The ongoing saga of home loan schemes has had a further development. There has still been no case heard to determine with certainty the success, or in the current climate, the increasingly likely failure of these schemes. In the meantime, HMRC have taken the unusual step of publishing guidance on the consequences of unwinding a scheme. The guidance was published in September 2017 and is located in the IHT manual at IHTM44120. Whilst the guidance has no statutory backing, it does set out HMRC’s views and may well help clients with these schemes reach a decision on whether or not to proceed with winding up the scheme. This article summarises how these schemes were structured and how the guidance suggests they should now be wound up.
What was the mischief?
These schemes were targeted at taxpayers whose estates were in excess of the nil rate band, and where property was held which formed a substantial part of the estate. The schemes sought to remove the value of the property from the estate whilst circumventing the gift with reservation of benefit (“GWR”) provisions so that the owner could continue in occupation without paying any rent.
These schemes were quite different to the Ingram type scheme which sought to carve out an interest in the property, which were largely being caught by existing anti avoidance legislation.
Essentially the taxpayer established a life interest trust for their own benefit, with the children as the remaindermen, and “sold” the property to the trust for the open market value. The contract for sale was left uncompleted and as the trust was without funds, the consideration was left outstanding and a loan note was issued to the settlor. (“Trust 1”).
The taxpayer also settled a second trust in which he was excluded from benefit. The trust was again a life interest trust, but in this instance the life tenants were the settlor’s children. (“Trust 2”).
The loan note was then gifted to the Trustees of Trust 2.
The tax consequences of the above transactions were that the sale of the property to Trust 1 was tax neutral as long as full PPR was available. The gift of the loan note to Trust 2 was a PET, so as long as the settlor survived for 7 years the gift was free of IHT. Trust 1 would be aggregated with the settlor’s estate on death, but the value of the trust was reduced by the value of the loan note. In many instances the loan note would be index linked in order to rise in value over time in order to ensure that the growth in the value of the property was outside the estate.
Following the FA 2006 changes, the trusts continued to be treated as interest in possession trusts and were not brought into the relevant property tax regime.
The Revenue approach
These schemes clearly did not find favour with HMRC, particularly as they did become quite heavily promoted by a number of different providers, as on the face of it the schemes provided a relatively simple solution to the age old problem of inheritance tax on the family home. However, rather than tightening the gift with reservation of benefit rules to block the scheme, the Revenue instead favoured the introduction of the pre-owned assets legislation in Finance Act 2004, Schedule 15, which introduced an income tax charge akin to a liability on the market rent for any asset which is gifted, but the settlor retains the use of whilst not being caught by the GWR rules.
This legislation largely brought the implementation of these schemes to an end. As far as existing schemes were concerned, HMRC would not settle the IHT position on death until a case had been heard in the courts. No such case has been heard to date and HMRC are now trying to encourage people to settle prior to such a case, if in fact one ever does get heard.
Set out below is HMRC’s detailed guidance on their approach to settling cases, which of course could be at various stages post implementation, depending on whether one or both spouses have died.
Position if the scheme remains in place until death
At present, where the scheme has not been unwound HMRC are prepared to settle cases, prior to a judicial decision, on the basis that a GWR arises in the house or other property comprised in the settlement in which the settlor had a qualifying life interest to the extent the house or other property is subject to the loan. The value of such property would then be included as a GWR in the estate of the deceased person on death.
Where property was settled jointly HMRC expect to see the deceased’s share of the property in which they had an interest in possession reflected in their estate on death. No joint property discount (IHTM15072) or spouse exemption (IHTM11031) is applicable. This would mean that IHT has to be paid on the first death on their share to the extent it is subject to the loan. There is no GWR in any excess value over the value of the loan. The major difference here, compared to if the scheme had not been entered into in the first place, is the lack of spouse exemption and joint ownership discount.
HMRC’s view is that the qualifying interest in possession (IIP) does not exist in the property to the extent it is subject to the loan (FA86/S102(3) does not apply). The deceased does retain a qualifying interest in possession in the excess value over and above the loan which can qualify for spouse exemption.
Unwinding prior to death (or prior to either death for joint settlors): If the home loan or double trust scheme is unwound during the taxpayer’s lifetime then (assuming the house remains in their estate at death) it will again be subject to IHT on death as an asset of their estate. However, unlike the position above joint owners will be able to claim spouse exemption where the property passes to the surviving spouse. In that event the tax charge on the whole property is deferred until the death of the surviving spouse.
When the scheme is unwound during the taxpayer’s lifetime (either by the loan being assigned back to the taxpayer or written off) the property is no longer subject to a reservation of benefit, and the whole house (or other property comprised in the qualifying IIP trust) is part of the taxpayer’s chargeable estate without a deduction for the loan. The GWR provisions provide that when a property ceases to be subject to a reservation of benefit the taxpayer is deemed to have made a potentially exempt transfer at that time. However, there is no loss to the taxpayer’s estate when the reservation ceases as a result of unwinding, so long as the property becomes comprised in the taxpayer’s estate, so there is no potentially exempt transfer to take into account on death.
Unwinding after first death: Where one joint settlor dies, before the scheme is unwound (IHTM44103), IHT may already have been paid on their share of the property, as a GWR (IHTM14301), at the time of their death. When the surviving joint settlor dies the whole value of the property could be reflected in their estate where the outstanding loan is disallowed as a liability under IHTA84/s175A (IHTM28029). Where the scheme is unwound the whole property will be reflected in the surviving spouse’s estate on death. Unwinding the scheme would then result in more IHT becoming due than if the settlors had never entered into the scheme.
However, HMRC have agreed that they will settle these cases, on the death of the surviving spouse, on the basis that half the value for the property held in the interest in possession (IIP) trust (IHTM16060), on the first spouse’s death, will not be brought into charge as part of the estate of the second spouse. The half share held by the surviving spouse will be brought into charge on their death without any allowance for a joint property discount (IHTM15072). This agreement applies only to schemes unwound between the deaths of the joint settlors.
If the whole property is subject to the loan, and is taxed on the first spouse’s death, because the first spouse was the sole settlor and it passes outright or on IIP trusts to the surviving spouse, the house is not brought into charge on the second death.
When submitting the IHT 400 the Executors should be clear in the disclosures that the second settlor unwound their home loan scheme, prior to death, and the value returned for the property represents the share of the property now subject to IHT. If the second settlor or surviving spouse did not unwind the home loan scheme prior to their death and the loan remains outstanding, the loan will be disallowed as a deduction (IHTA84/S175A) and the whole property value will be subject to IHT on the second death.
There are some home loan or double trust schemes (IHTM44103) where the outstanding loan, at the date of death, will be valued at less than the open market value of the property. There is a value in the taxpayer’s estate for settled property (IHTM16000) on the first death because the deceased spouse had a qualifying interest in possession (IIP) in the same, and this will affect the value for the gift with reservation (GWR) (IHTM14301).
If HMRC have charged to tax less than half the value for the property on the first death, then on the second death, where the scheme was unwound prior to death, HMRC will tax the balancing share. This ensures that HMRC will only tax the whole value for the property over the two deaths, and nothing more.
Downsizing: We have settled cases on the basis that a GWR (IHTM14301) arises in the property. When the taxpayer moves out of the property, or downsizes, then the reservation will continue in the smaller property and any surplus proceeds retained in the trust. Where the downsized property and surplus proceeds remain in the trust, there will be no loss to the estate and no deemed potentially exempt transfer (IHTM04064) under FA86/S102(4) brought about by the sale of the property.
If joint settlors unwind their scheme (IHTM44103) before either spouse dies then there will be no home loan scheme consequences on the death of the taxpayers. Their joint shares in the downsized property can pass by survivorship, and spouse exemption (IHTM11031) can be applied on the death of the first spouse.
Where one joint settlor dies, both before the scheme is unwound and before the property is downsized, IHT may already have been paid on their half share of the original property to the extent it is subject to a debt, as a GWR, at the time of their death. When the scheme is then unwound the whole value of the smaller property will then be reflected in the sole surviving spouse’s estate on death assuming the surviving spouse takes the property outright or on a qualifying interest in possession trust in the whole. In addition, the balance of the proceeds of sale may also now be reflected entirely in the estate of the surviving spouse.
As with the cases outlined above, HMRC have agreed to settle these cases, on the death of the surviving spouse, on the basis that only half the value of the property now comprised in the surviving spouse’s estate will be brought into charge. In addition, where the entire proceeds of sale are clearly evidenced within the account then only half will be subject to IHT on the death of the surviving spouse. Where the second settlor’s interest in possession trust (IHTM16060) continues, and the proceeds remain in trust, this should be self-evident. The proceeds of sale should be clearly separated from the remaining estate assets to ensure they are not brought into charge.
Tracing: if the property has been sold between deaths, HMRC will expect the taxpayer to keep evidence of the sale proceeds received, and show where they are now reflected in the surviving spouse’s estate. No deduction can be made where the proceeds are not clearly reflected within their estate, and again it will only be due on a half share of the proceeds of sale.
If the proceeds have been invested, HMRC will expect the taxpayer to keep the proceeds derived from the first spouse’s share separate from those of the second spouse. If the proceeds are invested as one portfolio and later withdrawals are made from it, e.g. for the surviving spouse’s capital expenditure, HMRC will treat the withdrawals in the same way as gifts below.
If the property is sold, and the proceeds not clearly separated then no deduction can be claimed unless there is clear evidence of the assets into which the proceeds were invested did represent the first spouse’s half share and that these have already been taxed on the first spouse’s death.
If the survivor gives away half the proceeds of the house, then the assumption will be that a quarter represents the share inherited from the first settlor and upon which a deduction can be claimed, and the remaining quarter reflects the share always owned by the surviving spouse.
The HMRC guidance is clearly helpful to anyone trying to advise a client on the implications of a home loan scheme and in particular what to expect as the HMRC approach on death. This guidance highlights scenarios where the amount of tax ultimately payable could be substantially in excess of the tax which would have been paid had the scheme not been implemented in the first place.
For any client who has one of these schemes, an update on their available options could well be very valuable advice. The guidance could of course become obsolete if a judicial decision becomes available and is contrary to how HMRC are currently interpreting the situation. The current guidance also includes what should be regarded as concessional treatment in that property which has been subject to tax on first death will be left out of account on second death even though the entire property or sale proceeds may be held in the estate of the surviving spouse. There is no statutory basis for this concession, which one can only assume is being given by HMRC to encourage taxpayers with these schemes to wind them up.
Each case will be slightly different and it is important to identify the exact circumstances when giving advice on how to proceed. It seems likely that there will be legislative change at some point in future but until then, following HMRC guidance on winding up a home loan scheme could avoid additional tax charges being incurred on death.
For further information and help with inheritance tax issues in general or on this specific issue, please contact the TaxDesk on 0845 4900 509 and ask for Carol Wells.