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Toby Harris LLB CTA TEP considers the recent decision in Phizackerley v CIR and its possible implications, offers some practical advice to taxpayers.

Introduction 

The case of Phizackerley v CIR may have worried people unnecessarily. The existence of the problem had been known for some time but the particular circumstances that have been highlighted by the case will naturally give cause for concern. This note has been prepared for the benefit of our clients as an initial response and to provide practical guidance.

Background

Many people will not be familiar with the theory and practice of the debt or charge scheme, so some background explanation may be helpful. Commonly, husband and wife (or Civil Partners) will want to preserve from IHT as much of their estates as they can and realise that an outright gift of the estate to each other, with residue passing to the children on the second death, is inefficient. The nil-rate band of the first spouse to die has effectively been thrown away because it overlaps with the exemption that is available on the transfer to a (UK-domiciled) spouse. Put in the simplest possible terms, the debt or charge scheme is a means whereby the nil-rate band of the first spouse to die is “put in the freezer” and is available to be drawn the second death. Unfortunately that simple description quite fails to recognise all the legal niceties that are involved and Phizackerley illustrates one of the pitfalls.

The English love houses and tend to tie up much of the family wealth in the family home with the result that few spouses are able, at death, to leave liquid assets equal to the nil-rate band to their children without unduly stretching the financial resources of the surviving spouse. The money is in the home. The debt or charge scheme commonly operates by terms of the will under which the first spouse to die leaves the amount available to him or her of the nil-rate band at death to trustees for, usually, the immediate family, with residue to the surviving spouse.

In the absence of sufficient liquidity, the gift of the nil-rate sum is satisfied in one of several ways, the commonest of which is effectively a promise of payment by the surviving spouse or a charge over the half share of the house owned by the first spouse to die. The result is that the trustees of the nil-rate band usually have under their control only a loan document in respect of the balance of the nil-rate band. It is hoped that the value of the debt will in due course reduce the estate of the surviving spouse.

Most members of the public will not be aware of the operation of s103 Finance Act 1986. The mischief to remedy which s103 was probably enacted is the situation where a person tries in effect to reserve a benefit out of a lifetime gift. It can be seen in the following example.

A gives Blackacre to B and, then or later, B lends £10,000 to A. If at A’s death the £10,000 loan is still outstanding it is not deductible in calculating the value of his estate to the extent that Blackacre exceeds £10,000 in value. As will be seen, the effect of this is to prevent A from deriving a £10,000 “cash back” benefit to himself by reference to the gift of Blackacre.

The facts in the Phizackerley case

Dr Phizackerley, a consultant biochemist, had lived in tied accommodation until his retirement in 1992 when he and his wife purchased, for £150,000, a small house which was put in their names as joint tenants. The agreed Statement of Facts, part of the evidence on which the case was decided, was that “Mrs Phizackerley did not work during her marriage, and the funds must have been provided by the Deceased.”

In 1996 Dr Phizackerley severed the joint tenancy so that he and Mrs Phizackerley held the property that they had purchased as tenants in common. The same week Mrs Phizackerley made a will which left the nil-rate sum on discretionary trusts and gave the residue of the estate to her husband (and this was crucial) absolutely. She died in 2000. Pursuant to the terms of the will, Mrs Phizackerley’s half share in the house was transferred, after her death, to Dr Phizackerley, who promised to pay the trustees of the nil-rate sum £150,000 (index-linked). On Dr Phizackerley’s death two years later his estate, ignoring the promise of payment to the trustees, was valued at just under £530,000.

The case was referred to the Special Commissioner to decide whether the liability, which had meanwhile increased to £153,222.99, was deductible from the estate of Dr Phizackerley or whether that deduction was prevented by s103 FA1986.

The arguments and the Decision

Section 103 FA 1986 prevents the deduction of the debt where, and to the extent that, the consideration given for the debt or incumbrance consists of “property derived from the Deceased”. The Special Commissioner said that on the face of it, the half share in the house was indeed derived from the Deceased. It was the subject-matter of a disposition made by the Deceased, so the debt incurred by the Deceased in favour of the trustees of the nil-rate band was not deductible. So the tax planning failed.

Counsel for the taxpayer argued that s103(4) should apply, which would save the situation by “switching off” the provisions of s103(1) because in certain circumstances the initial disposition, the gift, may be left out of account.

That argument was rejected by Rupert Baldry, Counsel for the Revenue.

Despite the taxpayer’s “persuasive argument” the Special Commissioner rejected the maintenance argument and dismissed the appeal.

Commentary

The s103 problem has been with us for some time. Some commentators considered that transfers between spouses were in some way in a class of their own with the result that s103 did not – or perhaps ought not to – apply. There is no reference to that argument in the report of the case.

It has for some time been standard advice, where it is known that there has in the past been a gift of property between one spouse and another, to frame the wills that employ the debt or charge scheme in such a way that the surviving spouse does not receive the residue outright. Instead, the surviving spouse receives only an interest in possession – nowadays an “immediate post-death interest” – with residue passing, usually, to the children. The argument runs that in these circumstances there is no deduction of the nil-rate band from the estate of the surviving spouse that can fall foul of s103 because the liability operates to reduce the value of the agreeable trust fund of residue rather than of the personal estate of the second spouse to die. It is therefore not “a liability consisting of a debt incurred by him or an encumbrance created by a disposition made by him” within s103(1).

In simple terms, therefore, it has been standard practice when taking instructions for debt or charge scheme wills, to make enquiries as to past gifts, to advise on s103 and to provide that the will of the first spouse to die leaves the residue of the estate on trust for the surviving spouse for life only, rather than absolutely. However, that may be quite difficult to explain to clients in practice. The fact that the will of the first spouse to die sets up not one trust fund but two may be just too much for some testators to accept. They have a simple alternative, which is to forego the use of the nil-rate band and to inflict upon their families a burden of up to £120,000 of extra tax!

Does this mean that the debt or charge scheme is dead? No. The debt or charge scheme is not to be entered into lightly or without proper explanation. Nor is it successful if, following its implementation, the parties behave as if the nil-rate band fund was always, and would remain, at the disposal of the surviving spouse. There must always be the “frisson” of uncertainty that the trustees could at any time call in the loan. Where, following the first death, the surviving spouse decides to “trade down” in property terms, it is always important for the trustees to consider calling in all or practically all of their debt, forcing the surviving spouse to use his or her own resources to purchase the replacement property and only to come to them for help when those resources are used up. Equally, the simple version of the debt or charge scheme, i.e. the one that is exemplified by the will of Mrs Phizackerley, is still effective where there has been no substantial gift or disposition between the spouses that falls within s103(1).

It is here that the agreed Statement of Facts in Phizackerley is particularly important. This was highlighted above. Setting aside the issue of whether it is, nowadays, proper to say that any wife “did not work during her marriage”, as if to deny the value of the contribution that a wife makes who does not specifically earn money, it is probably increasingly common that, at some time during a marriage, particularly in the early years, both husband and wife will work. Most wives will be able to claim, as a matter of simple mathematics and without even having to take account of the attitude of the courts on divorce, that they have actually made a contribution to the cost of the house and that the purchase of the house in joint names does not lead to the automatic conclusion that “the funds must have been provided by the Deceased”. Many families will be able to show that both husband and wife worked at various times during the marriage; that they both directly or indirectly contributed to the cost of one home after another; and that the family home that is in their joint ownership at the time of the death of the first of them to die is truly owned by them equally and that, for them, the facts of Phizackerley can be distinguished.

There is another more serious issue to address. S103 contains no time limit. The debt which the executors seek to deduct from the estate of the second spouse to die is, see s103(1) “subject to abatement to an extent proportionate to the value of any of the consideration for the debt or encumbrance which consisted of – (a) property derived from the Deceased; or (b) consideration (not being property derived from the Deceased) given by any person who was at any time entitled to, or amongst whose resources there was at any time included, any property derived from the Deceased.” It does not matter how long ago the property passed from one spouse to the other, it could still be caught. Clearly, these are matters of proof. Some executors will take a more cavalier approach to their duties in delivering accounts under s216 ITA 1984 than they should. If there is any clear link between the debt which is to be deducted from the estate of the surviving spouse and a gift made, however long ago, by that spouse to the first spouse to die, it would seem that Phizackerley can apply. This case increases the burden on executors and their advisers, and the risk of the penalty for failure to make proper enquiries.

It is for others to criticise the decision on grounds of chauvinism, impracticability or unfairness. Unless and until reversed, we must see how it affects the wills that have already been drawn and our future practice.

Practical implications

The debt or charge scheme is complicated, both in its establishment and its management. Phizackerley tells us that the enquiries that we make before recommending the use of the scheme may now have to be more searching than we previously thought. The fact that gifts between spouses are themselves exempt does not take those gifts outside the scope of s103. In practical terms, this will increase the cost of preparing Wills because of the extra enquiries to be made and, where it is appropriate for the residue of the estate to be left to the surviving spouse on an interest in possession trust rather than absolutely, extra time will be needed to explain how s103 works and how to avoid the trap that has caught the family of Mrs Phizackerley.

Where both spouses have helped to pay for the house, it may not be necessary to change anything. Where, however, there has ever been a substantial gift, existing structures should be reviewed. The problem arises only where the donor spouse is the second to die: so in the common case of value transferred in lifetime by husband to wife, where she survives him, there is no problem.

There are many variants of the debt or charge scheme, so we must handle it with care. A few years ago, it was common for testators to leave to a discretionary trust an interest in the family home that was equal to the available nil-rate band. Gradually practitioners appreciated that this was not a wise course for two reasons. If there was truly a discretionary trust of the share in the house, main residence relief under s225 Taxation of Chargeable Gains Act 1992 was not available to shelter the gain that might rise. Alternatively, if all the parties behaved as if the surviving spouse had an undisputed and exclusive right to the use of the property, and if that spouse paid no rent, the scheme could be – and was – challenged by HMRC Inheritance Taxes on the basis that there was in effect an interest in possession in the trust fund, nullifying the scheme. In other situations it appears that advisers led the family to believe that the promise of payment “would never be called in”, which naturally led to challenge on the ground that effectively the fund was part of the estate of the surviving spouse. Provided that practitioners and their clients fully understand the issues involved in setting up and running the debt or charge scheme, it is still capable of saving substantial IHT.

Many taxpayers are very concerned at the decision, which has attracted media coverage. They should consult their usual taxation advisor and, if there has at any time in the past been a substantial inter-spousal gift, they should review their wills.