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The Pre-Owned Asset Income Tax Regime and the Home-Loan Scheme

05 May 2005

Various types of Home-Loans Schemes have been entered into over the last few years but typically they involve the following steps:-

1. Taxpayer owns a valuable house but wishes to avoid any IHT being paid on its value at his death. He sets up a Life Interest Trust ("Trust A") under which he can enjoy the income of the Trust Fund ("Trust Fund A");

2. The taxpayer sets up a second trust ("Trust B") for the benefit of his children. He himself is excluded from benefiting from the Trust Fund ("Trust Fund B");

3. Taxpayer sells his house to Trust A but since Trustees of Trust A have no cash to purchase the property, the purchase price is left outstanding as a loan due from the Trustees of Trust A to the taxpayer;

4. The taxpayer gives the benefit of the loan to Trust B. this gift would become taxable if the taxpayer fails to survive the gift by at least 7 years;

The Effect of the Scheme

On the taxpayer's death, the value of Trust Fund A (i.e. the property) must be added to the value of the rest of the taxpayer's estate for the purpose of calculating IHT. However, the existence of the loan will reduce the value of Trust Fund A to nil (assuming the property has not gone up in value since the date it was sold to the Trustees of Trust A). The result of this is that no IHT would be payable on the taxpayer's death in respect of the property, provided that the taxpayer survived the gift of the loan to Trust B by 7 years.

The Regime as it applies to the Home Loan Scheme

The Regime was specifically introduced to target the Home Loan Scheme, although there may be some technical arguments for saying that the Regime is ineffective in the case of Home Loan arrangements.

For its success as a weapon against the Home Loan Schemes, the Regime relies upon the loan as being treated as " an excluded liability" but to be "an excluded liability" the Regime provides that:-

a. "The creation of the liability[ let us call this "transaction a"], and

b. Any transaction by virtue of which the person's estate came to include the relevant property or property which derives its value from the relevant property or by virtue of which the value of property in his estate came to be derived from the relevant property [let us call this "transaction b"]

c. Were associated operations as defined in Section 268 Inheritance Tax Act 1984"

The draftsman of this provision seems to assume that the date of the creation of the loan [transaction a] and the date of the transfer by which the property becomes comprised in the taxpayer's estate [transaction b] was, in both cases, the date on which the property was sold to the Trustees of Trust A. Arguably the property became comprised in the taxpayer's estate when the taxpayer first acquired it - perhaps many years before the setting up of the Home Loan Scheme.

But even if the draftsman is correct, it may be possible to "disassociate" transaction a from transaction b by the Trustees of Trust A appointing Trust Fund A (property and loan) outright to the taxpayer. Care would need to be taken to ensure that there were no Stamp Duty Land Tax problems.

If, for whatever reason, it later proves to be the case that the Regime is unsuccessful in targeting the Home Loan Schemes, then almost certainly the legislation will be amended to close the loopholes.

The Election

The time limit for making an election under the Regime for schemes in existence as at 6th April 2005 is 31st January 2007.

Taxpayers in these circumstances will have to consider:-

a. Whether they can afford to pay the income tax charge (i.e. effectively if higher rate taxpayers 40% of the full market rental value of the property).

b. If no election is made prior to 31st January 2007 it will be too late to make an election.

c. An election cannot be made by the taxpayer's personal representative so that it must be made during the taxpayer's life.

d. For taxpayers who will be leaving the property shortly - perhaps because they may need to go into a nursing home in the not-to-distant-future - the election should not be made.

The Effect of the Election

Under the Regime, the purpose of the election is to give the taxpayer, who would otherwise be subject to the Regime, the opportunity to opt out of the Regime and so avoid the income tax charge. The taxpayer does this by opting to come within the Reservation of Benefit Rules ("the ROB Rules"). In so doing the taxpayer makes himself liable to IHT in respect of the property, on his death.

However, the legislation as drafted may not work as intended. The mechanism of the election operates by invoking the provisions of Section 102(3) Finance Act 1986 (see note 1.) but that section may not work in the circumstances of the Home Loan Schemes.

Furthermore, if the election is made the liability (i.e. the loan which was an excluded liability under the Regime may still be a deductible liability under the ROB Rules. In other words, it may be possible to make the election to opt out of the income tax charge and into the inheritance tax charge but enjoy the benefit of being able to deduct the liability when the inheritance tax charge has to be calculated.

What should the Taxpayer now do?

It is difficult to asses how effectively the Regime will, in practice, apply to Home Loan Schemes because:-

a. the liability may not be an excluded liability if it can be disassociated from the "transaction"; and

b. if the election is made, the liability may still be deductible under the ROB Rules;

If the taxpayer wishes to preserve the IHT benefit then he should seek to disassociate the liability from the transaction and then seek to argue that the income tax charge does not apply on the grounds that the liability can still be deducted.

If the taxpayer wishes to avoid the income tax charge, then he should elect and have his executors argue that on his death the loan is deductible for IHT purposes.

Each case will have to be considered on its own merits and many factors will be relevant in determining the best strategy to be deployed for each client.

Notes

1. Schedule 15 para 21(2)(b) Finance Act 2004 provides as follows:-

(i) If an election is made the regime shall not apply;

(ii) Section 102(3) and (4) of Finance Act 1986 shall apply;

(iii) Section 102(3) deals with the situation where on the death of the taxpayer there is property subject to a reservation and provides that, for the purposes of IHT, he is to be treated as beneficially entitled to that property immediately before his death; and

(iv) However, Section 102(3) only applies to the extent that the property "would not apart from this section, form part of the donor's estate immediately before his death"

For more information please contact Harvey Barrett, Partner.
 

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