The Finance Act 2004 is set to get tough on inheritance tax avoidance. Matthew Hutton considers how taxpayers should react to the new rules


Schedule 15 to the Finance Act 2004 - which was first intimated on 10 December 2003 - represents a novel way of attacking inheritance tax avoidance. The new pre-owned assets (POA) regime comes into force on 6 April 2005.


There will be an annual income tax charge on, broadly speaking, those who enjoy a specified benefit from arrangements made since 18 March 1986 involving land, chattels or 'intangible property' comprised in settlor-interested trusts, while having divested themselves of the underlying capital for inheritance tax purposes.



Such successful schemes or arrangements have been well documented, with victory for the taxpayers most notably in Ingram and another v Commissioners of Inland Revenue [1999] 1 All ER 297, HL (E), and Inland Revenue Commissioners v Eversden and another [2003] EWCA Civ 668.



The specific anti-avoidance legislation that followed each decision has not proved 'watertight' - at least from the point of view of the Inland Revenue - and so more drastic measures were required. For the first time, we have one tax (income) being imposed - rather like a fine - on arrangements put in place (within the law) to avoid the ambit of quite another tax (inheritance).


Schedule 15 contains three separate sets of rules, those involving land and chattels being much the same, while the third dealing with 'intangibles' comprised in a settlor-interested settlement applies differently.


Broadly speaking, subject to an applicable exclusion or exemption, a person who occupies land or enjoys the use of a chattel is caught if he disposed of that land or chattel whether directly or indirectly since 18 March 1986 or provided the means, again directly or indirectly, for its purchase by someone else. Where the rules apply, the individual (the 'chargeable person') is subject to income tax on an amount which, in the case of land, broadly equates to the rent payable under a landlord's repairing lease on the (typically, increasing) value of the interest given away or, in the case of chattels, on a percentage - to be confirmed, but likely to be 5% at present - of the market value of the chattel.



In the case of intangible property - that is, property other than land or chattels - comprised in a trust under which the settlor can benefit, the charge is to be a prescribed rate, which is likely to be something less than 5% of the capital value of the trust fund. The only deduction here is any income tax or capital gains tax paid by the settlor under the anti-avoidance regimes. The Revenue has confirmed that the intangibles charge will not apply to certain insurance-based inheritance tax mitigation arrangements, including gift and loan trusts and discounted gift schemes. However, insurance arrangements based on the Eversden decision, for example, will be caught.



Prescribed exclusions are set out in paragraph 10 of schedule 15, which disapply the POA regime in the case of land and chattels (only). The most important of these, in the case of the disposal condition, is where there was a disposal of the chargeable person's whole interest in the property, except for any right reserved by him either by an arm's-length transaction with an unconnected person or by a transaction as might be expected to be made at arm's length between unconnected persons. And, in the case of the contribution condition, excluded is an outright gift of cash made at least seven years before the schedule 15 rules apply.


Otherwise, in relation to both conditions are excluded gifts to a spouse either absolutely, or on life interest trusts - for as long as that interest lasts - and gifts covered by certain other small inheritance tax exemptions.


The exemptions in paragraph 11, which apply to all three categories of property, are broadly three-fold:


- Where the inheritance tax estate includes the property concerned; or


- Where the estate is treated as including that property, because of the reservation of benefit rules; or


- The property would be subject to a reservation of benefit apart from certain prescribed exceptions, including the co-ownership exception and the full consideration exception.


A disposal comprising a qualifying post-death variation is not caught by the POA regime. Nor, broadly speaking, is property - which in the hands of a non-UK domiciliary (whether deemed or actual) or an excluded property settlement - is not subject to inheritance tax.


Although the POA regime is aimed at inheritance tax avoidance, also caught, albeit inadvertently, will be cases where disposal did not take the form of a transfer of value, for example, equity release schemes involving a disposal of part only of the house. It is hoped that these cases will be picked up and taken out of the regime by forthcoming regulations.


The sorts of arrangements that typically will be caught by the POA regime are:



- Lease carve-out arrangements making use of the Ingram principle before this was stopped from 9 March 1999;



- Eversden arrangements before 20 June 2003;



- Trust of debt or lifetime loan schemes; and


- Reversionary lease schemes.



What should a taxpayer do when caught by the regime? First, he could pay the income tax charge. Second, he could pay to the donee, under a legal obligation in the case of land and chattels, such an amount as reduces the chargeable amount to nil. (Although there is a de minimis of £5,000, this applies to the gross and not to the net amount.) Third, he could bring the occupation or enjoyment of the chattel to an end. Note that in the case of land it is not benefit but specifically occupation that is caught.



Finally, he could take advantage of the 'carrot' offered by the Revenue in the form of the transitional provisions in paragraphs 21 to 23 of schedule 15. That is, he could opt into the reservation of benefit regime. This must be done by 31 January following the end of the tax year in which the POA regime first applies, in other words, for most people 31 January 2007.



All the rules applying then to reservation of benefit will operate, so that in particular if the reservation ceases inter vivos there is a deemed potentially exempt transfer that becomes exempt once the taxpayer has survived seven years. The potential for double charges to inheritance tax on the same property must be watched carefully.



All that said, what tax planning opportunities remain for, in particular, lifetime inheritance tax mitigation of the family home? Consider the following:


- Disposals of the property for full consideration, subject to any right of occupation for a period of years expressly reserved.



- A gift of the property followed by a leaseback, either for a full market rack rent or for a full consideration premium.



- A gift of part of the property such that the donor and donee(s) occupy together, each bearing his or her share of the expenses.



- A gift of cash used by the donee to buy a property that is occupied by the donor once a lease of seven years has expired. (The Revenue is to confirm what is meant by 'occupation'.)


The regime is to be taken seriously. There will be a question on the self-assessment return for 2005/06 and subsequent years as to whether schedule 15 applies. The Revenue is considering compliance issues to be confirmed in regulations.



Matthew Hutton is a non-practising solicitor and a chartered tax adviser, lecturer and writer