Plenary: Intellectual capital

The future of inheritance tax

In her article ‘How equality broke the dreams of Europe’s young people’ (World Economic Forum, January 2018), Christine Lagarde raised questions about how and whether we should tax wealth. As she pointed out, wealth taxes are lower today than in 1970 but inequality is higher. Is this a sensible policy?

The UK capital tax system is a mess, with contradictory objectives and reliefs between our two main taxes on transfers of wealth: capital gains tax (CGT) and inheritance tax (IHT). For example, there is no reason why, as a matter of policy, transfers of wealth on death should pass free of CGT but subject to IHT, while lifetime gifts should pass free of IHT but subject to CGT!

Sadly, there is no specific tax regime to deal with transfers of assets between divorcing or separated couples 

As the report of the Mirrlees Review, published by the Institute for Fiscal Studies in 2010, pointed out, despite raising relatively little money (less than £6bn) and affecting less than 5% of all death estates, IHT remains deeply unpopular in the UK. It is widely perceived as double taxation (although we tolerate double taxation elsewhere) and disproportionately hurts those whose main wealth is tied up in their family homes and who cannot afford to make lifetime gifts or use agricultural property relief (APR) or business property relief (BPR), and thus avoid the tax. The rate is high – 40% – but with many anomalies, reliefs and loopholes.

It seems difficult to reform such a complex tax: there are many vested interests. So is it better to give up altogether and not tax wealth on death at all, or tax it at very low rates and instead have CGT on all gifts, whether on lifetime or death? A surprising number of countries have chosen variants of this option – Sweden, India, Pakistan, Italy, Switzerland, Australia, China, Russia, Israel, much of the Middle East, Portugal, New Zealand and Canada.

Office for Tax Simplification report

Some of these questions are discussed in two reports on IHT published by the Office for Tax Simplification (OTS). The first was published in November 2018 and dealt mainly with administrative matters, including possible reform of the IHT forms and review of HM Revenue & Customs (HMRC) guidance for personal representatives (PRs). The OTS noted that the average effective tax rate peaks for estates valued at £6m, and thereafter declines, as assets in high value estates are more likely to be covered by a relief such as BPR or APR. In effect, IHT is regressive for the wealthiest estates.

The second OTS report was published in July 2019, shortly after the Private Client Section annual conference. In its second report, the OTS recommended (inter alia) the following:

• replace the annual gift exemption and the exemption for gifts in consideration of marriage or civil partnership with an overall (possibly higher) personal gifts allowance
• reform the exemption for normal expenditure out of income or replace it with a higher personal gift allowance
• reduce the seven-year period to five years, so that gifts to individuals made more than five years before death are exempt from IHT
• abolish taper relief
• explore options for simplifying and clarifying the rules on liability for the payment of tax on lifetime gifts to individuals and the allocation of the nil rate band (NRB) (one particularly controversial recommendation is the suggestion that PRs should be liable for all tax on all lifetime gifts and reservation of benefit (ROB) property)
• where a relief or exemption from IHT applies on death, such as spouse exemption or BPR, remove the capital gains uplift and instead provide that the recipient is treated as acquiring the assets at the historic base cost of the person who has died
• review whether it is appropriate for the level of trading activity for BPR to be set at a lower level than that for CGT
• consider whether to align the IHT treatment of furnished holiday lets with that of income tax and CGT, where they are deemed to be qualifying trades, provided certain conditions are met.

It will be interesting to see whether the new government adopts any of these proposals, particularly the abolition of the CGT base cost uplift on death. The OTS report does not discuss wider reforms, such as the abolition of IHT or the introduction of a donee-based tax. That discussion is found in the Resolution Foundation Report published in 2018 ‘Passing on – options for reforming IHT’. This advocates root-and-branch reform, including replacing IHT with a donee-based tax. There is also currently an All Party Parliamentary Group on IHT reform, that is due to produce a report this autumn.

Trust reform and complexity

A consultation on the reform of trusts was published in November 2018 “inviting views on the principles that government believes should underpin the taxation of trusts: transparency, fairness and simplicity”.

The consultation document includes the following text.

“5:2 The policy principle underlying the taxation of trusts is therefore neutrality: the starting principle is that tax should neither encourage nor discourage their use and only deviate from this principle where there are clear policy reasons to do so.

“5.3 However, the complicating factor when assessing neutrality is determining which comparator to use. It is possible to approach trust taxation as though the property and/or income of the trust still belongs to the settlor – because the property has not been given outright to the beneficiaries. Alternatively, the property and/or income could be considered to be given free and clear to the beneficiaries without the use of a trust. These different comparative scenarios can give very different results, as can a third option of taxing the property or income as belonging to, and only to, the trustees themselves.

“Which of these possible approaches is genuinely ‘neutral’ depends on the specific terms of the trust and the circumstances of the persons in question.”

Further material is expected to be published in autumn 2019.

It seems difficult to see how genuine reform can take place without a clear set of policy objectives. Take the following example that illustrates some of the problems with our current system of trust taxation.

Example 1

Giles settles a picture worth £1m into a UK-based trust, where he can benefit, along with his issue. He has made no previous gifts. The picture shows a gain on disposal of £200,000.

There is no hold-over relief as the trust is a settlor-interested trust. Giles pays CGT of £40,000 on the gift. The trust pays CGT on future gains over £1m.

Income from the trust (if any) is taxed on Giles under the settlement provisions in the Income Tax (Trading and Other Income) Act 2005.

The transfer is an immediately chargeable transfer for IHT purposes – there is a 20% entry charge on the excess over Giles’ unused NRB. (Giles pays IHT.)

Giles dies 12 years later. There is an ROB for IHT purposes. Hence a further 40% is payable on Giles’ death on the value of the trust assets, with no spouse exemption and no CGT uplift – here, the liability falls on the trustees not his PRs.

In the meantime,10-year and IHT exit charges at up to 6% are payable

Giles might be forgiven for concluding that the above treatment is not neutral or fair.

The position is not much better if Giles’ wife could benefit but Giles is excluded. He avoids 40% IHT on his death, but all the other taxes remain.

Transfer of assets on divorce

Sadly, there is no specific tax regime to deal with transfers of assets between divorcing or separated couples. This is particularly problematic in the context of CGT. Transfers between spouses / civil partners must take place in the tax year in which they are living together: the assets can then be transferred on a no gain, no loss basis (see my article in Tax Adviser 2015 for further details on CGT and divorce). In practice, it is very difficult to agree a settlement quickly enough to avoid paying CGT, especially if the couple separate towards the end of the tax year.

For many divorcing couples, the matrimonial home is their most significant asset. As part of the divorce settlement, it is usual for it to be sold, and the proceeds split or for one partner to transfer their interest in it to the other. In order for full main residence relief to be available, currently the disposal must take place within 18 months of the property ceasing to be the main residence of the transferor. From April 2020, this will reduce to 9 months.

Section 225B of the Taxation of Chargeable Gains Act 1992 provides limited relief on the making of a claim. The transferred property may continue to be treated as the departing civil partner or spouse’s only or main residence until the date of actual disposal if all the following conditions are met:

• the disposal of the interest is pursuant to an agreement made in connection with the separation or dissolution of the marriage or under a court order
• in the period between the date when the disponer leaves and the disposal occurs, the other spouse occupies the house as their main residence
• the transferor has not elected to treat another dwelling as their main residence for any part of the period concerned (they can acquire another house but cannot claim any main residence relief on it, which means potential problems are stored up in the future).

No relief is available under section 225B if the property is sold to a third party and the proceeds split between the couple. The house has to be transferred to the other partner.

By contrast, the stamp duty land tax (SDLT) exemption is more relaxed: transfers of the family home from one spouse / civil partner to another in connection with divorce are exempt from SDLT under paragraph 3 of schedule 3 to the Finance Act 2003 if made “in pursuance of an order of a court made on granting decree of divorce, nullity of marriage or judicial separation” or “in pursuance of an agreement of the parties made in contemplation or otherwise in connection with the dissolution or annulment of the marriage, their judicial separation or the making of a separation order…”.

This is the case even if the transferee spouse takes over the mortgage, as assumption of such liability is not treated as chargeable consideration. Note, though, the need still to transfer the house to the other partner.

Disclosure of tax avoidance schemes

A limited IHT hallmark was introduced on 6 April 2011, covering arrangements whereby a relevant property entry charge was avoided. From 23 February 2016, the scope of IHT disclosure was widened to cover IHT arrangements that are subject to the premium fee and confidentiality hallmarks. From 1 April 2018, the 2011 hallmark was replaced.

The new IHT hallmark applies to arrangements if it would be reasonable to expect an informed observer (having studied the arrangements and having regard to all relevant circumstances) to conclude that two conditions are met.

Condition 1

The main purpose, or one of the main purposes, of the arrangements is to enable a person to obtain one or more of a list of specific advantages in relation to IHT (“tax advantage”). These include:

• the avoidance or reduction of a relevant property entry charge, ten-year anniversary and exit charges
• the avoidance of ROB where there is no pre-owned assets tax charge
• a reduction in the value of a person’s estate without giving rise to a chargeable transfer or potentially exempt transfer (PET).

For example, use of spouse or charity exemptions would fall within this condition.

Condition 2

There must be arrangements involving one or more contrived or abnormal steps, without which a tax advantage could not be obtained.

In the 2018 guidance, HMRC observed that the following would not generally be notifiable:

• gifts to individuals or trusts as normal expenditure out of income – this may breach condition 1, but is not contrived
• gifts to spouse or charity – not contrived.
• gift to a bare trust for a minor beneficiary – this is a PET, so condition 1 is not met.
• gifts of shares qualifying for BPR to trust – not notifiable provided the gift is not followed by a sale shortly thereafter
• gifts into trust every seven years within the NRB
• donor gives house away and pays full consideration for occupation
• settlement of assets into excluded property trusts just before a foreign domiciled individual becomes deemed domiciled in the UK.

Gifts of undivided shares of land where the property is used by the donor and donee are also approved (despite being outside the gifts with ROB rules under section 102B(4) of the FA 1986 and not subject to pre-owned assets tax), but HMRC notes that the analysis might be different “where the donor only retained a very small proportion of the property in comparison to their level of occupation”. Presumably this is referring to the situation where the donor gives away, say, 90% of his house, retaining 10%, and the donee and donor live together. In June 2018, the Society of Trust and Estate Practitioners and Chartered Institute of Taxation sent a list of questions to HMRC requesting clarification on a number of matters on which answers are expected imminently.

Gifts with ROB

With the introduction of the PET concept in 1986, it would have been possible:

• to make a tax-free lifetime gift
• to retain the use of / benefit in the gifted property.

This led to the introduction of the gifts with ROB rules (lifted from estate duty). The key provision is section 102 (1) of the Finance Act 1986 (FA 1986), which is as follows:

“… this section applies where, on or after 28th March 1986, an individual disposes of any property by way of gift and either—

a) possession and enjoyment of the property is not bona fide assumed by the donee at or before the beginning of the relevant period; or

b) at any time in the relevant period the property is not enjoyed to the entire exclusion, or virtually to the entire exclusion, of the donor [limb 1] and of any benefit to him by contract or otherwise [limb 2]; and in this section “the relevant period” means a period ending on the date of the donor’s death and beginning seven years before that date or, if it is later, on the date of the gift.”

This is a penal rule. See example 1 above. The donor is subject to IHT on death; there is no CGT uplift on death. There is no spouse exemption, so IHT is paid earlier. The property is still part of the donee’s estate, so can be taxed on his death.

Generally, gifts between spouses are protected from gifts with ROB problems by section 102(5) of the FA 1986, but watch gifts between cohabitees, as these are not protected from the rules even if they later marry.

Example 2

Henry gives his London flat to his boyfriend in 2004. In 2019, they finally marry, and Henry uses the flat rent-free. There is an ROB on his death that is not cured by the marriage.

Henry should have retained a share in the London flat and taken advantage of section 102(B) of the FA 1986, discussed below.

Co-ownership let-out (section 102B(4) of the FA 1986)

Example 3

Rosie, a widower, owns the family home, and has a son and daughter. Her daughter Elouise uses it as a second home. Rosie gives a 50% share of her house to Elouise and they continue to share the home. She leaves her retained share to her son in her will.

There is no ROB on Rosie’s death, provided Elouise continues to occupy the property (at least while Rosie is occupying it) and Rosie receives no collateral benefit (so Elouise must not pay Rosie’s share of the bills). It is not necessary for Elouise to stay there full time. Note that the exemption only applies if there is a gift of an undivided share rather than the whole. Watch equality between members of the family, as remember that if Rosie dies within seven years of the gift, her unused nil-rate band will be allocated first against the lifetime gift, potentially leaving much less for the son. In Example 2, if Henry had retained a share in the property rather than giving all of it away, this exemption could have been claimed.

In my session at the conference, I discussed in some detail the particular ROB conditions under section 102 of the FA 1986, and the extensive case law in this area, in particular the comments of Lord Justice Henderson in Hood v HMRC [2018] EWCA Civ 2405. Here, the judge stressed the need to identify carefully the gifted property and establish whether any new benefits are received by the donor. For more on this, see the recent updates of the chapter on ROB and home loan schemes in Dymonds Capital Taxes (Sweet and Maxwell).

The talk ended with a discussion on home loan schemes, noting the recent test case and considering the best way of winding these up.