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Tolley's Practical Tax by Matthew Hutton, MA, CTA (Fellow), AIIT, TEP

Matthew Hutton MA (Oxon) CTA (Fellow) AIIT TEP looks at inheritance tax and the family home following the introduction of the pre-owned assets legislationThis article was originally published in Tolley’s Practical Tax, LexisNexis Butterworths leading information service for small to medium sized tax and accountancy practices. It provides the day-to-day information needed to deal with all tax compliance issues and general client problems. For more information or to order this title please visit www.lexisnexis.co.uk/taxationweb

As if the reservation of benefit regime (‘GWR’) introduced in 1986 were not bad enough, the application of the pre-owned assets rules (‘POA’) from 2005/06 came as a rude shock, not only to those who had managed to construct arrangements designed to avoid GWR but also to professional advisers attempting to respond to client demand to put such plans in place for the future. Those advisers may well share the writer’s view that a gift of the whole of, or even a share in, the home by the older generation while still living there is not a sensible thing to do in principle; at the very least, security of tenure must be preserved. But the client needs to be advised on the available options: otherwise he or she will simply go elsewhere! This series of two articles explores five such options. A working knowledge of both GWR and POA is assumed.

What is ‘occupation’? The primary point is that (except perhaps in the case of the second or holiday home, discussed in Part II of this article) neither avoidance regime will apply unless the Client ‘occupies’ the house. Here the then Inland Revenue set out their view in the Tax Bulletin
November 1993 (now RI 55). The examples indicate that HMRC consider that the exception covers cases in which the benefit to the donor is insignificant in relation to the property given away, eg

a house which becomes the donee’s residence but where the donor subsequently stays (in the absence of the donee) for not more than two weeks of each year or stays with the donee for less

• than one month each year; or

• a temporary stay for some short term purpose in a house the donor had previously given away, e.g. convalescence by the donor after medical treatment, the donor looks after a donee convalescing after medical treatment or during redecoration of the donor’s own home.

Where the benefit to the donor is or becomes more significant, the GWR provisions are likely to apply eg;

• a house in which the donor stays most weekends or for a month or more each year; or

• a second home or holiday home which the donor and the donee both then use on an occasional basis.

The technical guidance on POA first issued by HMRC in March 2005 expressly adopts RI 55 for POA. In addition, HMRC say that a person would, for example, be regarded as in occupation not only if resident in the relevant property, but also while he used it for storage or had sole possession of the means of access and used the property from time to time. While this may be challenged, it does represent HMRC practice. However, most interestingly (and unlike GWR), it is expressly confirmed that a person is not regarded as occupying a property from which he receives rent from the actual occupier.

1. The full consideration let-out

(a) gift and lease back

Consider a potentially exempt transfer (‘PET’) to say the children (or trustees for them or for grandchildren), followed by a lease back at full market rent. Neither GWR (FA 1986, Sch 20 para 6(1)(a)) nor POA will apply (FA 2004, Sch 15 para 11(5)(d)).

It is essential that at no future time the donor should occupy for lesser consideration, as the property would be clawed back into his estate and if the donor then died IHT would be charged on its then value.

With either this suggestion or the alternative at (b) below, consider the SDLT implications: while SDLT would apply to the grant of the lease, could the exchange provisions of FA 2003, s47 also bite?

In either case, main residence relief from Capital Gains Tax is available on the gift under TCGA 1992, 223(1), though the house may then be growing in value within the estate (or, preferably) a trust which is not then benefiting from that relief.

(b) full consideration premium

Alternatively, there could be the grant of a lease for life for a full consideration premium, based on the lessee’s actuarial life expectancy. There would be no deemed settlement under IHTA 1984, s 43(3). The full consideration lease for life would certainly be treated in the circumstances as a lease for less than 50 years, triggering an income tax charge under TA 1988, s34. This charge could be mitigated by having a gift to the house to trustees who would grant the lease and receive the premium. The premium would be received by the trustees as trust capital and would therefore suffer only an income tax charge of 22%.

Alternative (b) obviously assumes that the Client has sufficient cash with which to buy the lease. If so, however, that cash leaves the estate other than by a transfer of value. Further, once the terms of the deal are established at the outset, the advantage over (a) is that there the Client is something of a hostage to fortune in terms of future market rents and the risk of HMRC alleging that a full rent had not been paid throughout the period of 7 years before death.

Arm’s length terms

Arm’s length terms must be ensured. Again, see RI 55 stating that there should be a bargain negotiated at arm’s length with the parties being independently advised, with terms following normal commercial criteria in force at the time. Accordingly, two firms of surveyors (and solicitors) should be instructed. It is important to note that full consideration is required throughout the relevant period. However, HMRC recognise that there is no single value at which consideration can be fixed as ‘full’. Rather they accept that there is a range of values reflecting normal valuation tolerances and any amount within the range can be taken as satisfying the para 6(1)(a) test.

2. Arm’s length transaction equity release schemes

Excluded from the POA disposal condition under FA 2004, Sch 15 para 10(1)(a) is the case where the disposal was a disposal of the individual’s whole interest in the property except for any right expressly reserved by him over the property either by an arm’s length transaction with an unconnected person or by a transaction such as might be expected to be made at arm’s length between unconnected persons. This was extended by para 6 of the first Regulations issued in March 2005 by a further interestingly phrased ‘exemption’ (but in relation to land and chattels only) for part disposals where:

(a) The disposal was by an arm’s length transaction with an unconnected person, or;

(b)The disposal was by a transaction which might be expected to be made at arm’s length between unconnected persons, and

(i) the consideration was neither in money nor in the form of readily convertible assets (as defined in ITEPA 2003, s702), or

(ii)the disposal was made before 7 March 2005.

By way of comment, this will cover inter-family equity release schemes involving a part disposal only, where done on normal commercial terms – but only before 7 March 2005. Thereafter, taxpayers are warned that the new exemption will apply only where the consideration is not in either cash or readily convertible assets – another interest in land would do, for example (subject to a double SDLT charge on the exchange).

But, in practice this new exemption is unlikely to be of practical use insofar as no financial institution would take on an acquisition of part only: see next paragraph.

Note that it is primarily the transaction which must be of a type which unconnected persons would make (which would therefore include an arm’s length consideration) not the consideration which is initially in question.

Happily, the market evidence of equity release schemes in a particular case should satisfy this. Incidentally, the lease could as well be for the Client’s life as well as for a fixed period of years: if the former, there would be no IHT deemed settlement under IHTA 1984, s43(3). There is no disposition by way of gift, so no GWR.

Option 2 assumes that one (or more) of the Client’s children has the financial wherewithal to make the purchase. The Client again has security of tenure for his life. H could do with the lump sum what he wanted, ie either spend it on himself or perhaps make gifts to other members of the family (not including the purchaser!).

3. The Internal Ingram Arrangement

The traditional disadvantage of the lease carve-out scheme was the latent capital gain in the appreciating value of the freehold reversion which had been given away. Of course, in the case of a dwelling-house, if the donee of the reversion ultimately came to occupy the house as his main residence, there would be a measure of relief under TCGA 1992, s223 if the house were sold in his lifetime and a CGT-free uplift to market value on death if not. Another possibility, at least before the reform of the offshore trust regime in 1998, might have been to settle that reversion on offshore trusts. Perhaps the neatest response was the so called ‘internal’ Ingram arrangement, which continues to hold good in the context of both GWR and POA; for this, the property concerned is held in trust, though it is essential that the settlor (if still alive) is not the occupant.

Example

Assume that the property concerned was originally held in trust, rather than put into trust expressly to take advantage of the scheme. The trust fund is divided into two distinct funds – one for the parent donor(s) and the other (from which the parents would be excluded from benefit) for the children or grandchildren.

The Ingram scheme would be effected within the settlement on a basis which would be effective for IHT purposes, but for CGT the two funds would comprise a single settlement. This would mean that on ultimate sale of the property the trustees would benefit from main residence relief under TCGA 1992, s225, as throughout their period of ownership the property had been occupied by a beneficiary entitled under the settlement. For such an arrangement, the settlor(s) should not be one of the trustees, nor should any appointment by the trustees require the consent of the settlor(s).

Such an arrangement continues to be effective for GWR purposes and would not fall foul of POA. This is because the parent(s) would satisfy neither the disposal nor the contribution condition. HMRC have expressly confirmed that a life tenant under a trust whose interest I diminished by act of the trustees (causing him or her to make a PET) does not make a disposal for purposes of POA. However, it is of course essential to this analysis that the life tenant was not the original settler after 17 March 1986, as the act of settlement would have constituted a disposal by him and, insofar as an interest in the trust fund was not subject to an interest in possession for the settlor or his spouse, POA would apply.

4. Potentially exempt gifts of cash

Example

Kevin gave his daughter, Yvonne, £500,000 on 1 August 2000. With it Yvonne bought a cottage in North Norfolk which she lets for part of the time and occupies for a month over the summer for much of which Kevin stays with her. Kevin is due to retire in 2008 and the plan is that he will go and live in the cottage fulltime.

For GWR purposes the tracing provisions do not apply to cash (FA 1986 Sch 20 para 2(2)(b)). As a fallback, although para 6(1)(c) of Sch 20 imports the associated operations doctrine into GWR, now of course severely cut down by the Court of Appeal in RysaffeTrustee Co (CI) Ltd v CIR [2003] STC 536, the degree of Kevin’s occupation of the property in the years following the gift is within HMRC’s 1993 de minimis test. Given that more than seven years elapse between the gift of the cash and the enjoyment of the property there should in principle be no POA issue (FA 2004 Sch 15 para 10(2)(c)).

However, because there is a degree of occupation by Kevin under para 3(1)(a), could he avoid the charge if he were to pay the appropriate rental value for his occupation? No. In this example, therefore, it is essential that, if Kevin does want ultimately to occupy the cottage without a POA charge, there is no occupation by him within the meaning of para 3(1)(a). The question needs to be raised as to what degree of occupation would count for this purpose. Kevin should be safe: see above.

5. Co-occupation as tenants-in-common: the statutory exemption from GWR

A gift by parents to one or more children who live with them in the home and bear no more than their share of running expenses need not be a GWR. Protection against a GWR would be obtained only for so long as each party remained in occupation, paying his share of the expenses (subject perhaps to the FA 1986, Sch 20 para 6(1)(b) defence).

The 1986 Hansard statement of this principle was made statutory by FA 1986, s102B(4): the rule now allows gifts of shares in holiday homes and indeed of interests in land in general, which were not covered by the 1986 Statement.

Though perhaps of more relevance to a bequest of a share in the home by Will to, say, children or trustees, note that on the second death the value of his or her share will be discounted by perhaps 10-15% to reflect the joint ownership.

In a College of Law video (September 2000), in discussing the co-ownership arrangement, Peter Twiddy (then Director of Litigation at the Capital Taxes Office) agreed on the one hand that statute does not require that both donor and donee should occupy to the same degree of intensity. Each case would have to be viewed on the facts. However, it might be that the occupation should be similar in nature, which would not be satisfied where the child lives elsewhere but visits the widow’s mother regularly every weekend, say has his own room in the house and leaves his possessions there.

If so, the question may become whether the surviving parent does derive a benefit from the visits of the child at the weekend, which would fall foul of s102B(4)(b). The writer considers this view to be too restrictive, especially in view of the meaning of ‘occupation’ adopted for POA purposes: see below.

An example

On 2 February 1995 Edwina, a widow, gave a one third share in her house to each of her unmarried daughters, Penny and Rosie, who were living with her. Each of mother and daughters therefore owns a one third share in the house as a tenant in common. Each pays her share of expenses. Given that Edwina enjoys no benefit from her continued occupation, there is no GWR in relation to the two one third shares given away (FA 1986, s102B(4)) and the seven-year risk period under the PET has now passed. Of course, if either of the daughters were to fly from the nest, a reservation of benefit would immediately arise in respect of that one third share, except if Edwina were then to pay full consideration for the share in respect of her continuing occupation (within the meaning of FA 1986, Sch 20 para 6(1)(a)).

Such an arrangement, if effective for GWR purposes, will escape POA under FA 2004, Sch 15 para 11(5)(c). There are three particular points which need to be watched in relation to such schemes.

(a) Meaning of ‘occupation’

For the exemption from GWR to apply, s102B(4)(a) requires both donor and donee to occupy the land. See above and last month’s article.

(b) How great a share can be given away?

The statutory exemption does not require the shares to equate to the number of co-owners. Indeed, it seems to have been implicitly if not explicitly accepted by HMRC some years ago that, for example, mother could retain just 10% and give away 45% to each of her two children living with her. They now seem to have backtracked on this and tend to argue that no greater share can be given than equates to the number of co-owners.

Certainly, the Inheritance Tax Manual at IHTM 14332 instructs its officers to investigate a case where the donor takes less than an equal share. But there seems to be nothing in statute to support such a view.

(c) Identify the expenses

It does not matter if the donor pays all the expenses. What is essential is that the donee does not pay more than his/her ‘fair share’: s102B(4)(b) requires the donor not to receive any benefit ‘other than a negligible one, which is provided by or at the expense of the donee or for some reason connected with the gift’. A distinction should be borne between property expenses and personal/living expenses. Property expenses may fairly be shared in the proportions in which the house is owned. However, personal living expenses such as the cost of a TV licence and food (or drink) bills should be shared equally between the coowners, unless some other apportionment based on actual use is appropriate in the circumstances. In any event documentation must be prepared year by year to show how the expenses have been met.

Holiday homes

An individual (or, perhaps, even better, a married couple – given the two £5,000 de minimis exemptions under POA) might have satisfied either the disposal or the contribution condition in relation to a family holiday home which they use from time to time. Let us say a gift has been made, for simplicity, to one or more of the children (or, perhaps, to trustees for the grandchildren – though different consideration might then apply). Could there be a POA issue? ‘It all depends on the facts’. The threestage analysis that follows assumes that no consideration is paid by the donor: of course, all IHT issues could be avoided by the donor paying full consideration for his occupation under a legal obligation.

GWR or POA? Ideally neither, though never both

(a) Is there occupation?

One hopes that the answer is neither; of course, it cannot be both. Before turning to the co-ownership exemption from both regimes, consider whether there is ‘occupation’ in the first place. In their technical guidance (see Part 1 of this article) HMRC expressly applied to POA RI 55 issued in November 1993 in relation to GWR. That states that there will be no GWR issue if the donor occupies the property either with the donee for periods in the year which do not exceed one month in the year or, in the absence of the donee, for periods that do not exceed two weeks in the year. Occupation apparently refers to nights spent in the property. However, if this de minimis test is to apply, HMRC say that there must be no right to occupy for the rest of the year.

In addition, of course, for POA HMRC are applying the test that storage of possessions or maintenance of the sole means of access also constitutes occupation, even when not physically present.

For a quiet life, at least, it would be sensible to ensure that no furniture or other possessions in the property were owned by the donor(s) and that, when not in residence, a key (even if not the sole means of access) is returned to the donee or his agent.

(b) What about the co-occupation exemption?

As to the co-occupation exemption provided for GWR in FA 1986 s102B(4), note that s102B(3)(b) provides a letout if the donor’s occupation is exclusive and for full consideration in money or money’s worth. Sub-para (4) envisages both donor and donee occupying the land (which, as against the 1986 Hansard concession, does not necessarily imply that such occupation is joint, ie it could be successive) and the donor receives no benefit other than a negligible one which is provided by the donee in connection with the gift. Satisfaction of the last condition can be met simply by (if appropriate) the donor paying all his expenses. If expenses are shared, then careful attention needs to be given to the detail and to the evidencing documentation, as this is a point known to be closely regarded by HMRC.

For POA purposes the co-occupation exemption is imported by FA 2004, Sch 15 para 11(5)(c). Note, however, that both that and the full consideration exemption imported by para 11(5)(d) seem to assume that the original gift was of the interest in land, ie that it is the disposal and not the contribution condition which has been satisfied.

The final point in relation to GWR and s102B(1) is that it refers to a disposal by gift ‘of an undivided share of an interest in land’. That seems to assume that following the gift donor and donee both share ownership as tenants in common in undivided (though not necessarily equal) shares. And HMRC have been known to argue that s102B does not apply in the case where the
individual disposes of his entire interest in the land: beware this point.

(c) Will the £5,000 de minimis prevent a POA charge?

Suppose that neither the de minimis co-occupation nor the occupation provisions apply, what about the £5,000 de minimis? This should in most cases be possible to ensure for POA purposes, having regard to para 4 of Sch 15 and the open market rental on a landlord’s repairing basis. The reference in para 4(1) to the occupation of the land by the chargeable person suggests that appropriate rental value is computed for the actual weeks occupied (or subject to a right to occupy), ie whether high, mid or low season. Of course, if no POA, consideration then needs to be given as to whether or not there is a GWR! At least then, where it is the contribution rather than the disposal condition that is in point for POA, tracing for GWR (though not POA) purposes stops with cash (FA 1986 Sch 20 para 6(2)(b)).

The argument it seems to the writer derives from the definition of ‘the taxable period’ in para 4(6) of Sch 15. That is, it is the part of the year of assessment during which para 3 applies to the chargeable person. The reference to part of a year of assessment surely envisages that the occupation may be for less than the whole year. Para 3 applies only where the chargeable person occupies the relevant land and the disposal or the contribution condition is met. Then, under para 4, the chargeable amount in relation to the relevant land is the appropriate rental value as defined ‘for any taxable period’. That said, there is a viewpoint that, once you occupy at any time during the year of assessment, the appropriate rental value of the property for the whole year (including any vacant periods) is brought into charge to income tax – or at least is apportioned between those persons who do occupy, on a pro rata basis. The point requires clarification.

Capital Gains Tax

The case under consideration assumes that the house in question does not benefit from main residence relief. If a share in it is to be given away, how is any chargeable gain to be sheltered (following the prohibition by FA 2004, Sch 22 on the well-established combination of gift to a discretionary trust under s260 hold-over and relief for the trustees on sale under s225 based on occupation by a qualifying beneficiary)?

Furnished holiday accommodation (‘FHA’) is treated as a business asset for purposes of s165 hold-over’: see the definition in ITTOIA 2005, ss324 and following. As such, the prohibition on combining the advantages of s260 holdover with s225 main residence relief does not catch a s165 hold-over with a view to taking advantage of s225.

Accordingly, suppose that husband owns a second home used by the family as a holiday home. He might give the home to his wife, on a no gain no loss basis under TCGA 1992 s58. While she
acquires his base cost, her period of ownership begins with her date of acquisition (and is not, for example, backdated as under s222(7)(a)). The wife starts to use the property as FHA for a reasonable period (ie a year or more) and then holds over the gain under s165 on transferring the property to a trust (which need not be discretionary, so the value can exceed the nilrate band) from which both she and her husband are excluded. (Interestingly, the statutory conditions for FHA do not preclude a measure of family use.) One of the children then occupies under the terms of the settlement and on ultimate sale by the trustees the whole of the gain including that arising before their period of ownership is effectively ‘washed’!

December 2005

MATTHEW HUTTON MA (Oxon)
CTA (Fellow) AIIT TEP

This article was originally published in Tolley’s Practical Tax, LexisNexis Butterworths leading information service for small to medium sized tax and accountancy practices. It provides the day-to-day information needed to deal with all tax compliance issues and general client problems. For more information or to order this title please visit www.lexisnexis.co.uk/taxationweb