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James Bailey highlights potential Inheritance Tax problems with loans.

Introduction

IOUs are used a lot in planning for Inheritance Tax (IHT). They can represent a way of having your cake and eating it, if properly used, but they can also lead to problems if not carefully structured.

A common use for IOUs relates to the family home. Until it became possible to transfer an unused Nil Rate Band from the first spouse to die to the other, it was commonplace to have a ‘Nil Rate Band trust’ as part of each spouse’s will.

The Nil Rate Band Trust

On the first death, the survivor was left everything except a sum of money equivalent to the Nil Rate Band for IHT (currently £325,000), which was left to a discretionary trust. The surviving spouse was often one of the beneficiaries of that trust, but it was a way to ensure the Nil Rate Band was not wasted.

Such trusts are still used in many cases, even though it is now possible to transfer the Nil Rate Band to the surviving spouse. For example, using such a trust can help protect the second spouse’s legacy from care home fees, or, for the cynical, disastrous second marriages.

The Family Home

Often, the only asset of sufficient value to satisfy the legacy to the Nil Rate Band trust is the family home, and the surviving spouse wants to go on living there.

One solution is to empower the trustees of the trust to accept an IOU instead of the actual property. On the second death, the value of the estate is reduced by the debt on the IOU, thus reducing or eliminating the IHT payable

This is fine as far as it goes, but unless those setting up the trust and the IOU know exactly what they are doing, there can be problems.

What Problems?

The IOU needs to be carefully worded, as otherwise one can be in the absurd situation where on the second death the trust is owed interest by the deceased’s estate, thus manufacturing an Income Tax liability where none need have existed.

Another problem can arise where the IOU is index-linked, to the RPI or something similar. Choose the wrong index and you can find yourself in the situation where the uplift due to the indexation is deemed to be income of the trust.

Neither of these problems need arise, and they are the result of those drafting the documents not understanding the full implications of the terms they include in the IOU. Some professionals reading this may be saying to themselves “No one would make that sort of elementary mistake” but I have seen both these problems in cases referred to me recently.

Things can get worse if you try to get too clever with IOUs.

Example

Mr Jones is a wealthy bachelor (so no transferable Nil Rate Band for him). His house is worth £400,000 and he has other assets worth £325,000. This would mean IHT of £160,000 payable on his death (£725,000 less nil rate band of £325,000 gives £400,000 at 40%).

He vaguely recalls a conversation he had with a friend about IOUs and IHT and he has a brilliant idea.

He gives his house to his nephew (he is deemed to sell it for £400,000 for the purposes of Capital Gains Tax (CGT), but it is exempt because it is his ‘main residence’), and then buys it back for £400,000, paying with an IOU instead of cash.

On his death, he thinks, his estate will be reduced by £400,000, being the debt due to his nephew so it will only be worth £325,000 and this will be covered by the Nil Rate Band.

Unfortunately, the IOU will be ignored for IHT purposes because it relates to an asset that was previously part of his estate. There is specific legislation (FA 1986 s 103) which denies relief for debts relating to ‘property derived from the deceased’.

Practical Tip

That was a very simple example of how section 103 works, but its scope is much wider and I have seen several IHT planning schemes come to grief as a result of not thinking carefully enough about whether it will apply.

Perhaps more than any other tax, IHT planning is not for amateurs!