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18 TAXATION 23 July 2015

INHERITANCE TAX

Debts and deductionsConfused about when borrowings can and can’t be taken into account for inheritance tax purposes? TERRY JORDAN enlightens us.

In Shakespeare’s Hamlet, Polonius said: “Neither a borrower nor a lender be; for loan oft loses both itself and friend, and borrowing dulls the edge of husbandry.”

These words were sound advice but, historically, borrowing has been a very useful device in estate planning, particularly for clients who are not in the first flush of youth. As originally drafted, IHTA 1984, s 162(4) provided that “a liability which is an encumbrance on any property shall, so far as possible, be taken to reduce the value of that property.”

For elderly clients whose principal asset was their home, the most practical approach to inheritance tax mitigation had often been for them to borrow money secured on the property. Typically, this was by way of a “lifetime mortgage” where neither principal nor interest are paid for as long as the client occupies the property.

The sum borrowed would be invested in a portfolio of trading companies listed on the Alternative Investment Market (AIM) which, once owned for two years, benefits from 100% inheritance tax business property relief. In the case of married couples and civil partners, as long as their wills had been drafted properly and one of them lived for two years, the relief was available. If owned for less than two years on the first death, leaving the shares to the survivor afforded the spouse exemption and the survivor inherited the deceased’s period of ownership under IHTA 1984, s 108(b). If the shares had been owned for two years, the best advice was to leave them to a discretionary trust, thereby locking in the business property relief.

Borrowing had also been a useful device for clients who are domiciled outside the UK because it gave them the opportunity to reduce the value of UK-situs assets. These are always potentially chargeable to inheritance tax, regardless of the domicile of the owner. It was originally suggested as a possibility for clients who wanted to remove valuable UK residential properties from non-UK corporate structures (so called “de-enveloping”) in order to avoid the annual tax on enveloped dwellings (ATED) which exposed the value of the property to inheritance tax.

This is an area in even sharper focus since this month’s budget announcement that from 6 April 2017 UK residential property will always be within the scope of UK inheritance tax even if it is held via a non-UK company and regardless of whether the company is in an “excluded property” trust settled by a non-domiciled settlor.

There has always been an “elephant trap” in securing borrowing on the wrong asset, as the example of Gerald from Tolley’s Guidance demonstrates.

The strategies outlined above have had to be rethought in the light of one 2013 budget day announcement in respect of which

KEY POINTS

�� Originally, liabilities on property were taken into account and would reduce its value.�� Borrowings could then be invested into inheritance tax

exempt assets.�� FA 2013 prevented the use of the tax-saving strategy

from 17 July 2013.�� Now, borrowings must be repaid after death if they are to

be deductible for inheritance tax purposes.�� A liability may be deducted against an estate only if it is

discharged out of the estate.�� The changes may affect the use of bank guarantees or

letters of credit by Lloyd’s names.

GERALD

Example of a loan secured on business property.Gerald runs a successful small manufacturing business. He purchased the factory and yard with a legacy he received many years ago. He buys a plot of land and engages a builder to build a pair of houses, which he intends to let. The bank is reluctant to lend on property which has not yet been built, but is willing to lend Gerald the money if he takes out a mortgage on his factory.

Gerald’s liability to the bank is secured on the factory, although the purpose of the loan was to finance the acquisition of the rental property. When Gerald dies, the liability will not reduce the chargeable value of the estate because it is secured on non-chargeable property.

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23 July 2015 TAXATION 19

INHERITANCE TAX

there was no prior consultation. The new provisions apply to individuals and to trusts.

FA 2013, s 176 and Sch 36 provide that, from royal assent on 17 July 2013, borrowings incurred to acquire, maintain or enhance excluded property (for example, non-UK assets of a non-UK domiciled individual) or assets that benefit from business property relief (such as AIM shares), agricultural property relief or woodlands relief, will be deducted first from the value of the excluded or relievable assets.

As originally framed, there were no “grandfathering” provisions to protect arrangements that predated the budget announcement. However, in relation to business, agricultural and woodlands reliefs, only borrowings incurred on or after 6 April 2013 are caught; arrangements made before that date are not affected. No such concession applies to borrowings incurred in connection with excluded property.

See Mikhail.The legislation is contained in IHTA 1984, s 162A, s 162B

and s 162C and there are useful examples in HMRC’s Inheritance Tax Manual at IHTM 28010 et seq.

Where a loan was incurred to acquire excluded property it may still be deducted if the property has been disposed of for full consideration in whole or in part before the charge to tax arose if the proceeds are themselves subject to tax or if the acquired property has ceased to be excluded. As an example, this might be a property abroad owned by a person who has become deemed domiciled in the UK.

Lifetime transfersIf borrowed money is used to acquire, maintain or enhance relievable property that is then given away during the taxpayer’s lifetime, the inheritance tax treatment of the borrowings will depend upon whether the gift was an immediately chargeable transfer (say to trust) or a failed potentially exempt transfer (one not survived by seven years) or a potentially exempt transfer that has been survived by seven years.

In the first two cases the borrowings are taken to reduce the value transferred by the gift and are not to be deducted again, but in the third they would be deductible against the value of the estate on death.

Repayment after deathPolonius was stabbed behind an arras long before the introduction of the new measures, but nowadays borrowings will need to be repaid after death if they are to be deductible for inheritance tax purposes. The legislation is in IHTA 1984, s 175A and HMRC’s explanation for these provisions was as follows:

“One of the principles behind the policy is that the economic consequences of borrowing are reflected in the tax treatment of the liability. The deduction should only be allowed where the estate left to beneficiaries is reduced as a result of having to repay the liability, unless there are commercial reasons for the repayment not to be made (and the non-repayment does not give rise to a tax advantage). If a loan is not repaid or is written off after death, the amount left to beneficiaries is increased, so the value of the estate subject to inheritance tax should also be greater.”

Originally, it was thought that the repayment had to take place before submission of the inheritance tax forms as part of the application for the grant of representation which would have given rise to real practical difficulties. Adopting a practical approach HMRC have said:

“The starting assumption will be that liabilities on death will be repaid so that all liabilities can be deducted for the purpose of calculating the inheritance tax due. After probate has been obtained, the expectation is that the liability will be repaid from the released funds. If a liability is not repaid later, HMRC will expect personal representatives to amend the inheritance tax return accordingly.”

The use of an employee benefit trust (EBT) is an example of such a situation. It was not uncommon that a loan advanced from an EBT would be written off if it had not been repaid when the recipient died. This would commonly happen after probate had been obtained. This aspect is illustrated in Duncan and Malcolm.

Non-residents’ bank accountsA little-known lacuna in the new provisions existed for exactly a year in relation to non-residents’ bank accounts.

Section 157 provides that the balance on qualifying foreign currency accounts held by individuals and by the trustees of settled property (where the settlor was non-UK domiciled when the settlement was made and the trustees are neither domiciled nor resident in the UK) in which the relevant person is beneficially entitled to an interest in possession are left out of account where the relevant person is neither domiciled nor resident in the UK immediately before his death.

As such accounts are not “excluded property” in the technical sense. For a period there could have been a benefit in moving the balance on an account in, say, Jersey (where it would have constituted excluded property) into one in the UK where it was to be left out of account.

MIKHAIL

Mikhail is domiciled in Russia and lives with his fourth wife in Esher. He borrows £2 million secured against his property in Esher to purchase homes for his former wife and children who remain resident in Moscow. Since living in Surrey, he has developed a passion for cricket. He assisted the local team by purchasing their grounds and building a new pavilion and clubhouse. He borrows £850,000 secured on the cricket club property to invest in a holiday village in France.

On Mikhail’s death, he would be subject to IHT on the full value of the residential property in Esher and the cricket club assets. The value will not be reduced by the liabilities secured on them because the loans have been taken out to finance non-UK property. This is excluded property because Mikhail was non-UK domiciled.

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INHERITANCE TAX

Amendments were made to s 162A, s 162C and s 175A so that no deduction is allowed for money that is borrowed and used to fund a qualifying foreign currency bank account that is left out of account under s 157. The foreign currency account is now treated in the same way as money that is borrowed and used to acquire, enhance or maintain excluded property. This change applied to transfers of value made on or after 17 July 2014.

Lloyd’s namesMany Lloyd’s underwriters use bank guarantees or letters of credit to support their underwriting, most often with the guarantee secured on property that does not qualify for business property relief (such as investment property). If individuals underwrite through limited liability partnerships, HMRC have allowed, by concession, the value of the guarantee to be deducted from an individual’s estate.

When the legislation was introduced, it was thought that bank guarantees and letters of credit were not liabilities.

I understand that HMRC have recently suggested that, as a result of the FA 2013 changes to the rules on liabilities allowed as deductions, bank guarantees and letters of credit arranged or amended after 6 April 2013 will fall within the rules under IHTA 1984, s 162B. Therefore, guarantees are treated as loans/liabilities on death and are restricted by relieving them first against the business assets (the underwriting business).

When the legislation was introduced, it was thought that bank guarantees and letters of credit were not liabilities, but charges until such a time that there was a call on them, Consequently, it was thought that they were, therefore, outside the scope of s 162B.

Compliance mattersIn most cases where an application is made for a grant of probate or of letters of administration the estate will be “excepted” with only a short-form inheritance tax account being required.

The Inheritance Tax (Delivery of Accounts) (Excepted Estates) Regulations SI 2004/2543 were amended by the Inheritance Tax (Delivery of Accounts) (Excepted Estates) (Amendment) Regulations SI 2014/488 and apply where the death was on or after 1 April 2014.

Where borrowed money was used to acquire, enhance or maintain excluded property, that liability may not be taken into account in arriving at the net chargeable value, even if one of the relieving provisions in s 162A would apply. If discounting the liability means that the net chargeable value exceeds the inheritance tax nil-rate band, form IHT400 must

be delivered with an explanation as to how the relieving provisions apply.

A liability may be deducted against an estate only to the extent that it is discharged out of the estate. If the personal representatives know, when filling in form IHT205, that a particular liability will not be repaid from the estate, that liability should not be taken into account in arriving at the net chargeable value. Similarly, if it turns out that a liability that was taken into account is not repaid the liability must be added back (HMRC’s Trusts and Estates Newsletter, April 2014).

ConclusionI’m fairly sure that Shakespeare was not thinking of inheritance tax when he was writing Hamlet, but as Polonius also said: “Though this be madness, yet there is method in’t.” n

Terry Jordan TEP is senior adviser, private client tax with BKLTax in north London and can be contacted on 020 8922 9360 terry.jordan@bkltax.co.uk.

DUNCAN AND MALCOLM

Duncan died in August 2013, leaving a one half share of his estate to his son, Malcolm. His liabilities included a debt of £10,000 to Swanky Homes Ltd, which had recently completed an extension to Duncan’s house. The debt represented the final payment due under the building contract and was to be paid after a defects liability period of 12 months. The personal representatives agree that Malcolm may take the house as part of his entitlement and, in calculating the balance of cash due to him, they make an allowance for the liability to the builder. Malcolm will take over the supervision of any repairs and will settle the final payment when he is satisfied.

Although the liability to the builder is not paid by the personal representatives out of the estate assets under their control, it will qualify as a deduction in calculating the value of the estate on death.

It turns out that Malcolm did not make the final payment because the builder refused to make good a crooked window. This appears to be a real commercial reason for the liability not to be repaid, and will not invalidate the deduction.

Duncan’s liabilities also included a loan of £50,000 from an employee benefit trust set up by his employer. Arrangements had been made with key employees to minimise income tax liabilities by replacing salary payments with loans from the EBT. Such arrangements became ineffective with the introduction of the disguised remuneration rules in April 2011, but the loans that had been created remained outstanding. It was agreed that the loans would gradually be discharged by recognising a portion each year as a salary payment, and tax paid accordingly. However, in the event of the death of the employee, the loan would be written off.

Duncan’s EBT loan is an example of a liability that will not be discharged out of the estate, and as such may not be deducted from the value charged to inheritance tax.