Inheritance tax review: reform of business property relief
The report covers a wide range of issues from relief for lifetime gifts to gifts to charity. But the main areas of interest for many privately owned businesses will be the conclusions and recommendations relating to the application of business property relief (BPR) and its interaction with the capital gains tax uplift on death.
BPR: conclusions and recommendations
BPR is a relatively costly relief. It is estimated to cost the Exchequer approximately £1bn per year. But, while there may have been some concerns that the OTS might recommend the abolition of BPR entirely, it does not. Instead the report recognises the “important role” that the relief plays in ensuring that businesses can pass from one generation to another.
The report does, however, acknowledge that some aspects of the BPR regime are distortive, overly complex and, at times, inconsistent with other parts of the UK tax code. The report contains some specific recommendations, which have caught the headlines – such as a proposal to withdraw the treatment of shares listed on AIM as unquoted securities for BPR purposes, and so benefitting from wider reliefs – but this note concentrates on the proposals that affect shareholders in privately-owned companies and groups.
- First, the report suggests that the government should consider why the level of trading activity for BPR is set so much lower than the comparable reliefs from capital gains tax.
Comment: BPR provides relief for 100% of the value of shares in unlisted trading companies and groups. For a company or group to be regarded as trading, its business must not consist “wholly or mainly” of holding investments. While “wholly or mainly” is not defined in the legislation, in practice, this is a 50% or more test. On the other hand, the capital gains tax reliefs which apply to disposals of shares in trading companies and groups - holdover relief and entrepreneurs’ relief - apply to companies whose activities do not “to a substantial extent” include activities other than trading activities. This test is treated by HMRC as satisfied where non-trading activities do not amount to 20% or more of the activities of the company or group.
The clear implication of the OTS report is that the government should consider aligning the BPR test with the tests for capital gains tax holdover relief and entrepreneurs’ relief. And, at first sight, the proposed reform appears a logical one. There are clear simplification benefits in aligning the tests in the various regimes; one test is simpler than two. In addition, the BPR test has many idiosyncrasies which could be ironed out by the adoption of the capital gains tax rules.
Such a reform would, however, not be welcomed by many privately-owned groups. As well as the move from a 50% to a 20% threshold, the change from a test which focuses on investment to a trading/non-trading test also represents a significant narrowing of the relief. Some may argue that it is not appropriate to align the rules for a relief from a tax charge which for the most part occurs on the death of the shareholder, with the rules for relief from a tax on profits which arise, for the most part, from a voluntary disposal at a time chosen by the shareholder.
The BPR test is a long standing one. Many private groups have been structured to reflect its provisions. A reform on this scale would require a period of adjustment. Some careful thought will also need to be given to other related parts of the IHT regime (such as the concept of excepted assets). So this is not a change which could or should be implemented in haste.
- The second reform proposed in the report is that the government should review the treatment of non-controlling shareholdings in unquoted trading companies which are held indirectly to ensure the use of a holding company structure does not inappropriately affect the scope of the relief.
Comment: At present, the treatment of minority stakes in unquoted trading companies is inconsistent. If such a stake is held directly by an individual, it may qualify for 100% BPR. However, if such a stake is held within a holding company structure, it is likely to be treated as an investment and may risk disqualifying the shares in the group holding company from BPR entirely.
This makes little sense in the context of shareholdings in closely-controlled joint venture companies. The capital gains tax holdover relief and entrepreneurs’ relief rules recognise this and include appropriate provisions under which shares in qualifying joint ventures are ignored and the activities of the joint venture company treated as part of the activities of the group as a whole when assessing whether or not the group is considered to be trading.
This is a sensible proposal. It follows logically from the proposed changes to the trading test for companies and groups, but should be adopted whatever the outcome of any consultation on that matter.
- The report also suggests that the government should review the treatment of limited liability partnerships to ensure that they are treated appropriately for the purposes of the BPR trading requirement.
Comment: The current wording of the IHT legislation suggests that a corporate trading group that has an LLP rather than a company as its holding vehicle may not qualify as “trading” for BPR purposes. The effect is to deny BPR for an interest in an LLP in circumstances where, if the holding entity of the group were a company, relief would be available.
This again is a sensible reform. However, it is not the only aspect of the treatment of LLPs which is inconsistent. Any review should, in our view, also extend to some of the other issues which arise from the presence of LLPs (and other entities such as US LCCs) within groups. This is an issue, not just for IHT, but for other UK grouping tests as well.
CGT: uplift on death
The report includes a discussion of the potentially distortive effect of the current rule under which beneficiaries of an estate acquire assets at their market value on the death of the testator, in particular, in cases where the gift to the beneficiary also qualifies for a relief from IHT such as BPR.
- The report recommends that, where a relief from IHT, such as BPR, applies, the capital gains tax uplift should be removed and the beneficiary should be treated as acquiring the assets as the testator’s historic tax base cost.
Comment: The OTS argues that current regime incentivises business owners to hold on to shares which qualify for BPR until death at which point the shares can pass to their beneficiaries free from IHT and with an increased base cost for capital gains tax purposes. This does not promote the transfer of family businesses between generations at the most appropriate time for the business and allows the next generation to dispose of the business tax-free immediately following the death of the original owner without having carried on the business.
It is difficult to argue against the logic. However, this will be an unpopular change. It might be slightly more palatable to privately-owned groups if the broader trading activity test is retained. But again this has been a feature of the IHT and CGT regimes for some time and any change would require an adjustment to the succession plans of many family-owned businesses.
The most accelerated timetable for any of these changes would be for a government response at the time of the Budget in the Autumn with possible legislation in Finance Act 2020 to take effect in April 2020. Perhaps more likely is a formal HMRC consultation announced at the Autumn Budget with legislation in Finance Act 2021 to take effect in April 2021.
This all assumes of course that the existing IHT regime survives that long. The most recent Labour Party proposals suggested the abolition of IHT and its replacement with a lifetime tax on gifts with a relatively low threshold and charged at income tax rates.
It is clearly too early to be implementing changes to group structures in response to these recommendations. But groups and shareholders taking the long view will want to see what difference these types of reforms could make, and consider the potential effect on BPR claims so that they are prepared, if and when the recommendations develop into firmer legislative proposals.