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Tolley's Practical Tax by Andrew Flint

Andrew Flint reviews the current tax treatment of private residences.A client’s private residence is likely to be a sensitive issue for most financial advisers, not least for the tax specialist. I suspect there are two main reasons for this.

First, the house occupies a special place in the British psyche. The wellworn phrase ‘An Englishman’s home is his castle’ should be extended to indicate that it is also his favourite investment and access to credit. At least one economic commentator has pointed to the liquidity of the UK housing market, and the consequent willingness of lenders to accept property as collateral, as the cause of the credit-fuelled UK economy outgrowing that of the eurozone, where house sales are more expensive and complex. House price inflation has had the subsidiary effect of extending the inheritance tax net as property values eat into the nil rate band.

Herein lies the second reason. Tax advisers have come under increasing pressure to find a way around, or at least to mitigate, increased liabilities to inheritance tax and (on a second home) capital gains tax.

Since the subject of the private residence and tax planning was last considered in this newsletter (see the articles by Mary Hyland in TPT 2003, p73 and p81) there have been two major developments, both of which have their origin in FA 2004. They are: the preowned assets regime (see FA 2004 s 84 and Sch 15); and major changes to the interaction between CGT private residence relief and hold-over relief.

Pre-owned assets regime

The pre-owned assets regime has been very ably explained in the two articles by Donald Drysdale (see TPT 2004, p129 and p137). Concentrating on the private residence, clients who are affected by the pre-owned assets regime are likely to fall into one or more of three categories.

1. Those who have made previously successful arrangements to avoid the gifts with reservation (GWR) rules but are now subject to an income tax charge.

2. Those who have made part sales, or gifts of cash, with no intention of any avoidance but who are now subject to an income tax charge.

3. Those who want to know what planning opportunities still exist for their house.

Existing arrangements

It is worth noting the comment of the Paymaster General that this new regime ensures that avoidance schemes are no longer a ‘one way bet’. In other words, the outcome of adopting an avoidance strategy could only be positive, since if it fails you only have to pay the tax that would have been due had you done nothing. If it succeeds, then it is up to the Revenue to plug the loophole, and since tax law does not operate retrospectively that will not affect you. This process is so well established that the Revenue have taken to rushing out press releases announcing blocking legislation, so that when the legislation is eventually on the statute book it can be made effective from the date of the press release without infringing the ‘retrospective rule’.

The pre-owned assets regime represents something of a departure from this model. It applies a new charge to arrangements that have been set up in the past (indeed as long ago as 18 March 1986) but since the new charge applies only to benefits enjoyed from April 2005 it can be described as retroactive, but not retrospective.

I suspect that the government is not altogether unhappy about the new level of uncertainty that this introduces into avoidance arrangements. The retroactive (or retrospective, depending on your point of view) element is not entirely new to the field of taxation, but it is rare. The lesson to take from this must be that the government has run out of patience in the particular matter of gifts with reservation of benefit, and this should be borne in mind when advising about further opportunities in this area, or in deciding whether to add further complication to existing schemes in order to ‘rescue’ them.

The main types of existing scheme that may be encountered are as follows.

• Ingram schemes. These involve the retention of a lease, subject to which the encumbered freehold is gifted. The decision in Ingram v IRC [1999] STC 37 established that the reservation of a leasehold estate in these circumstances did not constitute a reservation of benefit out of the gift of the freehold for GWR purposes. This avenue was blocked by FA 1999 inserting FA 1986 s102A for gifts of interests in land after 8 March 1999.

• Eversden schemes. These relied on the exemption for transfers between spouses taking a property out of the GWR regime completely. Thus an initial transfer granting the spouse an interest in possession for a limited period would protect any subsequent benefit enjoyed by the donor. This avenue was blocked by FA 2003 inserting FA 1986 s102(5A)–(5C) with effect from 20 June 2003 (the date of the relevant Revenue press release).

• Home loan schemes. The homeowner creates a trust under which he has an interest in possession and then sells the house to the trust for a consideration which is left outstanding and interest free. This debt is then gifted (by way of a potentially exempt transfer). The aim is to reduce the value of the house in the deceased’s estate by the amount of the debt.

There are, of course, other variations and arrangements designed to take all or part of the home out of a donor’s estate whilst retaining a right to occupation. It is likely that, along with the above list of schemes, such arrangements will now fall within the ambit of the pre-owned assets regime.

If existing arrangements are caught, there appear to be five main options, the first three of which are straightforward, the last two of which are not.

1. Pay the income tax charge. Whether this represents an attractive solution will depend on, inter alia, the inheritance tax position (for instance, whether any PET has, or is about to, fall out of the reckoning), life expectancy and ability to fund the charge.

2. Pay for the benefit. Note that this must be an amount equal to the appropriate rental value, and must be paid under a legal obligation. This may be an attractive option if the recipient is in a relatively advantageous income tax position – eg able to use personal allowance or basic/lower rate bands. It may be combined with the rent a room scheme (see example 1.10 in Donald Drysdale’s article in TPT 2004, p131). In any event it represents another opportunity to pass down wealth.

3. Cease to occupy the property. This is by far the easiest way to preserve any inheritance tax advantage and simultaneously avoid any income tax liability. Provided this is done by
5 April 2005 there will be no ramifications for the preowned assets regime. It may not, though, be either feasible or desirable from the current occupant’s point of view.

4. Opt back into the GWR regime. There are obvious disadvantages to this – the house remains in the donor’s estate for IHT purposes and the CGT tax-free uplift on death will be lost. Not only that, there are numerous traps in unscrambling the now redundant avoidance arrangements, a process which must be approached with great care. After all that, should the donor subsequently cease to occupy the property there will be a PET on the lifting of the reservation (see FA 1986 s102(4)).

5. Take further specialist advice on how the current arrangements may be altered to preserve the inheritance tax position whilst avoiding the income tax charge. This is more or less bound to be a complicated, expensive and risky option, but doubtless some clients will find it attractive.

‘Innocent victims’

There may be clients who have entered into transactions without any intention of avoiding inheritance tax but who now fall within the ambit of the pre-owned assets regime. For instance, the client may have made a contribution to the purchase of a house he or she now occupies (see examples 1.1 and 1.3 of Donald Drysdale’s article in TPT 2004, p129). Note that if the contribution is by way of cash then the seven-year exclusion applies, whereas if it is by way of the gift of an asset then it does not. Of course, the client may have neglected to mention a relevant transaction – although this may not prevent a future professional negligence claim. It may be worth spending a little time composing a small questionnaire confirming that there have been no such contributions, direct or indirect, towards the purchase of any property that is occupied.

As things currently stand, part sales of a property, even if at arm’s length, fall within the pre-owned assets regime. Thus, a part sale as part of an equity release scheme is caught.
However, the Paymaster General, in response to a Parliamentary question, has given her assurance that the pre-owned assets regime will not be applied to bona fide equity release schemes with arm’s-length providers.

Otherwise, the ‘innocent victims’ are faced with the same choices as the ‘tax avoider’ in the face of the pre-owned assets regime.

Surviving planning opportunities

There remains the possibility of gifting an undivided share of the property where the donor and the donee both occupy the property. The gift with reservation rules will be avoided provided that the donee does not pay more than his fair share of the outgoings and the donor receives no benefit of another kind connected with the gift (FA 1986 s102B(4)). There is a similar exemption from the pre-owned assets regime (see FA 2004 Sch 15 para 11(5)(c)). Thus, co-ownership arrangements are still viable.

It should also be remembered that a seven-year exclusion applies to cash contributions to the purchase of property.

Example 1

On 1 January 2005 Mr Brown gives £200,000 to his daughter to contribute to the purchase of a holiday home in Eastbourne. On 1 February 2012 Mr Brown retires to the Eastbourne house.

The pre-owned assets regime is not in point because of FA 2004 Sch 15 para 10(2)(c).

As is usual with inheritance tax planning, taking advantage of this opportunity requires the capacity for a high degree of forward planning and that the condition of family relationships be conducive to such flexibility. This is not always the case.

Interaction of hold-over and private residence reliefs

The availability of a capital gains tax exemption for the private residence has provided a useful tool for tax planning. The key lies in bringing a house within the ambit of the exemption. A popular route was through occupancy by a beneficiary.

Example 2.1

Mr Green owns a property which is not his only or main residence. It is worth £350,000. As things stand, if he sells the property he will make a chargeable gain of £200,000 (before taper relief). Mr Green wishes to sell the house and pass the proceeds on to his children, Kevin and Sally.

Mr Green transfers the house into a discretionary settlement, the beneficiaries of which are Kevin and Sally. The transfer is immediately chargeable to inheritance tax, and is not a potentially exempt transfer: so Mr Green may elect under TCGA 1992 s260 to hold over the capital gain on the disposal. The effect is to reduce the trustees’ base cost.

Under the terms of the settlement the trustees may allow a beneficiary to occupy the house. They allow Kevin to use the house as his only or main residence.

After a short period of occupancy, Kevin vacates the premises. The trustees then sell the house for £360,000. They are entitled to private residence relief on the gain of £210,000 (see TCGA 1992 s225). The proceeds are then distributed to Kevin and Sally.

It can be seen from Example 2.1 that such arrangements involve two disposals: typically one into the settlement and one by the trustees (described as the ‘later disposal’). This type of arrangement is effectively blocked for later disposals made after 9 December 2003. Broadly, claims to hold-over relief under TCGA 1992 s260 and private residence relief have become mutually exclusive (see TCGA 1992 s226A, as inserted by FA 2004 s117 Sch 22 paras 6, 7(3)).

The most straightforward scenario is that described in Example 2.1. In those circumstances, the private residence exemption provisions are simply disapplied. The effect is to make the trustees liable to a chargeable gain – in Example 2 of £210,000. Note that this includes not only the original gain of £200,000 which was held over on the transfer into the settlement, but also the £10,000 gain that arose during the trustees’ ownership (and Kevin’s occupancy) of the house.

It should also be noted that the anti-avoidance legislation applies to later disposals after 9 December 2003. There is some transitional relief - where all relevant earlier disposals took place before 10 December 2003, the denial of private residence relief only applies to
the period from 10 December to the later disposal. However, it could be argued that there is a retrospective element to these provisions and some may find themselves ‘stuck in mid-scheme’.

Because of the time limit for holdover relief claims (the normal TMA 1970 s43 limit applies) it may be that the claim for hold-over relief follows that for private residence relief. In this case, private residence relief is withdrawn and all necessary tax adjustments may be made notwithstanding normal time limits.

Example 2.2

Assume that in Example 2.1 Mr Green made the disposal into trust on 30 June 2003, and the subsequent disposal by the trustees took place on 14 September 2004.

Mr Green has until 31 January 2010 to elect to hold over the gain. The trustees may already have benefited from private residence relief on their gain before this time.

Transfers of the private residence into trust may also be caught by the antiavoidance legislation introduced by FA 2004 concerning disposals to settlor interested settlements generally (see TCGA 1992 ss169B-169G inserted by FA 2004 s116 and Sch 21 paras 4, 10 with effect in relation to disposals to trustees made on or after 10 December 2003).

Example 2.3

Assume that in Example 2.1 Mr Green wished to benefit from the sale of the property, rather than pass the proceeds to his children.

Mr Green could transfer the house into a discretionary settlement in which he has an interest, claiming hold-over relief under TCGA 1992 s260. The trustees, under the terms of the settlement, then allow his son, Kevin, to occupy the house as his main residence.

A short while later, Kevin vacates the house and the trustees sell it and claim private residence relief. Mr Green will be able to benefit from the proceeds in accordance with the nature of his interest in the settlement.

Depending on the circumstances, hold-over relief is either blocked or withdrawn in these circumstances.

Conclusions

There is no doubt that private residence relief from capital gains tax is a very valuable relief, and is increasing in importance with house price inflation. The fact that the inheritance tax nil rate band has not kept pace with house prices is beginning to register on various political radars, but a realistic increase in the near future does not seem likely. On the contrary, the government has given every indication of determination to close what it sees as loopholes in the taxation of the private residence. This should be borne in mind if further planning is contemplated.

ANDREW FLINT

Originally published in Tolley’s Practical Tax Newsletter on 1 January 2005, and reproduced with the kind permission of Lexis Nexis.