The government announced in July 2015 that an inheritance tax charge would be imposed on UK residential property held through offshore structures. Since then we have been waiting eagerly for the full details of how the tax charge will work and many individuals have deferred decisions about what to do with existing structures until more information became available.
That day has now come although even now the draft legislation which has been published is not quite complete.
Who will be affected?
The new rules will affect all non-UK domiciliaries and the trustees of trusts they have established who hold an interest in an offshore structure which derives its value from UK residential property; from loans used to acquire, maintain or improve UK residential property; or from collateral for such loans or who have thereunder made or provided collateral for such loans.
Which assets are relevant?
The new legislation imposes an inheritance tax charge on three categories of property:
- Interests (e.g. loans or shares) in closely held companies which directly or indirectly derive their value from UK residential property. The interest in the top company will still be caught even if there is a chain of companies underneath before you get to the residential property. However, if any of the companies is widely held (for example a real estate fund), this will not be caught.
- An interest in a partnership, the value of which is directly or indirectly attributable to UK residential property. Unlike companies, it does not make any difference how many partners there are and whether or not they are connected. A real estate fund which is structured as a partnership will therefore fall within the new rules.
- The benefit of loans made to enable an individual, trustees or a partnership to acquire, maintain or improve a UK residential property or to invest in a close company or a partnership which uses the money to acquire, maintain or improve UK residential property. To avoid back-to-back lending arrangements, assets used as collateral for such a loan will also be subject to inheritance tax under the new rules. An interest in a close company or a partnership which holds the benefit of the debt or the assets which are used as collateral are also caught.
One surprising omission from the list of assets which are caught is units in a unit trust although it is debatable whether units in a non-UK unit trust, which holds UK residential property are UK assets and therefore within the scope of UK inheritance tax in any event.
The most surprising aspect is the breadth of the rules relating to loans and collateral. In some circumstances this could lead to double taxation.
Take, for example, a (not uncommon) situation where a settlor interested offshore trust has made a loan to the settlor to enable him to acquire UK residential property. It is likely that the debt will not be deductible from the value of the property for inheritance tax purposes as there are anti-avoidance provisions which deny a deduction for a loan which is made out of assets previously given away by the taxpayer.
However, the benefit of the debt held by the trust will also be subject to inheritance tax on the settlor's death as it will be treated as forming part of his estate under the reservation of benefit rules since he is a beneficiary of the trust. The trustees will also be subject to ten year inheritance tax charges on the value of the debt.
The provisions relating to collateral could result in assets much greater than the value of the house, and certainly worth much more than the amount of the loan which can be deducted from the settlor's estate being within the scope of inheritance tax.
For example, if a taxpayer has borrowed 5m from a bank to acquire a property in the UK and has pledged his offshore portfolio of 10m as security for the debt, the whole 10m portfolio will be within the scope of UK inheritance tax.
This affects existing arrangements and not just new situations as the new rules will apply to any taxable event which occurs after 5 April 2017. There is no grandfathering for existing structures / loans.
Another surprise is that where property which would otherwise be caught has been disposed of, or a loan which would be caught has been repaid, the proceeds of sale / repayment remain within the scope of inheritance tax for two years.
This means, for example, that if trustees own a company which holds a UK property and that property is sold less than two years before a ten year charge, there will still be a liability to inheritance tax at the date of the ten year charge, even though no UK residential property is owned at that time.
Although it is not currently included in the draft legislation, there will be provisions to ensure that where a property has mixed use, it is only the value of the residential part which will be subject to the new rules.
Which taxable events do the new rules apply to?
All events on which inheritance tax could be chargeable will be affected by the new rules. This includes:
- The death of the individual who holds the property or who is a settlor and beneficiary of a trust which holds the property or who has a pre-2006 right to the income from a trust which holds the property.
- Lifetime gifts of any property which is subject to the new rules.
- Ten year charges and exit charges for trusts which hold such property.
The intended tax charge applies to any inheritance tax events which occur after 5 April 2017. However, if an individual has made a gift of property which is within the new rules before 6 April 2017 and dies after 5 April 2017 but within seven years of having made the gift, this will not give rise to a tax charge as the question as to whether the gift was of excluded property is tested at the time the gift is made not at the date of death.
Where an offshore entity has borrowings, the debts will be deducted proportionately from each of the assets owned by the company. This is good news if the company has borrowed to acquire property other than UK residential property as part of the debt will be deductible from the UK residential property in determining the value on which inheritance tax will be charged. However, it is bad news if the company has borrowed to acquire UK residential property but also owns other assets, as only part of the debt will be deductible from the UK residential property.
Am I protected by a double tax treaty?
The UK only has a small number of inheritance tax double tax treaties (11 in total). In some circumstances, exclusive taxing rights in relation to the sort of property caught by the new rules (for example, shares in a company) would be allocated to the other country.
The draft legislation includes provisions which override these treaties unless the other country charges inheritance tax or a similar tax and there is actually some tax to pay (however small) in that country.
So, for example, if an individual is domiciled in India (where there is no inheritance tax), the treaty will not assist.
On the other hand, if the individual is domiciled in Geneva but paying tax under the forfait system, there is a six per cent charge to inheritance tax on assets passing to a spouse or descendants. It is therefore likely that, as a result of the treaty, there would be no UK inheritance tax to pay
There will be a targeted anti-avoidance rule which effectively ignores any arrangements intended to side step the new rules. This is very widely drawn and could potentially apply to some seemingly quite straightforward situations.
For example, if a non-domiciled individual sets up a company to buy a UK investment property (which still may make sense going forward see below) and arranges for the company to borrow in order to help finance the purchase, even though the individual had enough money to fund the company himself, it could be said that the main purpose of the loan is to minimise the effect of the new rules and should therefore be ignored.
Clearly, we hope that HMRC will take a more pragmatic view in applying the targeted anti-avoidance rule but relying on HMRC's goodwill is somewhat unsatisfactory for taxpayers.
Who will be liable for the tax?
In the previous consultation, it had been suggested that liability for any inheritance tax due would extend not only to the individual or trustees who hold the property on which tax is chargeable but also the offshore entity which holds the UK residential property and possibly the directors of any offshore company which holds the property.
As a result of representations in the consultation responses, the government has decided not to include these provisions and so it is only the individual or the trustees who will be liable for the tax.
The government has, however, said in its consultation response that it will consider alternative approaches to ensure that the extended inheritance tax charge can be effectively enforced but no details are given at this stage as to what alternatives they have in mind.
What should you be doing?
If you have not already done so, you should review any offshore structure which owns UK residential property to see whether it will be caught by the new rules and, if so, when any inheritance tax charges are likely to arise.
You will now also need to review whether you have any offshore structures which have made loans or provided security for loans which have been used in relation to UK residential property or whether you, as an individual, have made any such loans or provided any such collateral.
Where a property owning structure is caught by the new rules, it will no longer provide any inheritance tax benefits. If the annual tax on enveloped dwellings is payable, there will be a strong case for dismantling the structure although this may well come at a tax cost.
There will be capital gains tax to pay on any increase in value since the property came within the Annual Tax on Enveloped Dwellings (ATED) regime as well as possible UK capital gains tax on gains relating to earlier periods if the owner is UK resident. There could also be stamp duty land tax unless care is taken if there are loans secured on the property.
The government has made it clear that there will be no relief from these tax liabilities.
You will therefore need to take advice as to what tax liabilities might arise and then weigh up the benefits of terminating the structure (no longer having to pay the ATED charge) against the upfront tax cost.
Where properties held through offshore structures are not within the ATED regime, there may be no disadvantage in retaining the existing structure. Indeed there may be some benefits as the rate of capital gains tax for offshore companies is lower than for individuals and funding the company with debt minimises UK tax on the rental income.
You will need to keep an eye on this last point as there will be a consultation launched at the time of the 2017 Budget as to whether offshore companies should come within the scope of UK corporation tax (and therefore the rules which apply for corporation tax purposes to limit the availability of interest relief).
Loans and collateral will need special attention given the scope for double tax charges and for inheritance tax being payable on amounts which significantly exceed the value of the property or the amount of the debt which will be deductible from the value of the property.
In some situations it will be worth exploring whether connected party debt can be replaced with bank debt.
Where a loan is secured on offshore assets either as well as or instead of the property itself, the feasibility of securing the loan on the property alone should be discussed with the lender or with alternative lenders.
The two year rule where an asset is disposed of or a loan is repaid only applies where the disposal or repayment takes place after 5 April 2017. If you are considering selling any UK property (and, as a result, disposing of the interest in the offshore structure which would be caught by the new rules) and / or repaying any loans so that the new rules do not apply, there is a good reason to do this by 5 April 2017 in order to avoid the additional two year inheritance tax exposure.
A sale of the UK residential property itself is, surprisingly, not caught by the two year rule and so if the proceeds are retained in the structure there will be no tax charge even if an inheritance tax event occurs within the following two years.
How can I protect myself against inheritance tax on UK residential property going forward?
The proposed new legislation is widely drawn and, in the future, it will be difficult to avoid paying UK inheritance tax on UK residential property. There are however a number of relatively straightforward ways of mitigating (but not necessarily eliminating) any tax liability:
- Lifetime gifts to the next generation but only if the parents do not live in the property or pay a market rent.
- For a married couple, using the spouse exemption on the first death, possibly coupled with a subsequent gift to the next generation.
- Life insurance relatively cheap in the early years but this becomes quite expensive once the owner gets older and so may not be a long-term solution. It is, however, a good solution for younger non-domiciliaries who will in due course leave the UK and then sell the property.
- Loan secured on the property to purchase or improve the property. Any growth in value will of course still be subject to inheritance tax.
- Where investment properties are being purchased, using a widely held company (i.e. getting together with other investors) will avoid any inheritance tax exposure.
We will no doubt see other, more complex, suggestions for the ownership of UK residential property. However, given the targeted anti-avoidance rule, any proposals will need to be examined carefully if one of the benefits is said to be freedom from UK inheritance tax.