The Finance Bill earlier this year contained a number of surprises, not least the introduction of some new rules relating to the deductibility of debts for the purposes of inheritance tax.
The new rules aim to tackle those arrangements which HM Revenue & Customs felt were entered into purely to secure a tax advantage. As has happened many times before, the words ‘sledge-hammer’ and ‘nut’ spring to mind.
No one has ever claimed the IHT rules are straightforward – far from it. The main principle, however, is simple. When someone dies IHT is charged on their estate using this formula:
- Add up the value of the assets owned by the deceased
- Deduct the liabilities of the deceased
- Take account of any exemptions, allowances and reliefs
- Pay tax at 40 per cent on what is left.
The Finance Act this year has introduced three main restrictions. These limit the situations where a liability can be deducted when calculating the IHT charge, which arises on death or other chargeable events. The restrictions apply depending on whether the money borrowed is repaid from the estate and depending on what the borrowed monies are used for.
Unpaid loans: Under the new rules the basic premise is that a liability can only be deducted for IHT purposes if it is repaid out of the estate. If it is not repaid out of the estate, then it will only be deductible if, in the opinion of HMRC, there is a real commercial reason for the liability not to be discharged.
There are many cases where family trusts lend money to beneficiaries. When a beneficiary dies, the trustees do not intend to call in the loan but instead are happy for the loan to be ‘rolled over’ to the next generation, and for those beneficiaries to inherit all of the deceased’s assets.
Following the introduction of the new rules, such loans will need to be repaid from other monies within the estate to secure the IHT reduction.
What is not clear is how such arrangements are to be policed. When completing a set of probate papers the executors will include all the liabilities, whether or not they have been settled. In the vast majority of cases, none of the liabilities will have been settled at that stage because of the requirement to obtain the grant of probate to, in turn, obtain the funds needed to pay the liabilities.
This will include debts such as credit card bills and mortgages, as well as loans from family members or trustees. The present position of HMRC appears to be that the probate papers should be completed as normal and that if a liability is not repaid, then a corrective account will need to be completed by the executors.
Loans between family members and trusts are frequently ‘flexible’ and decisions as to whether to write them off or not can often take years. It will be interesting to see how the Revenue’s approach to such issues develops.
A deduction may still be allowed if there is a commercial reason for retaining the debt and gaining a tax advantage is not the main purpose.
For example, if John inherits his father’s house, which is subject to a mortgage and John chooses to repay the mortgage from his own funds in order to keep the house then that should be fine, even though the debt is not repaid from the estate itself.
Borrowed money used to buy property qualifying for relief: One of the ‘nuts’ the Revenue was seeking to crack was that of an individual borrowing money and using it to acquire an asset that qualifies for relief from IHT such as business property, agricultural property or woodlands.
It used to be the case that if a liability were secured on a particular property then the liability reduced the value of that property. A taxpayer may have borrowed against the security of their own home and invested the borrowed money in an AIM share portfolio.
After two years that portfolio should qualify for full relief against IHT and with the reduced value of the house in their estate the taxpayer’s estate would receive a double advantage.
Contrast this with a business owner who needs to inject funds into his struggling company. The bank is unwilling to lend any further money to the company, but is happy to lend the money needed to him personally, secured against his home. The funds previously could have been introduced as additional share capital and, as with the AIM portfolio, after two years they should qualify for additional relief.
Now, in the event of the shareholder’s death, the full value of his home will be charged to IHT, even though the mortgage will need to be repaid and funds may not be available to do this.
Purchasing excluded property: Broadly, if an individual is non-domiciled then they will only pay IHT on their assets located in the UK. Any assets held off-shore will be classed as excluded property for IHT purposes and will not be chargeable. If the non-domiciled person borrowed against their UK home and used the funds to invest offshore, previously IHT would only have been paid on the net value of their home after deducting the value of the mortgage. Now the full value of their home will be chargeable.
Timing: As with many things, timing can have a significant impact. In the case of loans taken out to buy business or agricultural property or woodlands, only those taken out after 6 April 2103 are caught by the new rules. The new rules apply to all deaths or chargeable events on or after 17 July this year.
Are there any opportunities left?: One planning option unaffected by the new rules is for an individual to borrow against his property and to use the money to make a gift to his children or grandchildren.
This obviously carries the disadvantage that he will need to fund the costs of maintaining the borrowing, but as long as that can be managed this planning can still work well.
There is a degree of uncertainty in the new provisions. It will be interesting to see if the Revenue challenges individual situations.
In the meantime, it is sensible to review a client’s affairs if they have high value loans or loans from family members or trusts to see if there is an alternative structure which may result in a lower IHT charge.
Frances Davies is a partner and the head of Gordons’ private client department
Key points
- Under the new rules the basic premise is that a liability can only be deducted for IHT purposes if it is repaid out of the estate.
- Probate papers should be completed as normal and if a liability is not repaid then a corrective account will need to be completed by the executors.
- Any assets held off-shore will be excluded property for IHT purposes and will not be chargeable.
