IHT: Deductions for liabilities

By | 19 July 2013

Inheritance tax (IHT) anti-avoidance measures were announced at Budget 2013 without prior consultation and introduced in Finance Act 2013, affecting IHT deductions for liabilities. The background to the changes is that IHT is normally charged on the net value of a deceased person’s estate, after deducting liabilities outstanding at the date of death, and also after deducting any relevant IHT reliefs and exemptions, as well as the nil rate band, if available.

The main IHT legislation dealing with liabilities before the changes was contained in IHTA 1984, s 162. The effect of the new legislation is to amend s 162(4) and (5), so that the rules in those subsections concerning liabilities only apply to the extent that one of the changes being introduced does not apply.

Excluded property

Finance Act 2013 introduces three main provisions, all of which appear to be aimed at IHT avoidance. The first of these is a new IHTA 1984, s 162A, dealing with liabilities relating to excluded property. In broad terms, ‘excluded property’ is non-UK property which is beneficially owned by a non-UK domiciled individual (IHTA 1984, s 6(1)). In addition, settled property is excluded property if it is situated outside the UK and the settlor was domiciled outside the UK when the settlement was made (s 48(3)(a)). The importance of excluded property is that it falls outside the charge to IHT, whether it is property transferred during lifetime (s 3(2)), or is property owned on death (s 5(1)), or is property held in a settlement (ss 53(1), 58(1)(f)).

To illustrate how the new rule in s 162A will work, the following example looks at a situation prior to the changes, which s 162A is probably aimed at.

Example 1 – Excluded property

Manuel is a non-UK domiciled individual for IHT purposes. He has a property in the UK worth £750,000. Because the property is situated in the UK, it is not excluded property, and it therefore forms part of Manuel’s estate for IHT purposes.

Manuel took out a loan of £500,000. The loan is secured against his UK property. He subsequently invested the proceeds in a foreign property. If Manuel died before s 162A was introduced, what would his IHT position be in the UK?

His only UK asset is his property worth £750,000. However, this is subject to the loan of £500,000, so the net value is only £250,000. Manuel also has the foreign property worth £500,000. However, this is non-UK situs property owned by a non-UK domiciled individual, so is excluded property for IHT purposes.

Manuel’s chargeable estate for IHT purposes is therefore £250,000, which is covered by his IHT nil rate band of £325,000, so there’s no IHT payable on Manuel’s estate.

What would the position be if Manuel died after the Finance Act 2013 changes? Section 162A broadly provides that if a liability is directly or indirectly attributable to acquiring excluded property, or even to maintaining or enhancing that property, the liability must be set off against the excluded property.

Thus, in Manuel’s case the liability of £500,000 is deducted from the value of Manuel’s foreign property. This means that the full value of his UK property, i.e. £750,000 is liable to IHT, subject to his nil rate band.

Section 162A also deals with situations such as where the excluded property has been sold at full value. It broadly allows a deduction for the liability as long as the proceeds form part of the estate chargeable to IHT, i.e. they have not been used to acquire, maintain or enhance other excluded property, or to repay another loan which would not be allowable for IHT purposes (s 162A(2)).

Returning to the example of Manuel, if prior to his death he sold the non-UK property and used some of the proceeds to buy a second property in the UK, the liability could be deducted because he no longer owns any excluded property, and his second UK property is chargeable to IHT in the normal way.

BPR and APR property and woodlands

The second main change published in Finance Act 2013 is a new IHTA 1984, s 162B, dealing with liabilities incurred to finance property which qualifies for certain IHT reliefs. The reliefs in question are business property relief (s 104), agricultural property relief (s 116) and woodlands relief (s 125). Assets which qualify for one of these reliefs are termed ‘relievable property’.

Once again, this change seems to be an anti-avoidance rule, which is aimed at blocking what the Government apparently perceives to be a ‘double deduction’ for IHT purposes. The following example illustrates the type of situation that s 162B is perhaps intended to prevent.

Example 2 – Relievable property

Basil died in February 2013. His estate for IHT purposes consisted of his home worth £725,000, and a portfolio of shares in trading companies listed on the alternative investment market (AIM) worth £600,000. He had an outstanding loan of £400,000 at the date of his death.

Basil had taken out the loan three years ago, which was secured against his home. He subsequently invested the loan proceeds in the AIM share portfolio. Those shares are treated as unquoted shares for IHT purposes and qualify for business property relief (BPR) at 100%.

What would be the IHT position on Basil’s death? His total estate is worth £1,325,000, but as mentioned the AIM share portfolio of £600,000 attracts BPR of 100%. Basil’s net estate is therefore £725,000. The outstanding liability of £400,000 reduces the value of his estate to £325,000, which is covered by his IHT nil rate band of £325,000.

What would be Basil’s position under the Finance Act 2013 changes? As mentioned, the new IHTA 1984, s 162B concerns liabilities to finance business property, agricultural property and woodlands. Basil’s case involves business property, although the provisions dealing with agricultural property and woodlands work in a similar way. Section 162B broadly provides that if a liability has been incurred to acquire, maintain or enhance property which qualifies for BPR under IHTA 1984, s 104, the liability is set-off against the business property in priority to BPR. Any remaining value of the business property is then reduced by BPR, if appropriate.

In Basil’s case, the effect of the new rules would be that his AIM share portfolio worth £600,000 would be reduced by the liability of £400,000. The remaining £200,000 would be eligible for BPR at 100%. Basil’s remaining estate of £725,000 would be reduced by his nil rate band of £325,000, leaving £400,000 chargeable to IHT at 40%, i.e. £160,000. So the new rules have a significant effect on the IHT payable by Basil’s estate.

Two further points about s 162B are worth mentioning. The first point is that it only applies to the extent that the liability does not already reduce the value of the business. For example, a sole trader’s business may have been financed by a bank overdraft, which is already reflected in the sole trader’s accounts, so the net value of the business has already taken the liability into account fully. In that case, there would be no need for a reduction under s 162B.

Secondly, for the purposes of business property relief and agricultural property relief, s 162B also applies to relevant property trusts, such as a discretionary trust. In other words, liabilities are set-off against business or agricultural property held within a trust for the purposes of calculating IHT on a chargeable event, such as a 10 year anniversary charge or an exit charge.

Further provisions in new s 162C deal with the situation where a liability has been partly repaid before it needs to be taken into account for IHT purposes. Section 162C applies where a liability was incurred to acquire, maintain or enhance a mixture of excluded property, relievable property and/or other property, and part of the liability has been repaid.

Section 162C provides that the repayments must be applied in a set order. Firstly, the repayment must be set off against any part of the liability that was not attributable to excluded property, business or agricultural property, or woodlands. Secondly, the repayment is set off against any part of the liability that was used to finance business or agricultural property or woodlands. Finally, the repayment is set off against any part of the liability that was used to finance excluded property. In other words, it’s a case of ‘best goes first’, because the effect of these rules is that the part of the liability that might otherwise be allowable as a deduction is treated as repaid first.

Repayment of liabilities after death

The third change introduced in Finance Act 2013 is a new s 175A, which deals with unpaid liabilities at the time of death. Once again, this change appears to be an anti-avoidance measure.

Section 175A provides the general rule that a liability which exists on a person’s death may be deducted from the deceased estate if that liability is discharged on or after death out of the estate or out of excluded property owned by the deceased, and would not otherwise be disallowed for IHT purposes.

If all or part of a liability is not discharged on or after death, it can only be deducted if three conditions are satisfied. The first condition is that there is a real commercial reason for the unpaid liability not being discharged. For these purposes, “real commercial reason” basically means that the liability is on arm’s-length terms, or that an arm’s-length creditor would not require the liability to be repaid. The second condition for a deduction is that securing a tax advantage is not a main purpose of leaving the liability unpaid. The third condition is that the liability is not otherwise disallowable for IHT purposes.

An example where a liability might be caught by s 175A is a loan from a relative or close friend which is written off on death. Another might be where the trustees of an employee benefit trust have made a loan to a beneficiary, perhaps where interest on the loan is unpaid at the time of the beneficiary’s death and is written off afterwards.

Where the liability was incurred to acquire, maintain or enhance a mixture of excluded property, relievable (i.e. BPR, APR or woodlands) property and/or other property, and the liability has been partly repaid after death, there is a particular order for dealing with the repayments. Any part of the liability that relates to excluded property is treated as having been repaid first, followed by any part relating to relievable property, and then any remaining part of the liability. Note that this order of repayments is different from s 162C mentioned earlier, where liabilities in respect of excluded property are treated as being repaid last.

Other points

The new rules apply in part to transfers of value made on or after 17 July 2013 (i.e. the date of Royal Assent to Finance Act 2013), including deemed transfers arising on death. From that point of view, the rules are retroactive, in the sense that they could apply to liabilities which were already in place before the changes become law. However, the provision in s 162B dealing with liabilities in relation to relievable property only applies to liabilities incurred on or after 6 April 2013.

Overall, the provisions are likely to have far reaching consequences, affecting individuals such as business owners. For example, previously a business owner may have taken out or increased a mortgage secured on the family home in order to invest in their own business. That might be their only means of obtaining loan finance for the business, but despite the arrangements being commercial, under the new legislation they would lose the IHT benefit of a deduction for a new loan, as it would be deducted from the value of the business instead, on which BPR at 100% would be available in any event.

The new rules are also likely to affect IHT planning by many non-UK domiciled individuals, such as those with UK properties worth more than £2 million. It would seem that those individuals are largely left with a choice of owning the property through an offshore company (the shares in which are excluded property), and saving IHT at the expense of the new Annual Tax on Enveloped Dwellings and also potentially the new CGT charge on property disposals by non-natural persons, or alternatively owning the UK property as part of their estate for IHT purposes. No longer would they appear to be able to charge the UK property with a loan, and deposit the proceeds offshore as excluded property.