As part of Budget 2016, the government announced a few changes to the taxation of objects of national, scientific, historic or artistic interest. Min Nolan, Solicitor, and Geoffrey Todd, Partner, in the private wealth team at Boodle Hatfield explain the development.

What is Estate Duty?

Estate Duty was introduced in 1894 as a tax on property passing on death or on lifetime transfers. It was replaced by Capital Transfer Tax in 1975, which was in turn replaced by the current inheritance tax (IHT) from 1 August 1984.

Conditional exemption from IHT can be claimed in respect of property that is of national, historic or cultural pre-eminence. The owner of the property must give undertakings agreeing to meet certain conditions, including for example allowing public access to the property for a certain number of days and taking steps to preserve and maintain it among other things. In return the tax chargeable on heritage property is postponed indefinitely. There was a similar exemption for Estate Duty given under s.40 Finance Act 1930. The conditions then were slightly less onerous than they are today, requiring the property to remain in the UK and access to be allowed for specified purposes. There remain some legacy Estate Duty provisions in relation to property exempted before March 1975 and it is in relation to these that the law is changing.

What was the position and how is it changing?

A recapture charge can be triggered by certain events so that conditional exemption from Estate Duty or IHT is lost and tax becomes payable on the exempted property. These events include: (1) a sale or transfer during the owner’s lifetime where the undertakings are not renewed; (2) a breach of the undertakings; or (3) a transfer on death where the undertakings are not renewed.

In relation to the lifetime chargeable events at (1) and (2), HMRC can choose whether to levy tax at the rate applicable at the time the property was exempted (the Estate Duty rate), or at the current IHT rate. Previously in respect of (3), where the property passed on death, the Estate Duty exemption would crystallise and become absolute on the death of the owner, meaning effectively that it was washed out. If the subsequent owner of the property applied for and was granted IHT conditional exemption, then the IHT rate would apply to the property on a subsequent sale or breach of the conditions. The property was then taxed at the IHT rate, despite being exempted from a potentially much higher Estate Duty originally.

As of March 16 2016, the legislation has been amended so that the Estate Duty exemption does not become absolute on the death of the owner. As with events (1) and (2), HMRC can now choose to apply either the current IHT rate or the Estate Duty rate applicable at the time of the exemption, on a subsequent sale of the property.

What might be the significance for owners of these objects?

The change could increase the tax charge on the sale of inherited heritage property by as much as 40%. For example, Mrs A died in 1950 passing a Manet painting to her son Mr A who was then granted a s.40 FA 1930 Estate Duty exemption. At the time Estate Duty was applied on the painting at a rate of 80%. Mr A dies on 17 March 2016 and the Manet is inherited by Miss A. Even if Miss A gets IHT conditional exemption on the painting saving her from the immediate IHT charge, if she subsequently has to sell the Manet or wants to give it to her children who do not want to renew the undertakings, she will potentially be liable for an 80% tax charge rather than the 40% charge that would have been applicable previously. Those inheriting property which had been subject to Estate Duty at a rate higher than 40% will now either have the higher rate of tax to pay, or will be subject to the more onerous conditions applied under IHT conditional exemption rules while continuing to have the higher rate of duty hanging over them, where previously they had thought would be washed out (and in some cases halved) on their death.

HMRC have said that the changes will apply to deaths on or after 16 March 2016, and the old rules will apply to deaths before that.

Are there any other changes being made to Estate Duty and Inheritance Tax?

There was previously no provision to account for an object exempt from Estate Duty which had been lost. The definition of loss includes theft and destruction by fire. Following Royal Assent of the Finance (No.2) Bill 2016, if such an object is lost a charge can be levied, unless HMRC agree that the loss was outside the owner’s control. If HMRC is notified of a loss before Royal Assent is given, the lost item will not be subject to the amended legislation.

Additionally, museums and public galleries which had lost their tax exempt status under the terms of Schedule 3 IHTA 1984 due to their status as independent charitable trusts, will be reinstated to be within the scope of these exemptions. The exemptions include, for example, tax free private treaty sales under the douceur arrangements and it is hoped that reinstating these tax benefits will encourage gifts to public collections. There will also be a power to enable the Treasury to add further national institutions to this class.

Did this announcement come as a surprise?

The amendments were not anticipated as there had been no previous consultation in relation to the changes. HMRC comment in the Policy paper that the legislation was altered to ‘correct a technical issue with the current legislative framework’.

Does this fit in with the government’s other policies on tax avoidance and evasion?

The changes do not appear to have been brought in as part of the government’s clamp down on tax avoidance or evasion in the 2016 Budget. The purpose of conditional exemption was, and continues to be, to assist in preserving the cultural heritage of the nation and avoid objects or places of importance being sold to pay off death duties. Arguably, any tax that has been avoided under the conditional exemption rules has been chiefly in aid of this purpose.

The reasoning for the changes given by HMRC, that they are corrections of the current legislation, is understandable in relation to lost conditionally exempt property, and to the rectified exemptions given to museums and public galleries now operating as independent charitable trusts. It is less easy to see as a “correction” the change to the allocation of tax rates for s.40 FA 1930 exempt property following a transfer on death, which has been in place for decades. While the changes to the legislation are workable for those who have inherited s.40 FA 1930 exempt property, as far as they are able to claim IHT conditional exemption on the property, they are likely to make it much less appealing to trigger the recapture charge by disposing of inherited property where the initial Estate Duty exemption was over 40%. With Estate Duty historically going as high as 80%, the changes could result in a significant increase in the potential tax burden for those individuals who are in possession of s.40 exempted property. HMRC estimate the number of those who may be affected to be as low as 2,000, however, and so these changes are likely to have a negligible impact on the Exchequer.

This article originally appeared in LexisNexis Legal Analysis.