Enter Your E-mail

Tolley's Practical Tax by Donald Drysdale CA CTA (Fellow)

Donald Drysdale CA CTA (Fellow), Assistant Director of Tax at ICAS, outlines some recent developments concerning the pre-owned assets regime

Introduction

The pre-owned assets regime applies for 2005/06 and subsequent years. Opinions on its impact vary widely. Some think it well targeted towards taxpayers using contrived schemes to avoid inheritance tax. Others fear the unfair impact it may have on the innocent and unwary.

Rather than focus on avoidance schemes, this article examines aspects of the rules and guidance, encouraging practitioners to focus on first principles in considering the impact of the regime. All references are to FA 2004 unless otherwise stated.

Regulations and guidance

Two Ministerial statements on 7 and 8 March 2005 were followed quietly on 16 March (Budget Day) by publication of the HMRC’s Technical Guidance on the new regime. Also on 16 March, The Charge to Income Tax by Reference to Enjoyment of Property Previously Owned Regulations 2005 (SI 2005/724) were laid before the House of Commons, coming into force on 6 April – by which time the Technical Guidance had already changed.

It had been hoped that the regulations and guidance might have curtailed the scope of the pre-owned assets charge. This was not to be, save for one new exemption and a relief to avoid a double charge to inheritance tax foreshadowed in the Ministerial statements referred to. It is still hoped that concessions will be made, and that the guidance will be improved. Those relying on the guidance should always refer to the latest version on the HMRC website at http://www.hmrc.gov.uk/poa/index.htm, as changes are expected.

The prescribed rate

The regulations established the ‘prescribed rate’ for chattels and intangible property. It is equal to ‘the official rate of interest’ (currently 5%) set by ITEPA 2003 s 181 for taxable benefit from cheap loans. Note that this rate applied to the value of a chattel may be significantly above or below an arm’s length price for its possession or use. For example, the arm’s length rental value of a motor vehicle might equate to (say) 20% or more of its value, while that of a work of art might be as low as (say) 1% or less.

The Government had acknowledged arguments that the rate on intangible property should be lower than that on chattels, but this was not reflected in the regulations.

Valuation issues

The regulations prescribe the ‘valuation date’ as 6 April in the relevant year of assessment or, if later, the first day of the ‘taxable period’.

For land or chattels, the chargeable amount relies on a factor, ‘V’, defined as ‘the value of the relevant land at the valuation date’. The regulations consider this valuation at the ‘first valuation date’ (the date on which Sch 15(3) or (6) first applied to the chargeable person in relation to the relevant property) and a subsequent 6 April ‘five-year anniversary’. While the matter is not free from doubt, it would appear that the provisions of para 3 or 6 do still ‘apply’ where the de minimis exemption has effect.

Where no valuation date coincides with a five-year anniversary – for example, where there is no occupation, possession or use on 6 April in the year in question, or where the taxpayer is non-resident – the date on which para 3 or 6 next applies is treated ‘as the date on which, and being
in the year of assessment in which’ para 3 or 6 first applied, and the meaning of the expressions ‘five-year anniversary’ and ‘first valuation date’ are ‘subject to’ this new treatment.

It is arguable that this imposes a new basis of valuation retrospectively on all previous Sch 15 charges on the property in question, but unlikely that Parliament intended this! It is hard to find another reason why the definition of ‘first valuation date’ in regulation 4(3) is ‘subject to’ regulation 4(4). It would be more logical had the regulations provided simply for a new five-year anniversary, and the Technical Guidance offers this interpretation.

The five-yearly valuation of land and chattels helps contain compliance costs, but the absence of an option to revalue annually has serious implications where the value of property has fallen. Intangible property is not subject to five-yearly valuations, and must be valued each year for which the charge applies.

There is no prescribed procedure for establishing the value of property and no requirement to use independent valuers. For land the Technical Guidance advises: ‘The regulations do not specify the sources from which the required valuations should be obtained. However we would expect the chargeable person to take all reasonable steps to ascertain the valuations, as they would do if, for example, they were looking to let a property on the open market.’

The equity release exemption

The Government recognised concerns that equity release schemes involving part disposals would not qualify as excluded transactions, and the Treasury used its power to confer further exemptions by regulation, introducing a new exemption deviating in approach from the schemes of excluded transactions and exemptions contained in Sch 15.

The new exemption disapplies the charge on part disposals of land or chattels at arm’s length between unconnected persons. This is extended to a person ‘in relation to’ part disposals by transactions such as might be expected at arm’s length between persons not connected with each other, if either (i) for a consideration not in money or readily convertible assets or (ii) made before 7 March 2005.

Since Sch 15 does not impose a charge ‘in relation to’ a disposal, use of this phrase in defining the new exemption may cause some confusion. It remains to be seen whether this will enable the exemption to be claimed in circumstances beyond those envisaged by the Government.

The expression ‘readily convertible asset’ has the wide meaning given in ITEPA 2003 s 702, and no guidance is given on how references to ‘employer’ and ‘employee’ should be interpreted for preowned assets purposes.

The full consideration exemption

Sch 15(11)(5)(d) provides an exemption that depends on the operation of two otherwise distinct inheritance tax provisions in FA 1986 s 102C(3) and Sch 20(6). A Parliamentary exchange failed to secure Government confirmation that s 102C(3) covers circumstances not covered by Sch 20(6) and that the ‘and’ should therefore be read disjunctively so that it covers the two distinct cases. Fortunately the Technical Guidance at part 1.3.2 is unequivocal in its use of ‘or’ in the following explanation:

‘The provisions of Sch 15 are also disapplied if the property … would fall to be treated as subject to a reservation but for FA 1986 s 102C(3) and Sch 20(6) (exclusion of benefit). This refers to situations where the chargeable person continues to use or occupy the property but pays full consideration in money or money’s worth, or (emphasis added) where they leave the property but have to move back at a later date due to an unforeseen change in their circumstances and are unable to look after themselves because of age or infirmity.’

The Technical Guidance further confirms, at part 4.4, that Sch 15(11)(5)(d) extends the inheritance tax full consideration exemption to the pre-owned assets charge. It emphasises that, if the consideration paid is less than full consideration or becomes so over time, a reservation of benefit will arise and there will still be no pre-owned assets charge – by virtue of para 11(5)(a).

The full consideration exclusion of benefit for inheritance tax deals with consideration paid for ‘actual possession’ of chattels but not for their ‘use’, so there is no full consideration exemption available from a Sch 15 charge in respect of mere use of chattels falling short of actual possession.

Opt-out elections

Sch 15 created a possibility that, where a taxpayer made an opt-out election under para 21 or 22 and then died within seven years, two inheritance tax charges might arise on the same underlying asset value. The Government recognised this as a particular risk for taxpayers using ‘double trust’ schemes, and the regulations introduced a new inheritance tax relief.

The Technical Guidance states that an opt-out election must be made on form IHT 500. The authority for this is unclear as the form has not been prescribed by regulations.

A late election will be accepted only where there is a ‘reasonable excuse’, but this is not defined. The Technical Guidance goes into great detail in considering the expression, seemingly in contrast to the Revenue’s Enquiry Manual which states: ‘There are no absolute standards by which the words ‘reasonable excuse’ can be defined’.

There may be wide scope for establishing grounds for reasonable excuse – given the complexity of the new regime, the widespread confusion it has caused, absence of records of past transactions, and inaccessibility of third party records relating to property substitutions.

Where an individual ceases to be non-UK resident or non-UK domiciled, this may trigger ‘initial year’ charges for pre-owned assets purposes, giving rise to relevant filing deadlines for opt-out elections.

Where an opt-out election has been made and the taxpayer’s enjoyment of the property later ceases, the deemed reservation of benefit ends. It seems arguable (though the Technical Guidance advises otherwise) that FA 1986 s 102(4) also ceases to apply at that time, so the taxpayer would not be treated thereafter as having made a PET on termination of the reservation. This may offer some opportunities for deathbed tax planning.

Overlap of disposal and contribution conditions

There appears to be some potential overlap of the disposal and contribution conditions. For example, where money gifted and used to acquire the relevant property falls within the contribution condition, there seems nothing to prevent it from being treated also as ‘other property’ triggering the disposal condition also. An alternative view is that money cannot be caught by the disposal condition since the legislation should not be interpreted as envisaging ‘proceeds’ on the disposal of money.

Effectiveness of the backstop date

It is generally accepted that Sch 15 can arise only as a result of transactions or circumstances after 17 March 1986. This is not what the legislation says, and it is thought possible that the disposal condition might be triggered by earlier transactions.

Mr A retired in 1979 and feared he might be unable to afford the upkeep of his large house (the relevant land), so he considered selling 50% of the property to a bank under an ‘equity release’ scheme. Later that year he arranged instead for his son to buy a 50% interest in the property on more favourable terms. This allowed Mr A to remain in occupation for life, and he applied the proceeds in purchasing a life annuity. He still occupies the house, now worth £1m, and his 50% interest is part of his estate. There is nothing to restrict the application of Sch 15(3)(2)(b) to disposals after 17 March 1986, so Mr A’s part disposal in 1979 triggers the disposal condition. An alternative view is that the disposal condition is not satisfied because Mr X’s disposal ‘of all, or part of, his interest in the relevant land’ within Sch 15(3)(2)(b) is restricted to the interest that he owned in the relevant land at any time after 17 March 1986, as referred to within Sch 15(3)(2)(a); however, this is not selfevident from the words ‘his interest in the relevant land’ in Sch 15(3)(2)(b).

Meaning of ‘occupation’

The meaning of ‘occupation’ has been examined in many judicial decisions concerning rating, but is not defined for Sch 15. The Technical Guidance (at part 4.6) gives examples but leaves many questions unanswered. It offers no advice on whether (and, if so, how) the appropriate rental value of land may be reduced to reflect any limitations or restrictions on the taxpayer’s occupation of the land. For example, where the relevant land is a holiday home available for occupation by the taxpayer and others, it is unclear what adjustments can be made to the appropriate rental value to reflect any periods of (a) shared use by the taxpayer and others or (b) non use.

There need be no causal link between the provision of consideration and the occupation. Mrs B owned her London flat and gave her son £200,000 with which he bought a flat in the same building. Mrs B still lives in her original flat, and not her son’s, but she provided consideration given by him for an interest in the same land. The contribution condition is met by virtue of Sch 15(3)(3)(a).

Meaning of ‘possession’ or ‘use’

The Technical Guidance provides little help regarding the meaning of ‘possession’ or ‘use’ of a chattel. It indicates that very limited or occasional use will not incur a charge. It offers no advice on reductions to reflect any limitations or restrictions on the taxpayer’s possession or use of the chattel – for example, where the relevant chattel is a car available for use by the taxpayer and others, and used occasionally by the taxpayer jointly with others.

Confusion over replaced property

For both disposal and contribution conditions, replaced property may be any kind of property; for example, a Sch 15 charge on land is not precluded where the land in question replaced other property such as chattels or intangible property.

The Technical Guidance states, at part 1.3.1: ‘The concept of excluded transactions has no application to intangible property.’ Contrary to what this implies, an excluded transaction may involve any kind of property, including intangible property. For example, an excluded transaction could involve intangible property that was later replaced by land or chattels, thus removing the land or chattels from charge.

The concept of ‘non-exempt sale’ also deserves careful examination. The expression is defined in relation to disposals of interests in land or chattels but not other property. This creates an unwelcome trap where consideration has passed between connected persons on a sale of replaced property that was intangible, since the transaction cannot qualify as a non-exempt sale.

A disposal cannot qualify as a non-exempt sale if the consideration was not paid in sterling or another currency but took another form – for example, an exchange of one property for another. It is unclear whether a sale partly for monetary consideration could qualify as a non-exempt sale.

Residence and domicile

An individual may be UK resident for part of a tax year – for example, before or after a period spent working full-time abroad. The same rules will presumably apply for pre-owned assets purposes, but the Technical Guidance offers no advice on this.

Sch 15(12)(4) provides that a person is treated as domiciled in the UK at any time only if he would be so treated for the purposes of IHTA 1984. There appears to be no authority for the statement in part 4.1 of the Technical Guidance that ‘the relevant time for the purposes of the charge will be the first day of the year of assessment in question’, and this creates doubts about how Sch 15 will apply on a change of domicile part-way through a fiscal year.

It is generally accepted that the inheritance tax concept of deemed domicile is imported for pre-owned assets purposes. This could have been achieved without the word ‘only’ in para 12(4), making the purpose of that word unclear. It would be interesting to argue that the deemed domicile provisions are not imported, and that para 12(4) simply clarifies that a person is not to be treated as domiciled in the UK for pre-owned assets purposes, unless he is so treated for inheritance tax. The Technical Guidance ignores the use of the word ‘only’ and provides no clue as to its purpose.

It is unclear how wide to interpret the requirement in Sch 15(12)(3) that [no regard is to be had’ to excluded property. Mrs C, a UK resident, acquired deemed UK domicile on 6 April 2004 by virtue of IHTA 1984 s 267, a year after she had created a discretionary trust of which she is a potential beneficiary and transferred to it the shares in an overseas private company which subsequently acquired a new house for her occupation in the UK. There is no Sch 15 charge on the shares because ‘no regard is to be had’ to excluded property. The contribution condition is met in respect of the house, but questions arise. Is the house exempt by virtue of Sch 15(11)(3)(b) and (5)(a) because the value of Mrs C’s contribution is represented by settled property subject to a reservation of benefit? Or is para 11(3)(b) unable to provide exemption since no regard is to be had to the excluded property?

Weaknesses in the Technical Guidance

Finally, it may be helpful to identify a number of other shortcomings in the Technical Guidance.

Mention has been made of the apparent overlap of the disposal and contribution conditions. The Technical Guidance not only fails to clarify this, but demonstrates a fundamental misunderstanding of the provisions. At part 1.2.1 it states: ‘Note that the disposal condition will apply to the chargeable person’s occupation or use of property even if that property was never actually owned by them. If they sold property and gifted the proceeds to another person who used these proceeds to purchase the relevant land or chattel the disposal condition is satisfied, unless it qualifies as an excluded transaction.’ On the contrary, the contribution condition would be satisfied in the circumstances referred to.

Part 1.2 of the guidance is less than helpful when it asserts that the conditions for the charge to apply on intangible property ‘differ slightly’ from those for land and chattels. The conditions differ fundamentally.

Some Sch 15(11) exemptions rely on the expression ‘substantially less’, which is not defined by the legislation. Part 4.7 helpfully interprets this in a manner consistent with the use of “substantial” to mean ‘more than 20 per cent’ in relation to capital gains tax taper relief. However, it goes on to consider the value of derived property that can be ‘reasonably’ attributed to the relevant property, introducing a concept of reasonableness that is not reflected in the statutory wording.

Part 1.3.2 observes that FA 1986 s 102B (gifts with reservation: share of interest in land) usually applies to a 50% share. This is not thought to be of any particular significance and is certainly not a requirement of s 102B.

For the de minimis exemption provided by Sch 15(13), the amounts to be included for land and chattels are not the chargeable amounts but the sums before deducting any eligible payments in respect of occupation, possession or use. The effect is that aggregate chargeable amounts of less than £5,000 may remain chargeable. Part 1.3.4 is unhelpful in simply stating: ‘…where the amount exceeds £5,000 it is subject to the charge in full’.

While a Latin education may no longer be de rigueur for civil service entry, it is disappointing that the Technical Guidance twice (in parts 2.4 and 3.3) uses the abbreviation ‘ie’ where ‘eg’ is intended. This does nothing to help the poor confused taxpayer.

Donald Drysdale CA CTA (Fellow)

Assistant Director of Tax at ICAS, was recently admitted to Fellowship of CIOT on the strength of his writing for Simon’s Direct Tax Service on the Pre-Owned Assets regime.

This article was originally published in Tolley’s Practical Tax on 15 July 2005, and is reproduced with the kind permission of LexisNexis Butterworths.