Revenue stalks the matrimonial home

The matrimonial home has become an inheritance tax battleground. Robert Brodrick advises solicitors on how best to help their clients

Not only has Revenue & Customs waged a war on lifetime tax planning with the introduction of the pre-owned assets tax regime, but now it is also taking an unhealthy interest in a surviving spouse's occupation of the matrimonial home where a share has already been passed down to the next generation by way of deed of variation, or otherwise.


What was once innocent and straightforward tax planning is now being treated as devious tax avoidance by the Revenue, which is requesting unprecedented amounts of detail to justify the occupation. Practitioners need to consider carefully their response to this increasingly aggressive approach by the Revenue.


For example, Linda and her husband Hugh lived in Appletree Cottage, a house now worth £550,000. Hugh died in 1998 and Linda died in 2004. They had other savings and investments worth £100,000, as well as a small pension.


When Hugh died, his will left everything to Linda, but on advice from her lawyers, she entered into a deed of variation whereby Hugh's half-share of Appletree Cottage (worth the same amount as the nil rate band) passed directly to their two children, Tessa and Charlie. The children allowed their mother to continue living in the cottage but never got round to formalising the arrangement. Linda continued to pay for all the outgoings.


When Linda died in 2004, her will left everything to Tessa and Charlie equally. Her estate consisted of a half-share of Appletree Cottage (worth £275,000) and the savings and investments, still worth around £100,000.


The inheritance tax (IHT) position on Linda's death should be straightforward. After applying a deduction of 15% to Linda's half-share of the house (in line with the guidance contained in the Valuation Agency's practice note 2) the value of her estate comes to £333,750. The full nil rate band (£263,000 for the 2004-5 tax year) is available, leaving a tax bill of £28,300, which can be met out of the investments.


Tessa and Charlie complete the IHT account and pay the tax on this basis. They are surprised when they receive a letter from the technical group of the Revenue's capital taxes team, suggesting that they should have included the entire value of Appletree Cottage in their mother's estate. The letter goes on to ask them to justify various things, including:

Whether their mother was the only person who had any right to occupy the property having regard to sections 12 and 13 of the Trusts of Land and Appointment of Trustees Act 1996;

Whether Tessa and Charlie could disturb their mother's right to occupy the property and turn their interest in land to account during her lifetime;

Whether in fact Tessa and Charlie held their share of the property on trust for their mother for life;

Whether the property was originally occupied by Linda and Hugh as their matrimonial home;

Was Linda in exclusive occupation of the property between her husband's death and her death?

What explanation was given to all parties about the deed of variation and, in particular, their rights and obligations in relation to the property?

This sort of approach is not an isolated occurrence. What is more, the frequent absence of anything to back up the surviving spouse's occupation of the property is being used by the Revenue as evidence of something far more sinister, like an implied trust.


What should the practitioner do if faced with a similar list of questions from the Revenue, and how does one avoid running up an enormous bill for clients? The first thing is not to panic. Many of the questions can be dealt with simply. Look at each question in turn and decide whether the Revenue is entitled to ask for a reply, or whether the question is simply 'fishing' for further information that the client is under no obligation to disclose. It is important to be conscious that any answer given to the Revenue may provoke further questions.


There may be no right answer - it is often down to being able to persuade the Revenue, on the facts in question, that the surviving spouse did not have an interest in possession. It is the client's word against the Revenue's.


How can such a situation be avoided in the future? Is there anything the solicitor advising Linda at the time of the deed of variation could have done to avoid the Revenue mounting an argument that she had an interest in possession?


There are various options, each with their own downsides. The first is to think about whether Tessa and Charlie should have granted their mother a licence to occupy their half-share of the property. Linda could have been asked to cover routine expenses in place of a license fee, with any capital expenditure shared equally. When going down this route, it is important to ensure that this happens in practice.


The second option would be to make Linda pay a full market rent to Tessa and Charlie. This would be subject to income tax in their hands and is only worth considering if Linda already has more than enough to live on.


A more sophisticated approach would be for Tessa and Charlie to set up a trust to hold their half-share of the property for their mother, which reverts to them on her death. On creation, this would be a potentially exempt transfer, but the main advantage is that on Linda's death, section 53(3) of the Inheritance Tax Act 1984 (IHTA) (reverter to settlor exemption) would apply, and there would be no IHT liability. Linda's occupation of the property would be secure as she would have an interest in possession.


It would need to be clear that the children were the settlors because, if the trust were set up in the context of (or at the same time as) a deed of variation, the Revenue might argue that section 142 of the IHTA means that the deceased is really the settlor.


Another advantage of using a trust is that capital gains tax principal private residence relief would apply to both halves of the property. As Linda would be occupying the children's half-share as a beneficiary under the terms of a settlement, section 225 of the Taxation of Chargeable Gains Act 1992 would apply. If she were simply occupying the children's share as a tenant or licensee, any profit on that share would be subject to capital gains tax on a future disposal, with no death uplift and no principal private residence relief.


When advising clients in relation to the matrimonial home either before death or in the context of a post-death variation, practitioners should not underestimate the lengths that the Revenue will go to in an attempt to argue that the entire value of the property remains in the surviving spouse's estate. Therefore, they should make sure that they have advised clients of the possible risks, and looked at all the alternatives.


Robert Brodrick is a senior solicitor specialising in tax, trusts and estate planning in the private client department at City-based law firm Trowers & Hamlins