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Pre-Owned Asset Income Tax Regime Applicable to Land - An Introduction

05 May 2005

The new Pre-owned Asset Regime ("the Regime") was introduced by the Finance Act 2004. The Regime imposes an Income Tax charge on an individual taxpayer who occupies land after he has disposed of it. To be liable to tax under the Regime, the individual must occupy the land at any time after 5th April 2005 and must previously have disposed of the land at any time after 17th March 1986.

The Regime is particularly targeted at certain inheritance tax saving schemes, which have been gaining in popularity over the last few years. The most notable of such schemes are:-

a. The Home-loan Scheme;

b. The Lady Ingram Scheme;

c. The Reversionary Lease Scheme;

d. The Eversden Scheme; and

e. Chattel arrangements.

For those individuals, who have entered into the Home-loan Scheme these notes are intended:-

a. To inform them how they might be affected by the new tax Regime; and

b. To enable them to identify what opportunities might be open to them to avoid a Regime charge or an inheritance charge or both.

This should then allow those individuals to decide a strategy that would best suit their circumstances (see note 1.) .

First, however, it is necessary to have an appreciation of how the new Regime is constructed and is intended to apply.

To determine if indeed there is a charge under the Regime, the following string of questions need to be followed to conclusion:-

  1. Is an individual in occupation of a property (land or buildings)? If the answer to that question is "Yes", then:
  2. Was the property in question disposed of by the individual after March 1986? Alternatively, has the individual since March 1986 made any gift or disposal of any assets which themselves can be traced through to the acquisition of the occupied property? If the answer to either one of those two questions is "Yes", then:
  3. Was the disposal "an Excluded Transaction?" If the answer to that question is "No", then:
  4. Would one of the exemptions from charge apply? If the answer to that question is "No", then:
  5. The Regime applies

It may be helpful to consider, in a little more detail, each of these questions in turn.

Occupation

Unlike the concept of "occupation" as that term is used for the purposes of "Principal Private Residence" in the Capital Gains Tax legislation (where it is not possible to have more than one "Principal Private Residence" at any one time) it is possible, for the purposes of the Pre-Owned Asset Regime, to occupy more than one property at the same time. Indeed, merely storing your furniture in a property may constitute "occupation". However, a mere right to occupy does not, of itself, constitute occupation.

Disposal or Contribution The purpose of the Regime is to identify whether the property that is now being occupied by the individual either:

a. Has at any time since March 1986 been owned by the individual or

b. Can have its acquisition traced back to any gift or disposal by the individual since March 1986.

These two possibilities are known as "the Disposal Condition" and "the Contribution Condition", respectively.

The Disposal Condition will be met in either of the following two examples:-

a. X disposes of Blackacre to Y and X then occupies Blackacre.

b. X disposes of Blackacre to Y, Y sells Blackacre and with the proceeds of sale purchases Whiteacre. X occupies Whiteacre.

The Contribution Condition is met in the following three examples:-

a. X gives cash to Y. Y purchases Blackacre. X occupies Blackacre.

b. X disposes of Blackacre to Y. Y exchanges Blackacre for Whiteacre. X occupies Whiteacre.

c. X gifts cash to Y. Y purchases Blackacre. Y sells Blackacre and with the proceeds of sale purchases Whiteacre. X occupies Whiteacre.

Excluded Transaction

Even if the Disposal Condition or the Contribution Condition has been met, the Regime will still not apply if the transaction concerned was " an Excluded Transaction".

The following transactions are excluded whether the Disposal Condition or the Contribution Condition is being considered:-

a. The transaction is treated as excluded (and so the Regime does not apply) where the transfer (i.e. disposal) in question is to a spouse;

b. The transaction is treated as excluded (and so the Regime does not apply) where the transfer (i.e. disposal) in question is to Trustees of a Trust in which the spouse has "an interest in possession" (in other words a life-interest);

c. The transaction is treated as excluded (and so the Regime does not apply) where the disposal was for the purpose of family maintenance (see note 2. ) .

d. If the Disposal Condition would otherwise be met, it will nevertheless be an excluded transaction if the disposal was an arms length sale for the whole of the individual's interest in the property.

e. If the Contribution Condition would otherwise be met, then it will nevertheless be treated as an excluded transaction if the contribution in question is cash and there was an outright gift of cash more than 7 years prior to the occupation of the property.

Exemption from Charge

As can be seen from the above, if there is occupation of the property and the Disposal Condition or the Contribution Condition has been met and is not otherwise to be treated as an excluded transaction, the question is then whether there is, nevertheless, an exemption from charge.

There are three main exemptions and they are as follows:-

  • The value of the occupied property is comprised within the donor's estate for Inheritance Tax purposes. This might be, for example, because the property is held in trust and the donor occupies as a life tenant of that trust. There is an important limitation to this exception which applies to ensure that the Regime catches the so called "Home Loan Schemes". If the property in the Trust (in which the donor occupier has a life interest) is subject to a liability the creation of which satisfies certain conditions then the exemption from the Regime will be limited. Such a liability is known as "an excluded liability".
  • There is an exemption from charge if the property in question is subject to the "gift with reservation of benefit rules ". The exemption will still be available if the property is not subject to the reservation of benefit rules but would be subject to those rules but for the fact that any one of the following cases apply:-

(i) The occupation of the property is shared by the donor and the donee;

(ii) A full market rent is charged for the occupation of the property;

(iii) The donor, when he made the gift, had no intention of occupying the property but through age, infirmity or otherwise is unable to maintain himself and the occupation of the property represents reasonable provision by the donee for the donor's care and maintenance.

  • Where the disposal was effected through a Deed of Variation (see note 3. ) it will not be treated as having been made by the original beneficiary.

The Charge to Tax

If the necessary conditions are satisfied, so that

  1. there is occupation, AND
  2. the Disposal Condition or Contribution Condition has been met, AND
  3. the disposal or contribution is not an excluded transaction, AND
  4. none of the exemptions apply, then

it will be necessary to calculate the amount of tax payable.

The amount chargeable to Income Tax in any year of assessment is calculated according to the following formula:-

CA = R x (DV ÷ V) - P

Where:

a. CA = chargeable amount which is treated as income and is chargeable to Income Tax in the year of assessment.

b. R is the Rental Value, which is the rent that would have been payable for that period if the property in question had been let at an annual rent equal to the Annual Value.

Annual Value = the rent reasonably obtainable assuming:-

(i) the tenant undertakes to pay all taxes, rates and charges usually paid by a tenant and:

(ii) the Landlord undertakes to bear the costs of repair and insurance and other expenses necessary for maintaining the property in a state to command that rent.

c. DV = valuation of interest disposed of (i.e. as at 6th April 2005 in relation to the tax year 2005/2006).

d. V = market value of relevant land (as at 6th April 2005 in relation to the tax year 2005/2006). (see note 4.)

e. P = amount paid in pursuance of any legal obligation to the land's owner in respect of his occupation.

If the property were sold at an undervalue, and was not therefore regarded as exempt under the Regime, the Rental Value (R) is multiplied by the fraction

(MV-C) ÷MV

where:

MV = the value of the interest in the land at the time of sale
C = consideration paid

So;

CA = (R x (DV÷V) x ((MV-C) ÷MV)) - P

The following examples may serve to illustrate:-

Example 1 - Sale of land at undervalue

Assume Y sells for £800,000, property worth £1 million and the rental value is £50,000, then the appropriate rental value will equal:-

£50,000 x ((£1 million - £800,000) ÷ £1 million) = £10,000 (see note 5.)

Example 2 - Ingram Type Scheme Assume X effected an Ingram Scheme gifting freehold and retaining a lease, and suppose:-

a. at the valuation date the property was worth £1 million; and

b. at the valuation date the unencumbered freehold was worth £600,000; and

c. at the valuation date the rental value was £50,000.

In this case, the Chargeable Amount will equal

£50,000 x (£600,000 ÷ £1 million); = £30,000

Annual Exemption

If the Chargeable Amount (CA) when added to the amount (if any) paid in respect of the occupation (P) does not exceed £5,000 in the year of assessment then the individual in not chargeable to income tax under the Regime.

The Motive Test

It is important to note that there is no Motive Test. In other words, the Regime will apply to a taxpayer regardless of whether or not he has intentionally entered into a tax saving arrangement. Entirely innocent transactions can (and will) be caught by the new Regime!

Opt-out Election

The new Pre-owned Asset Income Tax Regime is somewhat unusual in that it introduces the option for the taxpayer to elect out of the Regime. If, however, the taxpayer elects to opt out of the Regime, he at the same time must elect to opt into the Reservation of Benefit Regime. It should be noted that as a result of opting out of the Pre-owned Asset Regime and into the Reservation of Benefit Regime, an Inheritance Tax charge will arise on the death of the taxpayer. That additional Inheritance Tax liability will be payable by the owner of the property, who may well not have been consulted by the taxpayer when the taxpayer decided to exercise his right to opt out of the Pre-owned Asset Regime!

In order to opt out of the Regime:-

a. the individual concerned must be chargeable in the year of assessment to the new Pre-owned Asset Regime and;

b. must not have been chargeable in the previous year of assessment.

In other words, there will be a time limit in relation to the election.

The election:-

a. will cause the property to be treated, for Inheritance Tax purposes, as if it were subject to a reservation of benefit; and

b. must be made in the prescribed manner on or before the Relevant Filing Date (31st January in the year of assessment immediately following "the Initial Year"), and

c. can be withdrawn or amended at anytime during the individual's life before the "the Relevant Filing Date"

Regulations

On Budget Day 2005 the government issued Regulations intended to clarify the operation of the Regime. The Regulations confirmed that the valuation of land has to be undertaken as at 6 April 2005 or on the first day the client becomes subject to the charge, if later. The land then has to be re-valued thereafter at 5 yearly intervals.

The Regulations do not explain how the taxpayer will know that his valuation has been accepted by the Inland Revenue (see note 6.) .

Difficulties in Self-Assessment

Failure to file a Tax Return might result in interest and penalties as well as tax. Taxpayers may well be unaware that they are indeed chargeable to tax under the Regime and the fact of their liability may only come to light many years later. If in doubt it may be worth making a "protective election" to avoid the tax.

Notes

1. It should be appreciated that there are very many different types of Home-loan Schemes and the circumstances of the individual taxpayers will differ.

2. A disposition is treated as a "disposition for the maintenance of the family" if e.g. it is for the maintenance, education or training of a child or is made as reasonable provision for the care or maintenance of a dependant relative (i.e. one who is incapacitated by old age or infirmity from maintaining himself) or the widowed, separated or divorced mother or mother-in-law.

3. A Deed of Variation here means a gift made in a particular way from an inheritance..

4. DV and V will only be different in value of the taxpayer disposed of less than his entire interest in the property.

5. This adjustment would only apply in respect of cash sales (not available on a property exchange) and has to be a sale of the whole interest (if the sale is part of an interest only then there may be a reservation of benefit so the Regime will not apply). There will not be a reservation of benefit if there is a sale at an undervalue in pre 1999 Ingram Schemes or Reversionary Lease Schemes.

6. With self-assessment, the taxpayer can volunteer his computation of the Rental Value but will not know for sure whether that has been accepted by the Inland Revenue.

For more information please contact Harvey Barrett, Partner.
 

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