp duty implications, disposals for capital gains tax purposes, and possibly inheritance tax in family situations.

The surrender of a tenancy may constitute a transfer of value if not done on a commercial basis. No APR would be available on the surrender if the tenant dies within 7 years, under the claw-back rules, as the tenancy would have disappeared.

If the values are large it may be possible to structure the surrender in other ways, but these are outside the scope of this article.

There is also the problem of how to value the tenancy surrendered. In a Lands Tribunal case called Walton it was held that the value was about 50% of the difference between the vacant possession value and its tenanted value. This is known as ‘the vacant possession premium’.

A similar valuation may be used to calculate the value for the disposal for capital gains purposes. If the surrender is between connected parties, or full commercial value is not paid for the surrender the tenant could be treated as disposing of the tenancy at full market value.

Holdover and rollover relief should be available on the capital gains arising on the surrender. Beware, however, that reinvesting the gain in the new farm business tenancy will be a rollover into a depreciating asset. This means that unless a subsequent rollover is made of this gain into a non-depreciating asset, the gain may be triggered as early as 10 years after the initial rollover into the farm business tenancy.

If farmers are considering surrendering their tenancies early, both the tenant and the landlord should be separately advised.

Licenses

An alternative way to hold agricultural property is under license.

Licenses differ from tenancies as under a license, exclusive right of occupation is not given to the licensee. Other individuals usually the landowner, are entitled to occupy the land. A license agreement, however, can give the licensee exclusive possession. In such a case, the agreement may be called a license but for tax purposes may be deemed to be a tenancy. Licenses are also usually granted for a short period of time, and the licensee has fewer rights than a tenant under a normal farm tenancy agreement.

The usual use of a license is to allow a licensee to graze his animals on the land. This is known as a ‘grazing agreement’.

The differences between tenancies and licenses become most apparent in relation to whether the farmhouse would qualify for APR.

Under a tenancy, the owner of the land is the landlord, and income received is taxable on him as Schedule A income (rental income).

Under a license, any income received by the owner is treated as trading income under Schedule DI and accordingly the owner is still treated as trading as a farmer. To maintain this title of trading, the owner must be responsible for the upkeep of the land including manuring, fertilising, seeding, hedging and ditching the land.

As will be explained in more detail later in the article, in order to attract relief on the farmhouse, the farmhouse must be of a character appropriate to the land that surrounds it. One of the tests of ‘character appropriate’ is that the occupiers of the farmhouse must be treated as farming the land.

Under a tenancy agreement, the occupier of the farmhouse is a landlord of the surrounding property and is not treated as farming the land. Under the license he is a trading farmer and the relief on the farmhouse should be available, subject to further complex conditions explained below.

3. AVAILABILITY OF APR ON A FARMHOUSE

There have been a number of Court cases over the years involving farmhouses and whether APR is available against the agricultural value of the farmhouse.

The main tests are:

- Is the property a farmhouse?
- Is the surrounding land farmland?
- Is the farmhouse of character appropriate to the surrounding agricultural property?

The first two points are fairly straightforward. The latter is more difficult to satisfy. The Inland Revenue look at all three tests and apply a balanced view on the whole picture. The overall test used to determine whether the property is a farmhouse is termed, ‘the elephant test’ – ‘it is difficult to describe but you know one when you see one!’

Character Appropriate Test - Beneficial Interest in Agricultural Land

For the property to qualify it must be at the centre of agricultural operations and must be of a character appropriate to the surrounding land over which the owner and occupier of the farmhouse must have a beneficial interest.

For instance, if the owner and occupier of the farmhouse no longer owns the surrounding farmland, even though it is being actively farmed, the farmhouse would not attract any relief. The owner of the farmhouse does not have a beneficial interest over any farmland to give the farmhouse its character.

Conversely, if the owner of the farmhouse had given away the land to his son, subject to a tenancy for him and his son, he will retain a beneficial interest in the land due to the tenancy of the land, and the farmhouse will attract relief.

Also if the owner of the farmhouse and surrounding farmland allows, for instance, his two sons to occupy the farmhouse and the sons are farming the land under a tenancy from their father, the farmhouse should still qualify for APR. The father has a beneficial interest in the land as he owns it, and it would attract 100% APR on his death. The farmland therefore provides the character to the farmhouse as the occupiers of it are farming the surrounding land. In that situation the reader should not forget that Principal Private Residence would not be available on any capital gain arising on the farmhouse. An uplift to market value will however still apply on death.

Once the beneficial ownership test has been satisfied the second problem is then how to judge whether the character appropriate test is also satisfied.

Character Appropriate Test – Three Tests

This depends upon three individual tests:

- Historical Association -

Has relief been given on the property previously under the current inheritance tax rules? Provided the transferor has a beneficial interest in the same acreage of land now, as satisfied the previous transfer, the character appropriate test should be satisfied.

- Geographical Comparisons -

Comparisons are made with similar holdings of land in the nearby areas. Although the size of the farmhouse does not form part of the character test it is often a character referred to in disputes over the availability of the relief. Judges have been known to look at the size and nature of the farmhouse to its requirements in the farming activities. Other farmhouses in the area would be compared.

- Financial Viability -

This is a character test being used more by the Inland Revenue. They attempt to question whether the farming activities undertaken are sufficient to maintain the farmhouse.

Many experts in this field believe this is an unfair test as it concentrates on activities conducted, not those that could be conducted. For instance, an elderly farmer may reduce his farming operations concentrating more on letting land for grazing, which in turn may reduce his return from the land. This could then affect the availability of APR on the farmhouse.

Care should be taken if land is gradually being gifted down generations to retain at least 10-20% of the farmland either in the farmhouse owner’s estate or to farm it under a tenancy. Otherwise APR on the farmhouse would be lost as there would be no land to provide the character to the farmhouse.

Alternatively the owner could grant a license over the whole land. As he will receive Schedule DI trading income he is deemed to be trading as a farmer of the land and the APR should still be available on the farmhouse he resides in.

Gifting of land, or holding under a license of course depends upon the level of income produced from the remaining land and whether it would satisfy the financial viability test.

If the farmhouse is of a substantial size the amount of acreage retained should reflect this.

The Inland Revenue’s view has been contradicted by an unpublished Special Commissioners’ decision. This stated that ‘whether or not one can make a living from a given acreage of land cannot be determinative of the question whether a building is a farmhouse…’. This point may be more relevant to a farm where the current owner has always owned only a small acreage of land surrounding a substantial farmhouse – not necessarily a case where gifts have actively been made to reduce the size of a substantial acreage. In the writer’s opinion the Inland Revenue may be more likely to argue that APR on the farmhouse would not be available in the latter scenario, as the act of farming will have been severely reduced.

- Agricultural Value -

Assuming the relief is available it is now important to ascertain the agricultural value of the farmhouse. As explained earlier this is the value of the property subject to a restrictive covenant prohibiting the non-agricultural use of the property.

The Capital Taxes Office’s view is that the agricultural value is around 2/3 of the open market value of the property.

Tax practitioners have argued that this should not be the case, particularly where the farmhouse is transferred together with the rest of the farm property. In this instance the agricultural value of the whole unit should not be much less that the open market value of the farm as a whole.

There is also an argument put forward that the agricultural restriction is a restriction on use not occupancy. A non-farmer may wish to purchase such a property because the agricultural restriction on the surrounding land protects the amenities sought. In this case the agricultural value should be equivalent to the open market value. The relevance of this argument will depend upon the area in which the farmhouse is situated and whether it is attractive to non-farmers.

4. INHERITANCE TAX PLANNING

Reasons for Making Lifetime Gifts

If 100% APR is expected on the agricultural property on the death of an individual, the simple strategy is to retain the property, ensuring it remains under the current qualifying conditions. No tax should arise on death and the beneficiaries would inherit at market value.

The rules of APR may of course change, and could become more restrictive. A lifetime gift may therefore be desirable to take advantage of the 100% exemption.

Also, practically it may be impossible to hold the property under the same conditions to ensure the relief is available. For example, where the farmer is becoming old and is unable to work. In this case the farmer may want to pass the farm down a generation.

Another situation where a lifetime gift may be tax efficient is where family members are tenants of the land being used for agricultural purposes. They may wish to change the usage of the land, especially in the current farming climate. They may consider developing the land as offices or as residential property. This of course is dependant upon the agricultural restriction being lifted and planning permission being obtained.

On such change of usage, the property will no longer attract APR. It is sensible for the transferor to remove the property from his estate by making a gift, before the usage changes. Provided he survives seven years the value of the gift will not form part of his estate, whereas if no gift had been made the value of the property would become chargeable at 40%. The reason for making the gift before the change of usage is more relevant to capital gains than inheritance tax. Any capital gains arising should be able to be held over under s165 of the Chargeable Gains Act, as the asset gifted will qualify as agricultural property.

Lifetime Gifts

If the transferor does not survive the 7 years, the availability of APR becomes important. In the above example, the gift of the agricultural property before the change in usage satisfies all the conditions for APR at the date of gift. Unfortunately the relief is not this simple - the availability of the relief is dependant upon the usage of the property on the transferor’s death.

In the above example where usage of the land has changed, APR will not be available on the gift, as the transferee will no longer use the land for agricultural purposes at the date of death. This is known as a ‘claw-back’ of relief. The same conclusion would arise where the transferee has disposed of the property before the death of the transferor. There is however, the ability to retain the relief if the proceeds are reinvested in other property attracting the relief.

The rules are slightly more generous where gifts are made during the lifetime into a discretionary trust. Such a transfer would be a ‘chargeable transfer’ and tax would be calculated and payable at the time the gift was made. Provided the gift attracts 100% APR no tax will be payable at the time of the gift, and the chargeable value of the gift i.e. £0 (after 100% APR) will be fixed for the purposes of calculating the cumulative value of gifts made before death.

Should the APR not be available at the date of death, the tax would still be payable on the gift made under the claw-back rules. The only difference between a chargeable transfer and a potentially exempt transfer in these circumstances is the fixing of the value of the gift.

Tax payable upon death is calculated by reference to the cumulative value of transfers made within 7 years of death. In certain situations this period will be extended to 14 years before death. The fixing of the value could reduce the overall tax liability payable on death and therefore in certain circumstances it will be preferable to make a chargeable transfer.

Any other type of gift that is not chargeable at the time the transfer is made, such as a transfer to an individual absolutely, will not fix the value for the calculation.

Reinvestment into New Qualifying Asset

This reinvestment must take place within three years of the sale of the original property. The reinvestment can be made in stages provided all purchases fall within the three-year period of sale and all the proceeds are invested. If anything less than the whole of the proceeds are reinvested, the whole of the APR will be clawed back. Also only one rollover of the proceeds is allowed, and the replacement asset must be held at the death of the transferor to attract the relief.

Interaction with BPR

The usual reinvestment would be in property qualifying for agricultural relief. A little known fact is that it may be possible to reinvest the proceeds in an asset qualifying for Business Property Relief (BPR) instead, and effectively swap the APR on the original gift for BPR. This is provided the original agricultural asset would have attracted BPR in its own right, due to it being a business asset. APR is always given in priority over BPR if both reliefs are available.

BPR is available for trading businesses only. Where land is held as an investment, and taxable under Schedule A, BPR in general, is not available. This would apply to tenanted land.

Will Planning

Whether or not lifetime planning has been implemented, there are opportunities to structure the Will tax efficiently. If the Will is not tax efficient the Executors and beneficiaries may consider using a Deed of Variation to rewrite the Will.

Ideally any individual holding agricultural land should ensure his Will takes advantage of APR and doesn’t waste it by passing those assets qualifying for the relief to the widow.

However, the widow may wish to control the farm after the death of her husband. Instead of leaving the assets direct to the spouse, the assets attracting APR can be added to a Nil Rate Band Discretionary Will Trust, from which the spouse can benefit. This is a trust set up in the Will of the deceased containing chargeable assets up to the value of the Nil Rate Band (£250,000 in 2002/03).

Assets that qualify for 100% relief can be added by the Will, to the trust, thereby increasing the value of the trust over the £250,000, without any tax becoming payable.

The trustees are then free to sell the agricultural property to the widow. There must be no binding contact on the husband’s death that the trustees will sell to the widow, as the assets will then not attract any APR.

This allows the APR to reduce the chargeable estate whilst still passing the agricultural assets to the exempt widow. Provided the widow holds onto the property for the required two year period 100% APR will be available on the same assets on her death. This is often known as ‘double dip relief’. The succession rules do not take effect in this instance as the widow purchased the assets from the trustees and did not acquire them direct from her spouse.

If the Will is not structured correctly and doesn’t specify to whom the agricultural property is to be left, this will cause problems. The 100% relief on the assets will be spread over the whole estate in whatever proportion the property is split, regardless of whether part of the estate is exempt. For example, if the relief were apportioned onto assets passing to the spouse the relief would be wasted as the transfer would already be exempt.

One final point with regard to maximising the APR is that any loans acquired should not be secured against any property attracting the relief as this will reduce their value and waste the relief. The loan should be secured against other non-qualifying property, thereby reducing the value of chargeable property and the tax payable.