Inheritance tax on UK residential property
In the July 2015 Summer Budget, the Government announced that an Inheritance Tax (“IHT”) charge would be imposed on UK residential property held through offshore structures from 6 April 2017.
There have been a number of revisions to the original announcement and on 5 December 2016, the Government published the latest draft legislation which is to be included in Finance Bill 2017. Although the draft legislation provides greater clarity on a number of issues, there are still frustratingly some areas which have not been fully addressed. The Government has indicated that they will publish further legislation in due course which may leave very little time to consider the options available to individuals.
Who will be affected by the new legislation?
The new legislation will principally affect UK resident but non-UK domiciled individuals and non-UK residents plus any offshore structures which they have created to hold relevant interests in UK residential property.
It was common tax planning for non-UK domiciled individuals to own UK residential property through a non-UK company in order for the property to be treated as excluded property and therefore not be subject to UK IHT upon death. The non-UK company was often then held through a non-UK resident trust. These structures will from 6 April 2017 be ineffective for IHT planning.
What relevant interests are within the new legislation?
There are three main non-excluded property categories which are caught by the new legislation:
1. Interests in close companies which either directly or indirectly derive their value from UK residential property.
The legislation will not apply to any close companies which are widely held for example a real estate fund.
Where there are layers of companies, the legislation will look through those companies to the company which ultimately holds the UK residential property.
2. An interest in a partnership which either directly or indirectly derive their value from UK residential property.
Unlike close companies, the legislation will apply to partnerships which are widely held. Therefore real estate funds structured as partnerships will be within the legislation.
3. Loans and collateral
This area of the legislation is the most concerning and will often affect sometimes totally commercial arrangements.
A relevant loan will be where a trust, partnership or individual has used that loan to acquire, maintain or enhance UK residential property or any non-excluded property. What does this mean in practice? Where loans are made, the lender will not be able to claim excluded property on the loan provided to the borrower who has then used that loan on the UK residential property. The borrower who owns the property will be able to deduct that loan from the value of the property to mitigate their IHT exposure.
The lender therefore could have an IHT liability either on death if it is an individual and they still hold the relevant loan or a ten year anniversary charge where it is a trust and the loan is held on the anniversary date.
However, it is not only loans that need to be considered, where collateral is provided that could be caught by the new legislation. Perversely the legislation as it currently stands not only includes the loan amount but also the entire value of the collateral. For example, if an investment account worth £10m was provided as collateral for a loan of £2m to purchase a home for £5m. The entire loan of £10m will be brought within the scope of IHT as well as the net value of the property. This would seem an extremely harsh measure to counter taking out a 100% loan against the property using other collateral.
These measures will affect existing structures as well as new structures and there are no grandfathering provisions for existing structures or loans. There will be many cases where loans have been provided via offshore structures and these should be reviewed immediately.
As is custom with new legislation being introduced, there are some anti-avoidance measures. Where property is disposed of or a loan has been repaid, the sale or repayment proceeds will potentially remain within the scope of IHT for two years as non-excluded property even where those funds are held offshore. For example, the sale proceeds on the sale of a non-UK company which owns UK residential property will be treated as non-excluded property and still within the scope of IHT for two years.
The UK currently has 10 IHT or Estate Tax double tax treaties in place. The draft legislation overrides those tax treaties unless the other country charges IHT or a similar tax in their country. The important factor here is there needs to be a charge to tax however small it is in that country.
Who pays the IHT?
It had been previously suggested that the Government would enforce the IHT liability on individuals, trustees or directors of offshore companies who own the property. Following representations, this has now been changed to the individual or trustees. However, they have indicated that they will seek alternative measures if necessary to ensure that the IHT is collected.
What to do next?
Where UK residential property is owned through an offshore structure or by a non-UK resident, they should be reviewed immediately. There will be a number of residential properties which are subject to the Annual Tax on Enveloped Dwellings (“ATED”) and with these changes in most cases any structure will be ineffective going forward. Therefore, one needs to consider de-enveloping those properties to mitigate ATED charges going forward. The Government have decided to not provide any relief for de-enveloping properties and therefore there could be Capital Gains Tax (“CGT”) charge to consider. Depending on how the property has been financed, there will also be Stamp Duty Land Tax (“SDLT”) issues to consider. Properties which remain within the ATED regime will also need to obtain a valuation on 1 April 2017 as the property will need to be revalued to determine which band of ATED it will now be within.
So what are the alternatives?
There are some relatively simple steps one can take to mitigate the exposure to IHT.
- Life insurance can be used to pay the IHT on death. The premiums are dependent on the age of the person insured but can be a relatively cheap for younger non-UK domiciled individuals. The life insurance market for non-UK residents is more limited as there are fewer insurance companies which can provide life insurance to non-UK residents.
- Holding the property personally and securing loans on the property to purchase or enhance the property.
- In certain circumstances purchasing the investment property with a widely held company as mentioned above will mitigate the IHT exposure.
- Making gifts during your lifetime to the next generation but care needs to be taken that the donor does not have occupation of the property and where they wish to occupy the property they pay a market rent.
- Use the spouse exemption on the first death and then consider gifts to the next generation.
- From 6 April 2017, the main residence property nil rate band will be introduced which will initially be £100,000 but will rise to £175,000 from 2020/21. This can be transferred from one spouse to the other on death. The band is reduced by £1 for every £2 where the estate exceeds £2m.
Every individual’s position is going to have different issues to consider. Please contact our Private Client Tax Director Rakesh Dabasia at firstname.lastname@example.org if you would like to discuss how the rules impact on you and the steps you should take to mitigate their impact.
Disclaimer: Please note that this document is not intended to give specific technical advice and should not be construed as doing so. It is designed to alert clients to some of the issues and 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. March 2017