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Taxation by Mark McLaughlin and Toby Harris

Mark McLaughlin and Toby Harris ponder some planning points and pitfalls in connection with inheritance tax business and agricultural property reliefs.THE GOVERNMENT MAY have recently attacked trusts in inheritance tax terms, but the generous business and agricultural reliefs remain intact, for the time being at least. In fact, Finance Act 2006 has the indirect effect that reliefs such as business property relief, agricultural property relief and heritage relief will be more important than many practitioners may previously have considered them.

Another effect of the recent inheritance tax changes is that moderately wealthy families must consider making gifts earlier in life than hitherto. In the past, it was fairly common for people to consider their financial priorities at around the age of 60 to 65, evaluate the pension pot and likely living or nursing-home needs and decide if there was anything left over that could be given to children. New urgency arises because the inheritance tax restrictions on gifts into trust have the effect that, if families want to give away more than the nil rate band per donor parent, otherwise than by outright gifts, seven years must elapse between each ‘bout’ of giving to avoid immediate charges. This article therefore considers some planning issues in relation to business and agricultural property reliefs. All references are to IHTA 1984, unless otherwise stated.

The ‘right’ business?

When claiming 100% business property relief, it is important to check the relief conditions, as not every business qualifies. Specifically excluded are businesses (incorporated or not) consisting wholly or mainly in dealing in shares or securities, land and buildings or the making or holding of investments (s 105(3)). However, the exclusion for investment businesses does not apply to market makers or discount houses. In the context of groups, there is also an exception if a company’s business consists wholly or mainly in being a holding company of one or more companies whose business does not fall within one of the non-qualifying activities (s 105(4)).

The above land and buildings restriction does not prevent a property construction business from qualifying for business property relief; see Inheritance Tax Manual, para 25264. Hotels and residential homes will also usually qualify for relief, based on the level of services provided. In addition, HMRC accept that short-term holiday lettings will normally be eligible, if the owner was ‘substantially involved’ with guest activities on and off the premises; see Inheritance Tax Manual, paras 25277 to 25278.

Problems often arise in defining and quantifying investment activities. For example, there has been a succession of tax cases involving caravan park businesses to determine whether the trading was substantially investment in nature due to rental receipts, or whether the trading, e.g. sales and service, components of the businesses were sufficient to enable them to qualify for business relief. In CIR v George and another (executors of Stedman, deceased) [2004] STC 147, Lord Justice Carnwath accepted on the facts that a caravan site qualified, commenting that it was ‘… difficult to see why an active family business of this kind should be excluded from business property relief, merely because a necessary component of its profit-making activity is the use of land’. This case is described by HMRC as ‘helpful’, although their Inheritance Tax Manual at para 25279 indicates that caravan park cases will be considered carefully, with cases being referred to their technical group.

Similar difficulties can arise with property lettings. For example, in the Special Commissioners’ decision Clark and another (executors of Clark deceased) SpC 502, a company’s business comprised rents from properties it owned, i.e. investment income, plus trading income from management charges in respect of a number of dwellings owned by family members. Overall, the company’s business was held to consist mainly of investments. The maintenance of the rented properties was held not to constitute the separate provision of services, but was inherent in the property ownership.

However, in Phillips and others (executors of Rhoda Phillips deceased) SpC 555, shares in a company which made informal, unsecured loans to related family companies were held to be relevant business property. This was on the basis that the company’s business was making loans, and therefore did not consist wholly or mainly of making or holding investments within s 105(3).

Unwise gifts

Against the background of planning urgency mentioned in the introduction to this article, it is understandable that mistakes will be made. For example, land and buildings or plant and machinery owned by controlling shareholders (or business partners) qualify for 50% business property relief if used wholly or mainly in the business (s 105(1)(d)). The order of gifts can be crucial to the availability of relief if both shares and assets are being gifted, as illustrated in Example 1.

Example 1: Getting it wrong

Jason owned 60% of Fleece Ltd, the family business, his sons Artemis and Theseus each owned 20%. Fleece Ltd traded from an industrial estate which Jason also owned. Jason wished to keep the parts of the trading estate that were let to third parties but was tiring of the risks of business itself and wanted to hand over the company and its factory premises to his sons.

He had intended this as a celebration of his retirement on reaching the age of 80, but as things turned out the lawyers were slow in dealing with the transfer of the land and it took place some weeks after the actual handover celebrations concerning the company itself.

The transfer of the shares qualified for business property relief but the later transfer of the factory premises did not, because by then Jason was no longer a controlling shareholder in the company (as required by s 105(1)(d)). Artemis and Theseus were therefore at risk of liability to inheritance tax until Jason had survived the gift by seven years. Understandably, they required the lawyers to pay them compensation equal to the cost of insuring Jason’s life for that period in a sum sufficient to pay the tax at risk.

Act in haste …

The compulsion ‘to get something done’ can prompt unwise gifts in the farming context. For example, securing agricultural property relief on the farmhouse can be problematic. To qualify for the relief, the farmhouse must constitute agricultural property, which means that it must be of a ‘character appropriate’ to the agricultural land and pasture (s 115(2)). As for business property relief, the order of gifts can determine the availability of relief on a later (actual or deemed) transfer. See Example 2.

Example 2: Repent at leisure

Geoffrey had farmed for many years. His house was the centre of the farming business. It adjoined a traditional range of farm buildings, some of which had been adapted over the years to allow the storage of modern farming equipment. It had been a small mixed farm but, over time, Geoffrey sold his stock and let some of the buildings as stabling and two of the fields as paddocks. Geoffrey’s daughter had married a farmer with land nearby. He had entered into a proper contracting agreement with his son-in-law for the fields that he still owned, but shortly before his death he gave the fields to his daughter, retaining only the house and the adjoining buildings.

This case is very similar to the Special Commissioners’ decision in Rosser SpC 368, in which a gift of 39 out of 41 acres of farmland effectively changed the status of the retained farmhouse to a retirement home, on which no agricultural property relief was therefore due. On Geoff’s death, the house in which he was living is no longer a farmhouse because it was no longer the centre of the farming business carried out on the land that he used to own but which now belongs to his daughter. While the gift of the land itself qualifies for the relief, it had disastrous consequences through the loss of relief on the house itself.

Here today, gone tomorrow

One difficult element of the business property relief rules is the effect of the clawback provisions of s 113A on relief claimable under s 105(1)(d). Let us return to Example 1, but with slightly different facts. If Jason had succeeded in making the gift of the transfer of land to Artemis and Theseus while he was still the majority shareholder of Fleece Ltd, the gift of the freehold would qualify for business property relief at 50% under s 105(1)(d). Jason then gives Artemis and Theseus more shares in Fleece Ltd, in equal proportions – for this example it does not matter how many. If Jason dies within seven years of the gift of the land, an enquiry must be made regarding transfers within that period, to satisfy the provisions of s 113A in case clawback of relief should apply.

The rules of clawback are not straightforward, but it would be reasonable at first to think that Artemis and Theseus are safe. They still own not only the shares that their father has given them, but also the land from which the company trades. If the policy of business property relief is to shelter family businesses and their assets from tax, Artemis and Theseus have done nothing wrong. They have not made a quick sale.

However, a difficulty arises because clawback operates by reference to an imaginary transfer by the donee (see s 113A(3)(b)). Availability of relief is tested by reference to the donee rather than the donor. Jason has treated his sons equally. As a result, whether or not they own all the company, a hypothetical gift of the land by them at the date of Jason’s death would come within the requirements of s 105(1)(d) because neither of them controls the company. Consequently, clawback could apply to this situation in the event of Jason’s death within seven years of the gift. This is perhaps an isolated example, but seems to run contrary to the overall policy of the legislation.

Placing debt

Examples 1 and 2 illustrate some pitfalls of gifts of business and agricultural assets. The business and agricultural property reliefs codes are difficult and technical with several anti-avoidance provisions. However, paying careful attention to the rules can save a considerable amount of money, sometimes at quite short notice. Take for instance, the proper placing of debt. The rules are simpler for agricultural than for business property relief. If a farmer owns land that qualifies for 100% relief and an attractive house which might not qualify so fully, it might be a simple matter for him to arrange that any borrowing is secured on the house rather than on the land, triggering the liabilities rule in s 162. This is a ‘snapshot’ test: provided that the debt sits against the assets that do not qualify for relief at the date of the transfer, it matters not that this was put in place only days before.

For business property relief, the rules are more complicated because s 110 regards liabilities incurred ‘for the purpose of the business’ as going against the value of the business, whether or not secured on it. See Example 3.

Example 3: Net value for IHT

Charles sets up in business as a solicitor. Having no previous capital, the premises and equipment are rented. At the end of his first year in business, Charles recognises the value of some of his work in progress under UITF 40. However, there is no money to pay the tax, so the firm goes into overdraft. On a valuation of the business at that date the overdraft would be netted off against the value of the work in progress.

David gives up his job as a solicitor and buys a will-writing business. Having no capital, he negotiates a loan from his bank, secured on his house, to buy a franchise interest, comprising a fireproof safe, a collection of 500 wills and a software package of precedents. On a later valuation of the business for business property relief, the loan secured against the house is not deducted from the value of the business, because it was a loan incurred to buy the business rather than for running the business.

Charles wants to retire and agrees to sell his business to David, who takes out a further loan. On a valuation of David’s business some time later, the second loan probably would be deducted from the value because the purchase of Charles’s business could be seen as a mere extension of the existing business so that the cost of finance was ‘for the purposes of’ the business that David already owned.

Staying on

A particular appeal of investments attracting business property relief over non-qualifying investments is the two-year minimum holding period (s 106), which compares favourably with the seven-year period required when making potentially exempt transfers. Shares listed on the Alternative Investment Market, PLUS (formerly OFEX) and, since 28 November 2001, NASDAQ Europe are regarded as unquoted for such purposes. However, it is important to ensure that the companies are carrying on a qualifying business (s 105(3)), and are not mere investment companies.

The basic two-year ownership requirement in s 106 is subject to certain exceptions in ss 107 to 109, which deal with holding periods for the purposes of replacement property, acquisitions on death and successive transfers respectively. There is no requirement for an asset to have been eligible for business property relief throughout the required ownership period, but it must be relevant business property immediately before the chargeable event. For example, a partner’s interest in a partnership is relevant business property (s 105(1)(a)). Upon retirement, the partner’s capital account is converted into a debt, and the retiring individual becomes a creditor of the partnership. The debt is not relevant business property; see the Special Commissioners’ decision in Beckman SpC 226. To preserve entitlement to business property relief, the partner may wish to make a gift of the capital before retiring, i.e. an interest in the business, as opposed to a simple gift of cash; see IHT Manual para 25250, or possibly to delay retirement by taking a lesser role on the business in return for a reduced partnership share.

Bound to fail?

Neither business nor agricultural property relief is normally available where the subject matter of the transfer is itself already subject to a binding contract for sale at the time of the transfer: see s 113 for business property and s 124 for agricultural property. In that sense there is a loss of relief, in that the owner of the property can no longer claim the relief on a transfer made after a ‘buy and sell’ agreement has been entered into.

However, arrangements between partners and shareholders can often be structured in such a way that relief is not jeopardised, such as through the use of options or accruer arrangements (see IHT Manual 25292 generally, and ‘Until death us do part’ by Penny Bates, Taxation, 17 March 2005, page 596 in the context of partnerships).

Come and get it!

Despite the Government’s recent lack of benevolence when it comes to inheritance tax, the current, remarkably generous agricultural and business property relief regimes remain intact. How long they remain in their present form, if at all, remains to be seen, so the old adage ‘use it or lose it’ holds true. But it pays to ensure that it was available in the first place.

Mark McLaughlin and Toby Harris
August 2006

The above article was published in Taxation on 7 September 2006.

Toby Harris LLB, CTA, TEP is a tax consultant in East Anglia. Mark McLaughlin CTA (Fellow), ATT, TEP is a tax consultant and general editor of TaxationWeb. Both have contributed to Tottel’s Inheritance Tax Manual 2006-07, from which some of the examples in this article have been taken. Mark is also Series Editor of ‘Tottel’s Core Tax Annuals 2006-07’. The series is due to be launched in September 2006. Each of the new Core Tax Annuals costs just £19.95, or all six cost just £99.50! The Core Set comprises:

o Tottel's Corporation Tax 2006-07;

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o Tottel's Income Tax 2006-07;

o Tottel's Inheritance Tax 2006-07;

o Tottel's Trusts and Estates 2006-07; and

o Tottel's Value Added Tax 2006-07.

To order Tottel’s Core Tax Annuals 2006-07 click here