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IHT and the family home

The article below is highly technical and not for the faint hearted but will give you an idea of the issues that are faced by many with highly valuable homes and large estates. This article formed part of the reading for the Society of Will Writers December online Continuous Development Training which I passed with a 100% score.

Is Christmas all-year round for HMRC? (The Family Home and IHT)

As we approach the annual festive season minds inevitably turn away from business to what are properly described as more pleasurable pursuits. So this month in the lead up to the holiday we are taking the opportunity to have a brief look at a number of changes to tax legislation that have taken place in the last few months, with especial reference to the effect that these changes have had on planning for the family home.

What has happened to the value of the family home during the past 12 months?

National Statistics demonstrate an 11.7% rise in property prices in the year ended July 2014. This is the steepest rise since the beginning of the recession (2008) and if it continues unabated we could expect the price of property to double within 6 years!!

Pricewise this increase means that an “average” house in the South East has increased to £337,000 and in the South West to £246,000.; while in London the figure comes in at a whopping (technical term) £514,000.

The effect is that middle income families now more than ever will almost certainly be in a position where inheritance tax is more likely than not to be paid on their estate, as their main asset (their home) is of a value approaching if not actually exceeding one and sometimes two nil rate allowances. Planners should bear in mind that the tax charge generally arises on the second of their deaths and that an unused nil rate allowance, on the first death, is transferable for the personal representatives of the surviving spouse to use.

However the need to look carefully at the composition of estates belonging to couples is of paramount importance when advising about testamentary dispositions. Various paths can be followed to reduce inheritance tax on death, for example estate planning or gifting to assist children and grandchildren to get their feet on to the property ladder. HMRC have closed down on most avenues of tax planning involving the family home in the past few years; so that there is now little scope for successfully reducing the inheritance tax liability created by a valuable home, especially if there is the potential for it to increase further in value over the years ahead.

To make matters worse the 3% stamp duty threshold of £250,000 is being more widely felt as prices soar.

The effect on the cost of acquiring starter homes has itself soared to £209,000 in July 2014 from £182,000 one year earlier meaning that without the “bank of mum and dad” first time buyers are struggling to get a foothold in the market. The adviser who can offer sensible testamentary and estate planning advice will benefit in these difficult times.

Is acceptable “tax avoidance” still possible?

With monotonous regularity we learn that nowadays HMRC are taking pains to make it abundantly clear that the previous long-established division between “tax avoidance” (acceptable) and “tax evasion” (criminal) has been replaced. The current following definitions have it seems taken over: “tax avoidance as intended by statute” (acceptable if you get it right) “aggressive tax avoidance” (acceptable but only by agreement with HMRC) and “tax evasion” (as ever socially and criminally taboo). However this change of stance to avoidance has not entirely shut the door on tax saving strategies completely as the recent death of Tony Benn has revealed.

It seems that Mr Benn along with his wife, who died before him, undertook sensible tax planning, which has proved to be entirely acceptable, so that the bite of inheritance tax on their estates could be reduced.

As they owned their valuable family home in London as tenants-in-common the first of them to die was free to leave their share (the actual shares are not known) to whoever they should choose, other than to the
surviving spouse. Mrs Benn left her share to their children. If the gift of the share, which would be a chargeable transfer, fell within the nil rate band at the date of her death there would be no immediate liability to inheritance tax on that gift.

As a gift made is made to the children its value would not form part of Mr Benn’s taxable estate upon his death and if within Mrs Benn’s nil rate allowance entirely free from inheritance tax. His own share would remain part of his taxable estate upon his eventual death and his available nil rate allowance would be applied to reduce the value liable to inheritance tax.

If Mrs Benn’s nil rate allowance had not been harnessed in this way, then as a result of the transferable nil rate allowance legislation, introduced in October 2007, her unused nil rate allowance could have been applied to the value of her husband’s estate, now including the whole value of the family home. The use of Mrs Benn’s nil rate allowance at the date of her death, sheltering her share of the family home, means that where the growth in value of the nil rate allowance fails to match general house price inflation, especially as has happened in London, a significant reduction in tax could result.

Mr Benn has not made the gift and continues to occupy the house by virtue of his share in the property, without the need to pay any rent for his occupation. CGT should not be an issue as the “uplift on death to market value” applies as the property has been their principal private residence.

There is one matter that would have exercised the Benn’s full and careful consideration. Making a gift of Mrs Benn’s share to their children will place that share under the control of the children, with all the potential concerns attendant on that fact. If the children were to be bankrupted or divorced the property might need to be sold disrupting Mr Benn’s twilight years. In this event Mr Benn would only receive a portion of the sale proceeds in line with his share. All may depend upon the quality of family relationships and commercial business acumen.

Should the matrimonial home really be used for IHT tax planning purposes?

If the family like the idea of this form of tax planning, as mentioned above, but want to control the actions of the children, then by making the gift of the share into a discretionary trust should overcome the control issues – but in return potentially create a host of tax problems; especially if the surviving spouse is deemed to have an interest in possession, under s49 IHTA1986. This was the problem in IRC v Lloyds Private Banking Limited [1998] STC 559. However the exact statutory position is unclear; there is no formal authority for “deeming” an interest in possession, only that it may represent economic reality, especially if “exclusive” occupation is granted. In Judge and another (personal representatives of Walden, dec’d) v HMRC Comrs [2005] SpC 506 the court held that there was no deemed life interest, rather that the trustees had disregarded their absolute discretion i) to permit the surviving spouse to occupy the property and ii) her entitlement to veto its sale.

The provisions of the Trusts of Land and Appointment of Trustees Act 1996 suggest that it is no longer necessary to secure the occupation of the surviving spouse without by conferring specific rights that could lead to the interpretation that an interest in possession exists cancelling the sought-after tax saving.

Many think that attempting to carry out tax planning with the matrimonial home, especially where there is a possibility (real or otherwise) that children could exercise a destabilising influence, contains too many unknowns. It may be preferable to give the surviving spouse absolute security of the matrimonial home and look for other assets to use for IHT planning purposes. Where in the case of Mr and Mrs Benn, their house provided the ideal asset to use – given the huge growth in London house prices since Mrs Benn died and the absence of control concerns; so estates should be checked for assets that may be capable of significant out-performance of the future growth in value of the nil rate allowance. If such assets do exist then a gift of that asset(s) on the first death into a discretionary trust may prove attractive, subject to the tax considerations, without the attendant complexities that using the matrimonial home for tax planning purposes could involve.

Changes to the Principal Private Residence (PPR) relief:

When IHT planning is undertaken the attendant liability to Capital Gains Tax (CGT), must always be considered. Where in the above section the use of the matrimonial home to mitigate IHT is considered it is imperative that CGT is also considered.

The major relief for CGT is the PPR relief. Whereas when purchasing property the liability to Stamp Duty is an additional cost (starting at 1% on properties over £125,000); when a property is sold by its occupants, being their principal private residence, relief from tax on any capital gain has been a feature available for many years.

Many of the ideas that will writers use when making dispositions of property either in wills or using lifetime trusts rely for their efficacy on making use of PPR (including s225 CGTA1992 – the trustee version). The qualifying period of ownership was originally 12 months and increased to 36 months in 1991. The idea was to make it easier to move houses during difficult economic times (the depression of the early nineties). Changes to this important relief should be carefully noted.

The government announced its intention to legislate for a reduction in the final period of relief down from 36 months to 18 months in the 2013 Autumn Statement as confirmed by the 2014 Budget for house sales completed after 6 April 2014.

Where the owners live in their one and only property up to the date of sale the new provisions will not affect them. The period of 36 months deemed occupation is also retained for disabled persons or long-term residents of care homes.

A disabled person (Finance Act 2005 Sch1A) is someone who:

Within the meaning of Mental Health Act 1983 lacks the capacity to administer their property or manage their affairs; and is receiving Attendance Allowance; disability living allowance (assuming entitlement to the care component at the highest or middle rate); personal independence payment (replacing disability living allowance); an increased disablement pension; or the armed forces independent payment.

The definition of a long-term resident in a care home is an individual who is:

Resident in a care home that provides accommodation, or Reasonably expected to be resident in a care home for 3 months at the time of disposal of the main residence.

The definitions are designed to be applied strictly so that persons who employ live-in carers or use a care home for respite care will not qualify for the 36 month period of relief; that is PPR will not be available for these persons unless they are living in what is their only home at the time it is sold.

The end of “flipping”:

Abuse of the PPR relief became commonplace. Individuals acquired a second property and then by taking advantage of the pre 6 April 2014 rules elected which property should be treated as their only or main (principal) home. The rules allowed them to change the elected property at will and avoid the payment of CGT. Known as “flipping” HMRC have moved to stop this practice by these legislative changes.

The taxation of residential property:

As property prices rise inexorably especially in London and foreign buyers enter the residential property market in increasing numbers, it is not surprising that HMRC’s attention should be focused on extra tax pickings at a time of national austerity.

Before March 2012 a non-UK domicile and non-UK tax resident purchaser of a UK residential property had a much easier time – tax wise. The regular advice was for the qualifying individual to purchase the property via an offshore limited company, in which they would be the main shareholder.

The shares would be given the special tax status of “excluded property” for IHT purposes. There would be no CGT payable by the qualifying person when the property was sold. Occupation of the property from time to time would not cause corporate tax issues for a non-UK domiciled or non-UK tax resident person.

The 2012 Budget attacked these benefits:

These notes are an indication of how the UK government is flexing its taxing muscles to bring the Treasury every tax pound possible; even it would seem at the risk of deflating the property market and potentially driving away prospective foreign investors. The following changes have been introduced:

A 15% Stamp Duty Land Tax (SDLT) was introduced from 21 March 2012 on the purchase of UK property where the purchase price of a single dwelling exceeds £2 million and the purchaser is not a natural person, but instead is a company or partnership. A new tax was introduced – an annual tax on enveloped dwellings (ATED) and applied where for example a company buys a property over £2 million. The bite of the tax ranges from £15,400 (£2m) to £143,750 (£20m), requiring significant resources to meet these annual tax amounts.

When an offshore company sells a residential property that is liable for ATED, the capital gains accruing since 5 April 2013 are subject to CGT at 28%.

Relief from ATED is available if the property is let commercially to a third party or held as part of a developer’s stock-in-trade.

ATED could be avoided if the property is changed from corporate ownership into individual ownership (“de-enveloped”), but as the extracted property will be UK situs it would then become subject to IHT, which would suggest other planning would need to be considered.

The de-enveloping process would itself be subject to a tax cost, offshore property shares owned by an offshore trust now attract CGT on the disposal. Where there is no trust the company would need to be dissolved and the transfer to the non-UK resident would attract CGT on any capital gain since 5 April 2013.

From the 2014 Budget the 15% SDLT threshold has reduced to £500,000 and from 1 April 2016 properties between £500,000 and £1m (down from £2m) will be subject to annual ATED of £3,500.

Up to now residential property has been a favourite target for non-UK domiciles and non-UK resident investors – will these new taxes presage a cooling of London’s property market?

Further attention to PPR/CGT issues:

Furthermore the Government is consulting on the current rule that non-UK residents do not pay CGT on the disposal of UK assets. The consultation which closed in June 2014 was to consider:

a) That henceforth CGT should be charged on all disposals of UK property used (or could be used) as a dwelling by non-UK resident persons, and

b) Further restrictions on the availability of PPR by removing the right to elect which one of two or more properties should be treated as the taxpayer’s main residence.

Still further attention may focus on reducing the qualifying final ownership period down from 18 months.

A “Mansion Tax” could be on the agenda after the Election for dwellings over £2m. Advisers in all disciplines should watch these developments carefully.

Donatio mortis causa (DMC):

The law and the legal system of England and Wales has a number of anomalous features; one of which is a gift donation mortis causa (“a gift on account of death”). A DMC is a present gift which remains conditional until the donor dies. The gift is made conditional upon death and only takes effect when the donor dies. The gift takes effect as an anomalous exception to the Wills Act 1837 as it is a gift that takes effect in the future by becoming absolute on death. The gift is neither entirely “inter vivos” or “testamentary”.

The gift is classified as a constructive trust, which side-steps the formal requirements for the transfer of land and the creation of trusts of land. The task of the court in deciding whether a valid DMC has been made is to distinguish between a genuine DMC and an attempt to make a testamentary gift without adhering to the provisions of the Wills Act.

Accordingly for the last 150 years the test that the court has set has been a high one. The evidence required to support the DMC must be both clear and unequivocal in character.

For there to be a valid DMC the following conditions must be found:

1) The gift must be in contemplation of death: but not necessarily in expectation, of impending death. The court will judge on the facts of the case before it. The test is strict. The manner of death may differ from the expected death. To be valid the donor must have regard to something more than a realisation of the general truth that we will all die someday.

2) There must be delivery of the gift: to be valid the subject matter of the gift must be delivered to the donee before his death. The physical delivery of chattels is sufficient. A key to a locked box will validly effect a gift of the contents.

3) The gift must take effect on death: if the donor recovers the gift fails. The donor may revoke the gift at any time, but may not effect revocation by his Will, see Jones v Selby (1710) Prec Ch 300. The DMC does not have effect if the donor’s intention was to make an inter vivos gift; that is without the contemplation of death, other than in a general sense.

4) The subject matter of the gift must be suitable: the DMC of a cheque made payable to the donor can be valid but a cheque drawn by the donor cannot be valid because it is a revocable mandate that is automatically terminated on death (Re Beaumont [1902] 1 Ch 889. A gift of shares should be valid.

Note: A valid DMC has no effect on the estate IHT calculation as tax is payable on both legacies and a DMC as they are both part of the deceased’s estate for tax purposes.

Because of the formal rules that are required to make a valid transfer of land, it was thought that land could not be the subject of a valid DMC, however the Court of Appeal in Sen v Headley [1991] Ch 425 finally decided that it was possible for real property to be passed by DMC. In that case the delivery of the title deeds. The conditions that are required for a valid DMC were set out clearly by Nourse LJ in the ratio decidendi of the case.

The court held the gift of real property by Mr Hewett to his friend Mrs Sen was a valid DMC. The judgement is well-worth reading and can be found in some detail in “A Modern Approach to Lifetime Tax Planning for Private Clients” by Christopher Whitehouse and Professor Lesley King, published by Jordans ISBN 978 1 84661 518 4 at para 4.24 and 4.25 page 40.

In a recent case Vallee v Birchwood [2014] 2 WLR 543 the legal effect of DMCs was examined once again. Mr King lived with his aunt who was worried about her future. The time elapsed between the gift of the deeds to her house by the aunt (the donor) to her nephew Mr King (the donee), until her death was four months.

The effect of the DMC, if valid, was to leave very little in the Will to the named charities.

Not surprisingly the charities attacked the DMC claiming i) that the aunt lacked capacity (she did not know what she was doing), ii) the words used did not suggest that the gift was conditional upon her death (“this will be yours when I go” – referring to the house) and iii) that she had not contemplated her death (as 4 months had elapsed).

The court held that the donor did not have to be at “deaths door” for the DMC to be valid and that handing over the deeds to the house was a sufficient parting with possession, even though Mr King kept them in his bedroom in the house.

It should be kept in mind when contemplating a DMC that the test for a valid DMC is rigorous and although the court in this case found in favour of a valid DMC, leave was granted for the charities to appeal. It may not be over yet!

One case where it is all over:

When Lord Lonsdale died in 2006 he left his estate to his eldest son along with a £9m IHT liability. Due to a long-running family dispute and despite electing to pay the IHT bill by instalments (over 10 annual instalments) funds to settle the tax bill could not been found. Faced with a potentially ruinous liability and little time left to pay, the family was forced to sell an asset that they had owned for over 400 years and was an important part of the family heritage. The family mountain!

This extreme situation amply demonstrates the need for funding a foreseeable and expected IHT liability and source of the funding necessarily forms an important part of any effective Will/ estate planning.

December CPD certificate

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