UK: Pre-owned Assets Tax

The Finance Act 2004 introduced an income tax charge on what the Revenue press releases referred to as "pre-owned assets": the income tax is on income that does not exist; the assets do not necessarily need to be pre-owned. In general, commentary on the new tax has been hostile: pre-owned assets tax has been called, amongst other things, a ‘mongrel’ tax and a ‘wealth tax in disguise’. It is perceived to be an attack on widely-marketed inheritance tax mitigation arrangements – Ingram, Eversden and the so-called ‘double trust’ schemes - which operate to allow individuals to live in what is effectively their principal residence, the capital value of which is removed from their estates. These schemes rely on successful potentially exempt transfers ("PETs") of property where the donor manages to retain an enjoyment of that property without falling foul of the reservation of benefit provisions.

Pre-owned assets tax is to take effect from 6 April 2005. It has what the Revenue has chosen to call ‘retroactive’ effect and what most people would see as retrospective effect in that it applies to arrangements put in place on or after 18 March 1986. This date is the one on which PETs and the reservation of benefit provisions were introduced suggesting further that what is being targeted is inheritance tax planning relying on successful use of the former and avoidance of the latter.

The provisions are contained within schedule 15 to the Finance Act 2004 and references to paragraphs in this bulletin are references to paragraphs within that schedule. References to the "1984 Act" are to the Inheritance Tax Act 1984, to the "1988 Act" to the Income and Corporation Taxes Act 1988, and to the "1992 Act" to the Taxation of Chargeable Gains Act 1992.

All UK residents are potentially within the charge. Non-UK residents are outside the scope of the tax.

UK resident and domiciled individuals are caught in respect of worldwide property that they occupy or enjoy. Non-UK domiciled individuals are only caught in respect of UK situated property that they occupy or enjoy.

Three categories of property fall within the scope of pre-owned assets tax:

1. land;
2. chattels; and
3. intangible property comprised in a settlorinterested settlement.

More than one part of an arrangement can be caught; for example, a structure in which a house is held by a company held by a trust is potentially caught twice: the house is land; and the shares are, depending on the terms of the trust, intangible property comprised in a settlorinterested settlement. Provisions prevent double taxation but each situation must be reviewed to see what is caught and which exclusions and exemptions apply, if any.

The charge on land is contained within paragraph 3. Paragraph 3 applies where, in any year of assessment, an individual ("X") occupies any land (the "Land"), whether alone or together with other persons, and satisfies one of the ‘disposal’ or ‘contribution’ conditions. These conditions are where, after 17th March 1986:

1. X disposed of an interest in the Land (disposal condition 1).

2. X disposed of an interest in other land, the sale proceeds of which were applied by another to acquire the interest in the Land (disposal condition 2).

3. X directly or indirectly provided any of the consideration for the purchase of an interest in the Land (contribution condition 1).

4. X directly or indirectly provided any of the consideration used by another person for the acquisition of any other property the sale proceeds of which were applied by another to acquire the interest in the Land (contribution condition 2)¹.

Note that X acting as a guarantor for borrowings used by another to purchase any property does not necessarily make X the provider of consideration for the purchase of that property (paragraph 17). Commentary suggests that this applies even if X provides security for the guarantee or deposits funds with a bank as a back-to-back loan.

The calculations appear complicated. They operate to establish an ‘appropriate rental value’ - which is based on the land’s ‘annual value’- and a capital value for the land. The annual value will be slightly higher than an open market value as the legislation assumes that repairs and insurance costs will be borne by the landlord. The valuation date to establish the capital value of the land is to be announced in regulations which have not yet been published.

Payments to the legal owner of the land under a legal obligation are eligible deductions from the charge so properties which are caught should have their maintenance costs paid under a binding obligation on the occupant to mitigate the charge to tax.

Individuals occupying land which they have given away have sought to avoid the reservation of benefit provisions by paying a full market rent for their occupation. Provided that it is full consideration, then the land should be exempt from pre-owned assets tax: see further below.

The charge on chattels in contained within paragraph 6. Paragraph 6 applies where, in any year of assessment, an individual is in possession of, or has the use of, any chattel, whether alone or together with other persons, and satisfies one of the disposal or contribution conditions which follow the form of the conditions applying to land.

A calculation is required to discover the ‘appropriate amount’. This is based on ‘notional interest’, which is established by reference to the prescribed rate of interest, and the value of the chattel at the valuation date.

Individuals enjoying chattels which they have given away have sought to avoid the reservation of benefit provisions by paying a ‘full rent’ for their enjoyment. Provided that it is ‘full’ consideration, then the chattels should be exempt: see further below.

"Intangible property" means any property other than chattels or interests in land, for example: shares; insurance policies; and bank accounts.

The charge applies to intangible property within a settlement where:

1. that intangible property is or represents property settled by X; and
2. the terms of the settlement² are such that any income arising from the intangible property within it would be treated as the income of X by section 660A of the 1988 Act (the fact that no actual income arises is irrelevant)³.

This catches shares held by a trust, but not intangible property transferred to a company owned by the trust. Land or chattels held directly by a trust are obviously not caught by the intangible property provision (but will be caught if the settlor occupies the land or enjoys the chattels under the separate provisions for land and chattels referred to above).

The "chargeable amount" for intangible property is the notional interest return on the property based on the prescribed rate of interest and the value of the property at the valuation date.

Allowable deductions include taxes payable in respect of the property by the taxpayer under, for example, sections 660A or 739 of the 1988 Act (attribution of trust income to the settlor) or sections 77 and 86 of the 1992 Act (attribution of trust gains to the settlor).

A disposal condition (see above) will not be satisfied if the disposal is an excluded transaction. Similarly, a contribution condition (see above) will not be satisfied if the provision of property is an excluded transaction. The exclusions apply only to land and chattels, not to intangible property comprised in a settlorinterested settlement.

In summary, the following transactions are exempt from pre-owned assets tax:

1. Arms’ length transactions of land and chattels Where the ‘disposal condition’ is of the individual’s whole interest in the property, except for any right expressly reserved by him over the property, either with a person not connected with the individual or by a transaction such as might be expected to be made at arm’s length between persons not connected with each other, then the transaction is excluded.

1. Where the ‘disposal condition’ is the individual’s transfer of the property to his or her spouse (or to a former spouse under a Court Order), the transaction is excluded: note that this transfer does not need to be by way of gift;
2. Where the ‘contribution condition’ is the individual’s provision of consideration to his or her spouse (or to a former spouse under a Court Order), to acquire any property, the transaction is excluded.

1. Where the ‘disposal condition’ is the individual’s gift of the property to a settlement giving his or her spouse (or to a former spouse under a Court Order), a life interest, the transaction is excluded.
2. Where the ‘contribution condition’ is the individual’s provision of consideration to the acquisition of property which becomes settled into a trust granting his or her spouse (or former spouse if settled under a Court Order), a life interest.

These exclusions will not apply if the spouse’s (or former spouse’s) life interest comes to an end during his or her lifetime.

Disposals and the provision of consideration for family maintenance (which are relieved from inheritance tax under section 11 of the 1984 Act) are excluded transactions.

5. Annual Exemption and small gifts Disposals and the provision of consideration which are ‘outright gifts’ which fall within the annual exemption from IHT (currently £3,000) or the small gifts exemption from IHT (currently £250 per gift) are excluded transactions.

This excluded transaction incorporates into the regime the equivalent of a potentially exempt transfer and applies where the ‘contribution condition’ constituted an outright cash gift (in any currency) by the individual to another person which was made at least seven years before the earliest date on which:

1. in the case of land, the individual occupied the land, whether alone or together with any persons;
2. in the case of a chattel, the individual was in possession of, or had the use of, the chattel, whether alone or together with any persons

An individual is not chargeable in a year of assessment if the appropriate chargeable amount for the land, chattels or settled intangible property charge does not exceed £5,000.

If the transaction is not an excluded one, consideration needs to be given to see whether it is exempt. The exemptions only apply to land and chattels. In general terms, the exemptions are:

There is one important exception to this general exemption. If the value of a person’s estate is reduced by an ‘excluded liability’ affecting any property, that property is not treated as comprised in the person’s estate except to the extent that the value of the property exceeds the amount of the "excluded liability". A liability is an excluded liability if it and any transaction by virtue of which the person’s estate came to include the relevant property (or property derived directly or indirectly from it) are associated operations.

This effectively scuppers the "home loan" inheritance tax saving schemes. These worked by X settling a trust granting himself a life interest. He then sold his house to the trust with consideration being left outstanding and the loan being interest-free. X then settled A&M or life interest trusts for his children from which he and his wife were excluded from benefit and settled the right of repayment onto these trusts, thus effecting a potentially exempt transfer. If X survived 7 years, the PET became absolutely exempt and, on his death, the value of the house was reduced by the amount of the debt.

Under the pre-owned assets regime, the creation of the debt is connected to the house so constitutes the associated operation necessary to make the debt an excluded liability as soon as X settles his right to its repayment into the trust from which he is excluded

Relevant property which is within the reservation of benefit provisions or which would be were full consideration not provided is exempt. So is relevant property which derives its value from property in which a benefit has been reserved.

There is an important point to bear in mind here when looking at a structure created by a non-UK domiciled individual. Whilst the Revenue has agreed that the excluded property rules override the reservation of benefit provisions, that does not mean that a benefit ceases to be reserved in an excluded property settlement. Where there is such a benefit, the reserved benefit exemption the reserved benefit exemption will apply (see further below).

All dispositions made of interests in the estate of a deceased person are disregarded for regime purposes, the most obvious being a s142 variation ⁴.

Non-UK domiciled individuals who are resident in the UK only need to worry about property situated in the UK: the tax exempts:

1. foreign situs property they occupy;
2. foreign situs chattels they enjoy; and
3. foreign situs intangible property owned by settlements they have settled and in which they retain an interest.

In addition, when considering someone who was formerly domiciled outside the UK, the legislation provides that no regard is to be had to any property which is excluded property for inheritance tax purposes.

Where a benefit has been reserved in relevant property, or in property which derives its value from the relevant property, the relevant property will be exempt (and will maintain its excluded property status if it had it).

The house is situated outside the UK and is therefore outside the regime until the individual becomes domiciled in the UK. The shares constitute intangible property within a settlorinterested settlement. They are exempted under 2 counts: they are included within the individual’s IHT estate; and constitute property from which the trust in which a benefit has been reserved derives its value.

The shares are excluded property and are therefore exempt. The house, because it is situated in the United Kingdom, is potentially caught. However, if the individual has an interest in possession in the trust, the IHT estate exemption (see exemption 1 above) will be available in respect of the house, (to the extent that the value of the house exceeds any ‘excluded liability’). In addition, the shares derive their value from the house which brings the house into the derivative exemption (see exemption 2 above). If the trust is discretionary, the settlor has reserved a benefit under it, so the derivative reserved benefit exemption (see exemption 3 above) will apply.

If the individual becomes UK domiciled, the shares remain excluded property and thus exempt. The land, however, seems potentially caught under the land charge. The Revenue has not confirmed that this point would not be taken but to do so would be moving beyond what the legislation was drafted to prevent, namely avoidance of the reservation of benefit provision. The tax treatment of UK situated land held by an offshore structure where the settlor becomes UK domiciled is still a moot point.

On or before 31 January in the tax year following the first year of assessment in which the relevant property is caught (i.e. 31st January 2007 for most tax payers; 31st January of the year following their change of domicile status for those UK residents who become UK domiciled at a later date), taxpayers can elect to opt out of preowned assets tax and be taxed instead under the reservation of benefit provisions.

It may make sense to elect to be taxed under the reservation of benefit provisions in the following circumstances:

1. when the property qualifies for spouse exemption, agricultural property relief or business property relief;
2. when the property may fall within the taxpayer’s nil rate band;
3. where dealing with the UK inheritance tax through life insurance is cheaper than paying pre-owned assets tax.

If a company is in the structure, shadow directorship issues are likely to arise after the election so a liquidation should be considered if other tax consequences do not make it prohibitively expensive.

It may make sense to pay pre-owned assets tax when the taxpayer’s life expectancy is short enough to make it cheaper to pay the tax than for the estate to bear inheritance tax on the property. shares remain excluded property and thus exempt. The land, however, seems potentially caught under the land charge. The Revenue has not confirmed that this point would not be taken but to do so would be moving beyond what the legislation was drafted to prevent, namely avoidance of the reservation of benefit provision. The tax treatment of UK situated land held by an offshore structure where the settlor becomes UK domiciled is still a moot point.

The tax is complicated to apply and compliance will be expensive. It targets inheritance tax mitigation by imposing an income tax charge on income which does not exist. It almost closes the door on the double trust schemes as they stand but loopholes are already evident in the new legislation (third party borrowing gets round some of the contribution conditions) and no doubt these loopholes will soon be exploited.

© RadcliffesLeBrasseur

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.