An inheritance tax anti-avoidance rule potentially affecting ‘innocent’ situations, and a possible solution – courtesy of HMRC!
Inheritance tax (IHT) is a particularly unpopular tax. Not only does it cause us to think about our own mortality, but the prospect of estates being diminished by IHT at the 40% ‘death rate’ is unwelcome to say the least (although I have heard some say that it does not bother them, as they will be dead!).
Various IHT saving schemes and arrangements have evolved over the years. Many of them have subsequently been blocked by IHT anti-avoidance rules (and even a special income tax charge on ‘pre-owned assets’). One such IHT anti-avoidance rule concerns unpaid liabilities at the time of death.
Loans, etc on death
IHT is charged on death as if the deceased had made a transfer equal to the value of his or her estate immediately before death. As a general rule, a liability may be taken into account in valuing a person’s estate if it is legally enforceable, and is imposed by law or incurred for consideration in money or money’s worth (IHTA 1984, s 5(5)).
However, following legislation introduced in Finance Act 2013, there are conditions and restrictions to this general rule in respect of the deduction of liabilities, including liabilities unpaid at death (IHTA 1984, s 175A). These are anti-avoidance measures to block schemes and arrangements aimed at exploiting the IHT rules on liabilities to reduce the value of an estate. Those arrangements broadly involve (among other things) obtaining a deduction for a liability, and not repaying it after death.
Following the introduction of these anti-avoidance measures, a liability which exists on a person's death may be deducted from the deceased’s estate if it is discharged on or after death, and would not otherwise be disallowed for IHT purposes.
Alternatively, if all or part of a liability is not discharged on or after death, it can be deducted if three conditions are satisfied. First, there must be a real commercial reason for the liability not being discharged (nb for these purposes, ‘real commercial reason’ broadly 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 is that the liability is not being left unpaid as part of arrangements with a main purpose of securing a ‘tax advantage’ as defined (note that ‘tax’ for this purpose includes income tax and CGT). The third condition is that the liability is not otherwise disallowable for IHT purposes.
An example of a liability being caught by s 175A might be a loan from a relative or close friend, which is written off following death. HM Revenue & Customs (HMRC) may wish to know why the loan was made in the first place, as well as the reason why it is being written off. In most cases, there is unlikely to be a ‘real commercial reason’ for the write-off, so the liability would be disallowed when calculating the deceased's estate on death for IHT purposes.
There are also rules dealing with the partial repayment of liabilities after death, where the liability was used to acquire certain types of assets (i.e. including ‘excluded property’, ‘relevant account balances’ and ‘relievable property’) (s 175A(7)). Those rules are beyond the scope of this article. However, in broad terms they provide an order of set-off, which potentially restricts the amount of any deduction from the death estate where a liability is not repaid in full.
Unfortunately, the problem with most anti-avoidance legislation is that it can affect cases where no deliberate attempt has been made to exploit the rules they were intended to protect.
For example, many people take out life insurance policies. This can help (for example) to ensure that outstanding liabilities (e.g. mortgages or loans) are repaid in full, in the event of the individual's untimely death. In practice, such policies are often written into trust (e.g. where the trust is created for the benefit of the individual’s family members; the trust receives the proceeds of the insurance policy on the death of the individual insured).
If the policy is not written into trust, the insurance proceeds will generally form part of the deceased's estate. Consequently, there can sometimes be delays in the insurance company paying out, due to the deceased's executors first having to obtain probate to administer the estate, including dealing with the insurance claim.
In addition, if the insurance policy proceeds are paid to the deceased's estate, this could result in an IHT liability on those proceeds. By contrast, if the policy is written into trust, the proceeds are payable to the trustees instead, and normally fall outside the deceased’s estate. Trust arrangements can therefore result in IHT savings.
However, if the insurance policy has been taken out to cover a loan or mortgage, and the policy has been written into trust, what about the above anti-avoidance rule requiring the loan or mortgage to be “discharged on or after death, out of the estate…”? If the insurance policy is written into trust, and the proceeds are used (e.g. by the trustees, or a beneficiary of the trust) to repay the loan or mortgage, the liability will not have been paid “out of the estate”. On the face of it, no deduction would therefore appear to be available for the mortgage or loan when calculating IHT on the deceased’s estate.
The effect of the anti-avoidance rules in such circumstances has caused some concern, particularly when the rules were first announced.
HMRC to the rescue!
Fortunately, HMRC guidance in its Inheritance Tax manual (at IHTM28028) acknowledges the practical difficulties in similar situations. HMRC also offers two possible solutions. The first is for the deceased’s personal representatives to take out a new loan, to repay the original one:
Example 1 – New loan to repay old mortgage
“Kevin's estate is valued at £750,000, £700,000 of which is attributable to his home. A mortgage of £100,000 is secured against the house. The executors borrow £100,000 to repay the mortgage and secure the new loan on the house, so that the beneficiary receives the property charged with the new debt. You may accept that the liability has been discharged out of the estate.
There is no need to raise any enquiries into the source of funds lent to the executors, including whether or not the beneficiary is the creditor for the new loan. Provided the mortgage has actually been repaid from funds charged against the estate, the deduction may be allowed as this has the same effect as the liability being discharged out of the estate had there been sufficient liquid assets.”
The second solution applies where there is an insurance policy held in trust:
Example 2 – Loan from insurance proceeds
“It is possible that the beneficiary may be able to make a loan to the estate from the proceeds of an insurance policy held in trust outside the estate for the purposes of repaying the mortgage. Again, the source of the funds does not matter.”
This second type of arrangement would be particularly useful in family situations where (for example) the trust beneficiaries are the same as the legatees under the deceased’s will.
Remember that it is not always necessary for a liability to be repaid before a deduction is allowed in the deceased's estate. There may be a good commercial reason for a loan to remain in place.
For example, a family member may inherit a house on the deceased's death. The house may be subject to a commercial loan or mortgage. If the lender is content that the house can be transferred to the family member provided that they take over the loan and continue making the repayments, HMRC accepts that the liability may be allowed as a deduction against the deceased’s estate.
Although the liability has not been repaid, the arrangements are commercial, and there is no tax advantage in the family member taking over the mortgage (see IHTM28029, at Example 2).
Detailed guidance on the IHT rules for the discharge of liabilities after death is included in HMRC's Inheritance Tax manual (at IHTM28027 to IHTM28032).
Mark McLaughlin CTA (Fellow), ATT (Fellow), TEP
The above article was first published by Tax Insider (www.taxinsider.co.uk).