Changes to excluded property settlements - latest update
In very general terms, the intention is that the changes involving additions to settlements will have effect in relation to tax charges arising after the Finance Bill becomes law, even if the addition to the trust took place many years ago.
On the other hand, the changes to the rules relating to transfers between settlements were only supposed to have effect where the transfer takes place after the Finance Bill becomes law.
Unfortunately, the legislation in some respects creates uncertainty and in others, has unintended consequences.
No changes are now likely to be made to the legislation which has passed its way through the House of Commons and will become law by the time Parliament rises for its summer recess on 22 July 2020.
The key changes are explained in our previous note.
Whilst, for the most part, the changes are well known, there are two significant points which are less well understood.
Loans to excluded property settlements
Under the new rules, the key question in determining excluded property status for assets held in a settlement will be whether the settlor was neither domiciled nor deemed domiciled in the UK when the property became comprised in the settlement rather than when the settlement was first made.
This has led to speculation as to whether a loan to a settlement results in property becoming comprised in the settlement. If it does, that property will not be excluded property if the loan is made at a time when the settlor is domiciled or deemed domiciled in the UK.
On a literal interpretation, it could of course be argued that, in one sense, the funds which are lent to the settlement become comprised in the settlement.
However, the legislation must be interpreted looking at the overall context. On this basis, it is clear that the concept of property becoming comprised in a settlement involves some sort of addition to the settlement. If it were otherwise, a sale of an asset to a trust at market value would result in property becoming comprised in the settlement. A loan where there is a right to repayment of the sum lent is no different.
The idea of property becoming comprised in a settlement for inheritance tax purposes is not new. It has for many years been part of the mechanics for calculating 10 year anniversary and exit charges under the inheritance tax relevant property regime. In this context, it has never been suggested that the making of a loan to a settlement results in property becoming comprised in the settlement and therefore affects the calculation of any such inheritance tax charges.
In principle, the answer to this question should be no different whether the loan bears interest at a market rate of interest or whether it is interest-free. However, some caution should be exercised in this context as, whatever the merits of the legal position, it might be more tempting for HMRC to argue that property has become comprised in a settlement where some value has been provided as a result of the loan being interest-free. However, even in such cases, it is difficult to see how HMRC could argue that any property has become comprised in the settlement beyond the interest foregone or, possibly, any profits made as a result of investing the loan.
It is also possible to envisage extreme cases (for example where substantially all of the funding for a trust has been provided by way of loan) which might fall foul of the general anti-abuse rule so that none of the property in the settlement would be excluded property.
In normal situations however, the making of a loan to a settlement after the settlor has become domiciled or deemed domiciled in the UK will not affect the excluded property status of the assets held by the trust.
Transfers between settlements – tax on the settlor’s death
As a result of what is almost certainly an oversight, a transfer between two excluded property settlements made at a time when the settlor had become domiciled or deemed domiciled in the UK will result in a 40% inheritance tax liability on the settlor’s death if they are a beneficiary of the transferee settlement. This will be the case even if the transfer took place before the Finance Bill becomes law.
Example
Anika has lived in the UK since 1990. In 2004, before becoming deemed domiciled in the UK for inheritance tax purposes, she established two settlements, one holding a business interest and the other holding liquid investments.
In 2010, following the sale of the business, the trustees consolidated all of the assets into a single settlement in order to save administration costs by transferring the proceeds of sale of the business to the trust which held the liquid investments. On her death after the Finance Bill becomes law, Anika will be subject to inheritance tax on that part of the trust assets which represent the funds transferred from the business trust.
This problem could be solved if Anika is prepared to be excluded from benefiting from the trust (or at least that part of it which represents the funds transferred from the business trust if they can be separately identified). If this is done before the Finance Bill becomes law, it will have no inheritance tax consequences. If it is done afterwards, there would be a tax charge if Anika fails to survive for seven years as the property will by then no longer be excluded property.
Assuming it is right that this situation results from an oversight in the drafting of the legislation, it is possible that the Government may be persuaded to correct it (hopefully retrospectively) in a future Finance Act. It would however perhaps be unwise to rely on this given the fierce competition for space in each Finance Bill.
Conclusion
The rules relating to excluded property settlements will in the future be more complicated than ever. The legislation has evolved on a piecemeal basis which has inevitably led to uncertainties. We might perhaps hope that HMRC will be willing to give guidance on their interpretation of the legislation including the circumstances in which they might consider that property has become comprised in a settlement.
