I want to start to distribute my assets to my family, but continue to use them and understand that I may be taxed under the Pre-Owned Assets rules. How does this affect me?

From 6 April 2005 there is a new income tax charge on individuals who continue to benefit from an asset which was once part of their estate for Inheritance Tax purposes. This legislation has been introduced to try and counteract some of the planning that taxpayers were deploying to get round the Inheritance Tax rules.

Pre-owned assets

Last year’s Finance Act introduced an annual income tax charge designed to catch all those who have gone in for Inheritance Tax planning schemes since 1986. It is known as the pre-owned assets legislation and it applies to three distinct categories of schemes. In each case, an essential characteristic of the schemes involved is that they successfully avoided the “gift with reservation of benefit” provisions introduced into the Inheritance Tax legislation in 1986. An example might help to make this point clearer.

Suppose that Arthur gave a half share in his house to his son, but continued to live in the home. His son lives elsewhere.

Arthur might have been under the misapprehension that, so long as he were to live for seven years from the date of the gift, he would escape Inheritance Tax liability on the half of the house which he gave away. This would not in fact be so.

Arthur has kept a benefit in the share which he gave away, because he continued to enjoy exclusive use of the whole property. His gift would therefore be a ‘gift with reservation of benefit’, and as a result for Inheritance Tax purposes Arthur would be treated as continuing to own the whole property.

So Arthur would have achieved nothing by giving the half share away. In fact he would have made things worse because if he had kept all the property in his estate until his death, his son could receive the property under Arthur’s Will revalued to its then current market value for Capital Gains Tax purposes.

Suppose, however, that Archie next door was better advised. He sold a half share in his house to his son for proper market price paid in cash. Like Arthur, he continued to have exclusive use of the whole property. Archie then gave away the money he received from his son.

Archie will have avoided the gift with reservation of benefit rules for the simple reason that he has not made any gift of the property at all. He sold the one half share for market value, so there was no gift element in the transaction.

Archie’s arrangement would therefore successfully avoid Inheritance Tax on the one half share sold so long as he lived for seven years from the time that he gave away the money received.

In fact, Archie’s scheme would normally have been carried out in a more sophisticated manner. The better arrangement was to sell the house to a specially formed trust in which Archie would have a life interest, and the sale price due from the trustees would be left outstanding as a debt. Archie would then give the debt away to another trust, of which the beneficiaries would be his children. This became known as the double trust scheme and it was marketed quite widely.

The pre-owned assets legislation is the Revenue’s reaction to the various Inheritance Tax schemes which were being widely adopted, and it applies to three categories of schemes:

(1) those where an interest in a property has been disposed of, with the homeowner continuing in occupation. Alternatively, under this head the taxpayer might have given money to a third party who would use it to buy a house for the taxpayer to live in;
(2) where works of art or other valuable possessions have been given away, but the donor continues to have use and enjoyment of them. Alternatively, an interest in the possessions might have been given away, or money given for valuable items to be purchased and then used by the donor;
(3) where a person has put funds into trust under which he or she personally is one of the possible beneficiaries and the trust has successfully avoided the ‘gift with reservation of benefits’ provisions.

Occupation of property

For cases in the first category above, the income tax charge is based on the market rental of the property. The calculation is:

Current value of the interest given away Full current value of the whole property

x Annual rental value

The double trust scheme involved a sale of the whole property, but many of the arrangements devised in recent years in relation to the family home worked by dividing the ownership of the property into separate interests, and giving away one of those interests. For example, one might create a lease over the property for a suitable period which the homeowner would retain, and he would then give away the freehold interest to his children.

It will be seen that if the current value of the interest given away is half the full value of the property, income tax will be payable each year on one half of the current rental value. Very often, this will be quite a substantial tax liability and of course there is no income produced by the scheme to meet the tax due.

Chattels

For cases in the second category above, those involving valuable possessions, the formula to calculate the tax charge is similar except that in place of current rental value the charge is based on the rate of interest applicable to loans to employees. This is currently 5%, and is known as the ‘official rate of interest’. Accordingly if one gave away a painting worth £200,000 whilst continuing to have possession of it, income tax would be due each year on £200,000 multiplied by 5%; thus tax would be payable on £10,000. If one gave away only an interest in the painting, then a fraction of the value would be chargeable, in the same way as applies to properties.

Trusts

In relation to the third category above, which applies to settlor-interested trusts, the charge is again based on the official rate of interest. This is applied to the value of the funds in the trust and income tax is payable each year on the result of this calculation. The value is taken as at 6 April each tax year.

De minimis exemption

There is a de minimis exemption from the charge which is £5,000 per annum. So, if, in the example above relating to a painting, the value of the picture had been £100,000 rather than £200,000, and the person concerned has no other assets within the pre-owned assets legislation, the charge would be on £100,000 multiplied by 5%. This is £5,000 and is therefore covered by the de minimis exemption. However, once the chargeable amount exceeds £5,000, the whole is chargeable to income tax and not just the excess over £5,000.

In general, the new tax charge will apply only to those who have carried out Inheritance Tax planning schemes since 1986. There will undoubtedly be some arrangements caught by the legislation where tax planning was furthest from the minds of those involved, but these situations will be the exception rather than the rule.

Life insurance schemes

Rather surprisingly, the Revenue has accepted that most of the Inheritance Tax schemes marketed by life insurance companies fall outside the legislation. This is because of the particular type of trust which was normally set up within the scheme. It is quite likely therefore that those who have purchased Inheritance Tax planning schemes from life insurance companies will not have any tax charges under the pre-owned assets legislation, although it would no doubt be as well to check this with the life insurance company concerned.

Electing out

Those who are caught by the legislation can escape its clutches by making an election for the arrangements entered into to be disregarded for Inheritance Tax purposes. The election works by treating the gift previously made as being within the Inheritance Tax gift with reservation rules, so that Inheritance Tax will be due on the full amount of the asset within the scheme on the death of the taxpayer.

The election must be made by 31 January in the tax year following that in which a tax charge under the legislation would first arise. However, perceived wisdom is that it is best to leave the election until the last possible date since, if the taxpayer elects too early and then dies, IHT savings will have been lost and the income tax saving will have been minimal.

Although making the election solves the problem of having the annual income tax liability to pay, it does of course mean that the scheme is effectively unwound and treated as if, for Inheritance Tax purposes, it had never been entered into.

It is very important, however, to appreciate that this treatment solely applies to Inheritance Tax. The consequences for other taxes are not unwound and they remain as they are. For example, if the scheme was a gift of an interest in a property, very often the donee will have a low Capital Gains Tax base cost for his share in the property. In the course of time, that share is likely to be sold at a considerable profit and Capital Gains Tax will be due. Making the Inheritance Tax election does not change the capital gains position. Generally, therefore, it will be better to find another solution to the problem.

New trust arrangement

One solution is for the interest in an asset given away to be put back in trust for the original donor for his or her life; thereafter the asset would pass back into the ownership of the person setting up this new trust. This is known as a ‘revertor to settlor’ trust and it benefits from various Inheritance Tax and Capital Gains Tax reliefs. Because this type of trust puts the asset given away back into the estate of the original donor for Inheritance Tax purposes, it prevents any income tax charges arising under the pre-owned assets legislation.

Although these trusts can be highly tax efficient and they can also successfully avoid the pre-owned assets legislation, it must be borne in mind that on setting them up there will be a Capital Gains Tax disposal of the asset transferred in. Experience is proving that often the Capital Gains Tax liability to date is quite substantial so that setting up a revertor to settlor trust can itself involve considerable tax liability.

Each case therefore has to be reviewed to see if a revertor to settlor trust can be used to deal with the pre-owned assets income tax problem and if one is fortunate enough to be able to proceed with the trust, it will be essential for it to be carefully drafted in order to produce the full tax benefits available.

Other possibilities for home owners

If a revertor to settlor trust is not viable in the circumstances of a particular case, there are some other possible steps to take.

For instance, if full payment is made for the use of the share in the property which has been given away, the income tax charge under the legislation will not arise. At first sight, paying full rent looks to be much worse than simply paying income tax on the benefit, but there are other ways of looking at the position. If the home owner is looking to make further transfers out of his or her estate and into the estate of the heirs under the will, paying full rent is one way of passing value over without there being any chargeable transfer for Inheritance Tax purposes. The payees will of course have income tax liability on the rent received, and so the Government is still likely to get its tax take.

Another possible solution to the problem involves an exemption in the legislation for property sharing arrangements. If the donee of the share in the home also occupies the property from time to time and keeps possessions there, he or she may be able to claim a specific exemption for this type of scenario in the pre-owned assets legislation.

Valuable possessions

Paying full consideration for the use of valuable possessions is the best way out of the income tax charge for schemes caught by the second category listed above. Generally the payment to be made amounts to a very small sum each year, perhaps one % of the capital value of the chattels, and so this is quite manageable. Settlor-interested trusts

There are also some fairly simple ways out of the pre-owned assets charge in relation to settlor-interested trusts. We can guide you through the rules and discuss what action may be appropriate. Summary

All in all, there are many planning opportunities available in order to manage prospective income tax liabilities under this legislation. The one remaining worry is of course that, since the legislation primarily sets out to attack schemes which have been entered into in the past, amendments to it could similarly be introduced to attack those who have sought to avoid the charge.

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FOR GENERAL INFORMATION ONLY

Please note that this answer is not intended to give specific technical advice and it should not be construed as doing so. It is designed to merely alert clients to some of the issues. It is not intended to give exhaustive coverage of the topic.

Professional advice should always be sought before action is either taken or refrained from as a result of information contained herein.

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Gordon Leighton is registered to carry on audit work by the Institute of Chartered Accountants in England and Wales