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Ray McCann, Partner at Joseph Hage Aaronson and Deputy President, Chartered Institute of Taxation, gave evidence on the tax measures contained in the November 2017 Budget to the Treasury Select Committee on 5 December 2017.

Full details on the written evidence can be accessed here.

KEY POINTS

Due to the imposition of IHT on all enveloped structures holding UK residential property of any value from April 2017 an urgent review is required of any such holding structures.
INTRODUCTION

• Any solution must be tailor made to fit the particular circumstances of the client.
• After April 2017 some options for de-enveloping will be closed. For example it will not be possible to take foreign companies holding residential property out of a trust without an exit charge arising of up to 6% of the value.
• Borrowing taken out to purchase UK residential property needs to be considered very carefully as in some cases it will also be subject to IHT.
• The proceeds of sale of companies holding residential property can also be subject to IHT for two years after the sale.
• Gifts of companies holding residential property should be effected before April 2017.

The Government confirmed in the consultation document published on 19 August 2016 that all UK residential property held in foreign companies or partnerships will come within the scope of UK IHT from 6 April 2017. The draft legislation setting out how this policy will be implemented was released on 5th December 2016.

BACKGROUND TO THE REFORMS

If a UK asset is held directly by a trust or an individual then IHT is already payable under the current legislation irrespective of where the individual or trust is domiciled or resident. The rate is broadly 40% on the death of an individual and 6% every ten years for UK assets held directly by trusts. In some cases a double IHT charge can arise if the asset is held in a trust from which the individual settlor can benefit, resulting in 40% on death and 6% every ten years.

In order to avoid IHT it has been common for foreign domiciliaries including non UK residents to hold UK assets such as pictures and houses through wholly owned foreign companies. This is often called “enveloping”. As the individual or trust then holds foreign situated property rather than the UK property no IHT is payable; it effectively becomes “excluded property” in that it is excluded from IHT by the Inheritance Act 1984 (IHTA) s6 and s48.

While enveloping still works for assets such as commercial property and pictures, from April 2017 such enveloping will no longer provide any IHT protection for UK residential property and indeed there may be positive disadvantages in enveloping such UK residential property.

The IHT changes are part of the Government’s ongoing attempts since 2013 to put the taxation of UK residential property between residents and non-residents on a more level playing field. The first shot in the bows was the introduction of Annual Tax on Enveloped Dwellings (“ATED”) in April 2013 which imposed an annual charge on any high value property (over £2m) owned through a company. The ATED charge has since been extended to any property worth £500,000 or more although it is not imposed on let property. The annual rates are high – over £23,000 pa for property worth more than £2m in April 2012 or at the date of acquisition if later. The next revaluation date will be April 2017 and some properties will fall into a new higher band then. On any disposal of such properties by the company a special CGT charge is imposed at 28% on the increase in value since 2013. However, the IHT protection afforded to enveloped structures meant that in many cases people were prepared to pay ATED to save IHT particularly where the owner was elderly and more likely to die. With the loss of IHT protection, ATED and ATED-related CGT has now become merely an additional cost without any offsetting benefits and makes the case for keeping enveloped structures much less compelling.

The second change in relation to UK residential property came in 2015 with the introduction of non-resident CGT: this applies to disposals of residential property by all non UK residents but only in respect of increases in value accruing since April 2015. The third change now is IHT: there will be IHT due at 40% on the death of an individual owning enveloped residential property after April 2017 irrespective of when the property was acquired. There are no transitional reliefs. That individual will be still entitled to the same reliefs and exemptions as a UK domiciliary or UK resident such as exemption on transfers between spouses. Trusts will also be subject to ten year charges at 6% on the value of their residential property going forward. Any transfers of enveloped property into trust will be taxed at up to 20% immediately and transfers of enveloped property out of trusts will be taxed at up to 6%.

Many advisers had hoped for some kind of de-enveloping relief to aid individuals in unravelling what are now tax inefficient structures but the Government has rejected the prospect of any such relief. As it stands therefore there may be a significant cost (mainly capital gains tax or SDLT) in extracting residential properties from the company especially for UK resident shareholders or where the property is subject to borrowing.

This note considers briefly the scope of the new legislation. Tread very carefully is the key message – the tax rules in this area are complex and navigation of these rules is not to be undertaken lightly. The legislation is only draft and is clearly likely to be amended and expanded before it finally becomes law but the broad shape of the proposal is now clear.

THE NEW IHT LEGISLATION

Clause 42 and Schedule 13 of the draft Finance Bill 2017 operate to amend the definition of excluded property in section 6 and section 48 IHTA to charge IHT on residential properties situated in the UK if held through foreign structures such as companies and partnerships. IHT is now imposed on the shareholder or loan creditor of the company or the partner of the foreign partnership that holds such UK residential property as if the company or partnership was UK situated. The charge only applies to companies that are closely held i.e. under the control of five or fewer participators.

The definition of residential property is widely drawn and includes any dwelling interest including those existing for off-plan purchase. There is no relief for let properties and it applies to all residential properties, whatever their value. The legislation includes a targeted anti-avoidance provision which disregards any arrangements entered into for the sole or main purpose of avoiding or mitigating the effects of the new legislation. Of interest for individuals who have long benefited from various double tax treaties mitigating the effect of a UK IHT charge, the new rules specifically exclude double tax relief where no such equivalent tax is charged in a home jurisdiction.

If the land changes in character from residential to commercial or vice versa during the course of ownership there is a tax charge only if it is residential at the relevant point of charge. The Government’s original proposal to have a two year clawback if, for example, the land changes in nature from residential to commercial in the two years before death, has been dropped. Where property is owned by a company and used for both commercial and residential purposes e.g. the flat above the shop, then one would assume a just and reasonable apportionment will be made between the commercial and the residential elements as the commercial element is not taxable albeit there is no provision for this in the legislation as drafted.

Any gifts to individuals or trusts should be done before April 2017 to avoid a PET or chargeable transfer for IHT purposes. If the settlor can benefit from any trust that holds enveloped property bear in mind that after April 2017 this property will be subject to a reservation of benefit and charged at 40% on his death so the settlor may need to be excluded or the trust ended prior to this date.

How this charge will be enforced and collected remains uncertain as no legislation has been published on this part of the proposals. It seems likely from comments in the related documentation that some sort of duty of disclosure will be placed on the directors.

PRACTICAL EFFECT

The practical effect of the changes can best be illustrated by way of some examples.
WHY DE-ENVELOPE?

1. Peter is foreign domiciled and non UK resident and owns a portfolio of residential let properties through a foreign incorporated company. At present there is no IHT on his death or on any lifetime gift. From April 2017 this will change and the company shares will be subject to IHT on his death to the extent they derive their value from the UK properties. If he leaves the shares to his wife he may be able to benefit from spouse exemption. If he settles the shares into trust before April 2017 there is no entry charge as it is excluded property. If he settles the shares into trust after April 2017 an entry charge will arise at 20%. If he gives the company shares to his son now there is no PET. If he gives the company shares to his son after April 2017 there is a PET and he needs to survive 7 years. If the shares are settled into trust Peter must be excluded from benefit to avoid a 40% IHT charge on his death without the possibility of spouse exemption. He should be excluded from any trusts holding UK residential property before April 2017 to avoid a seven year run off period.
2. The trust of a deceased foreign domiciled settlor owns a valuable UK property through a foreign incorporated company. It is occupied by a beneficiary. ATED is payable each year. The ten year charge of the trust falls in October 2017. At that point the trust will be subject to tax under the new regime. A small ten year anniversary charge will arise based on the fact that the trust has held relevant property for six months. (Prior to that the shares of the company were not relevant property). If the trust distributes the company shares then an exit charge will arise. The legislation contains special provisions to prevent death bed sales of foreign companies to avoid the charge.
3. John holds a valuable UK property through a foreign incorporated company. He has lived all his life in Hong Kong. Just before he dies he sells the company for full market value to his son and then John dies, leaving his cash back to his son. On his death John holds excluded property (the cash) which is free of IHT. As he has made no gift, without anti-avoidance legislation there would be no tax due. No non-residents CGT or SDLT is payable on the sale of company shares. The draft legislation deals with this by providing that if the individual sells the company shares, a two year rule is imposed to charge the proceeds of sale. The individual must survive 2 years from the sale to avoid IHT on his death. The same two year rule does not apply to sales of the property itself.
4. A trust set up in 2008 by a now deceased foreign domiciled settlor holds UK residential property through a foreign incorporated company Newco. The settled property is therefore currently excluded property. However, in 2018 Newco will be subject to a small ten year anniversary charge based on the value of the UK property. In the absence of any new anti-avoidance provisions could the trustees sell the company holding the UK property on the open market before 2018 and thus avoid the ten year charge? In fact as IHTA is currently drafted* an exit charge will arise if the trustees sell the company or the company sells the property at any time before the ten year anniversary and the draft legislation extends this charge in certain circumstances. By contrast if the trust holds the UK property direct and sells it just before the ten year anniversary then no exit charge arises. In addition in order to stop people avoiding the tax charge by borrowing from connected party structures or borrowing from banks with back to back collateral the legislation imposes a charge on the borrowing even if it is allowed as a deduction from the value of the UK residential property.
5. Settlor lends to Trust to enable it to purchase residential property. The loan is £600,000 and the property is worth £1m. The borrowing is deductible against the value of the property in the trustees’ hands but the loan will be chargeable to IHT on the death of the settlor. It will also be chargeable if it is repaid and the settlor dies within two years.
6. Settlor lends £1m to son who uses the funds to purchase UK property. The son can deduct the loan when calculating his IHT charge but the loan is chargeable on the settlor on his death or if he settles it into trust or gives it away and dies within 7 years. If the settlor lends to the son to buy Spanish property then there is no IHT charge on the loan.
7. Son borrows from a bank to buy UK property with the help of a back to back deposit at the bank from a trust where he is a beneficiary. The bank borrowing is deductible but the back to back loan is chargeable to IHT in the hands of the trustees.

It is gradually being acknowledged that the confidentiality and privacy attractions of these structures have in any event over time been lessened by the global transparency agenda quite apart from the hefty ATED cost of owning such structures. Many countries have now introduced a variant of a register of ultimate beneficial owners and the tendrils of the Common Reporting Standard stretch far and wide. How to tackle security and privacy issues will need to be considered alongside the tax issues. It is possible to hold properties in nominee names without falling foul of ATED charges.

HOW TO DE-ENVELOPE?

There will typically be two common incarnations of these property holding structures. Either the property is held in a non UK company, the shareholder of which is the non dom individual- either UK resident or non UK resident. Unwrapping from here is more straightforward and a liquidation and distribution of the property out to the shareholder, taking account of the capital gains tax position may be all that is required.

In the alternative, the property is held in a non UK company which is in turn held in the trust of the non-UK domiciled, likely UK resident settlor and the tax position on de-enveloping this structure is more complex, particularly where beneficiaries of the trust have been occupying the property, as the capital gains tax triggered on the liquidation and distribution may be significant.

In either scenario, in order to de-envelope, careful consideration of the historical CGT position will be required. The property will need to be valued at 5 April 2013 in relation to any ATED CGT and if the individual is non UK resident, a 5 April 2015 valuation will be required to take into account the gain that has accrued since the introduction of non-residents CGT. A 2008 valuation will also be needed as this may be relate to another transitional issue called trust rebasing.

The extent of the tax at stake will need to be carefully balanced and of course funding any tax charge may be a challenge if an individual needs to remit funds in order to do so. It may be possible to transfer the company shares out to the individual with hold over relief and thereby obtain CGT rebasing on the company shares if the individual becomes deemed domiciled for all tax purposes under the new rules on 6 April 2017.

WHY PUT OFF TO APRIL 2017 WHAT CAN BE DONE TODAY?

Delaying taking action will simply increase the cost of extracting these properties.

Transferring the property out of the trust in advance of April 2017 will avoid any additional IHT 10 yearly and exit charges. In relation to the “gift with reservation of benefit” rules, the settlor ought to be swiftly excluded from benefiting from the trust or the property should be distributed out to him.

Co-ordinating any liquidation/distribution process is a time consuming process which requires significant input from overseas advisers. There may be circumstances where consent is needed from funders and/or landlords which will also take time to navigate. Action sooner rather than later is therefore advisable.

* This is for the following reasons:

1. Under s65(1) a charge arises where property ceases to be relevant property.
2. However, s65(7) provides that tax is not charged if the property “ceases to be situated in the UK and thereby becomes excluded property by virtue of s48(3)(a).”

Originally printed in Business Tax Voice in May 2016

Even by today’s standards when anti-avoidance legislation seems to be more and more radical, the Transactions in Securities rules (TIS) were widely seen as condemning tax avoidance transactions to history with some early judicial comment describing them as making tax avoidance no longer possible. As is now clear, this was true only so far as the tax avoidance was within their scope and over the intervening years the Revenue found that the scope of these provisions was very limited indeed. So much so that in the cases of Kleinwort Benson, Sema Group Pension fund and Laird Group, arrangements that the Revenue could reasonably believe were fairly within the cross hairs of the TIS rules escaped. Thus it is clear that where they did apply their impact was severe, so much so that even fifty years on no other provision operates quite like them, but they did not apply very often.

Ray McCann takes a look at the history of the TIS rules and considers the impact of the Tax Law rewrite programme and the 2016 changes.

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