Business Property Relief – The Two Year Rule

By | 17 May 2008

Ownership requirement

It is relatively well known that to qualify for Business Property Relief (BPR) for Inheritance Tax (IHT) purposes, there is a general requirement that the business property must have been owned for a minimum period of two years (IHTA 1984, s 106). However, there are certain exceptions to this basic two-year ownership requirement, in connection with replacement property, acquisitions on death and successive transfers respectively.

Replacement property

With regard to the first of these exceptions (the ‘replacement property’ rule), the ownership test is treated as satisfied if the property replaced other business property eligible for relief, provided that the combined period of ownership is at least two years out of the preceding five years (IHTA 1984, s 107(1)). However, the BPR available is restricted to what it would have been had the replacement or any one or more of the replacements not been made (s 107(2)). The replacement property rule may be helpful in certain circumstances:

  • Incorporation of a business (i.e. the acquisition of the business by a company controlled by the former business owner);
  • Partnerships changes – resulting from the formation, alteration or dissolution of a partnership (e.g. retiring from one partnership to form another);
  • Company reorganisations, etc – the ownership period of unquoted shares which would (under the CGT rules in TCGA 1992, ss 126-136) be identified with other qualifying shares previously owned may be treated as including the ownership period of the original shares (s 107(4)).

For situations within either of the first two bullet points, the potential restriction in BPR mentioned above is disregarded (s 107(3)).

A recent IHT case (The Executors Of Mrs Mary Dugan-Chapman & anor v Revenue & Customs Commissioners (2008) SpC666) concerned a BPR claim that relied on the company reorganisation exception to the two-year ownership rule mentioned above. In that case, Mrs Dugan-Chapman (Mrs DC) was allotted one million ordinary shares in the company on 27 December 2002, two days before her death. The issue was broadly whether those shares could be identified for BPR purposes with other shares in the company which she had held for at least two years prior to her death.

Unfortunately, the Special Commissioner dismissed the executors’ appeal against HMRC’s determination that the value of those shares could not be reduced by BPR. HMRC had contended that the shares were issued as the result of a simple subscription for shares. There was insufficient evidence or documentation to support the executors’ argument that a reorganisation had actually taken place. For example, only Mrs DC took shares on 27 December 2002. A rights issue would involve the other shareholders renouncing their pro-rata entitlement, so that Mrs DC could acquire the full million shares.

Practical points

Two points from the case may be of possible interest to firms, concerning BPR and also in terms of acting for family and owner-managed companies generally.

  • Firstly, 300,000 shares had been allotted to Mrs DC on 23 December 2002 (i.e. six days before her death) as a pro-rata entitlement on a rights issue, following the conversion of a loan account of £300,000 that Mrs DC had with the company. It was agreed that those shares qualified for BPR (i.e. as a result of IHTA 1984, s 107(4)). The case is a useful reminder that director’s loan account balances do not qualify for BPR. It also provides a useful potential planning point on how to address this issue.
  • Secondly, the executors in the above case stated that the company conducted its affairs with relative informality. They raised the principle established in Re: Duomatic Ltd ([1969] 2Ch 365) which broadly allows certain formalities to be treated as satisfied. They argued (unsuccessfully, in the circumstances) that the rights issue had effectively taken place so that events should be interpreted as if it had. However, it may be possible to argue that the Duomatic principle applies if, for example, a director’s bonus has not been determined by a company resolution, but had nevertheless been approved less formally by the business owners (see the Employment Income Manual at paragraph 42300).

The above article is taken from the Mark McLaughlin Associates eNewsletter (March/April 2008). To receive future copies, contact us.