Last week, I looked at the important role that will trusts can play in the overall estate planning strategy of investors who have a strong need to retain full control over their investments during their lifetime, use their nil-rate band on death but retain flexible, inheritance tax-effective access to the funds left subject to the trust for the surviving spouse.
This access will usually be through interest-free loans. The deductibility of such loans on the death of the survivor was the subject of the recent Phizackerley case.
Dr and Mrs Phizackerley bought a house in 1992. The house was owned on a joint-tenancy basis but Dr Phizackerley, as the only one of the couple working, provided all the funds.
In 1996, Dr and Mrs Phizackerley severed the joint tenancy so they owned the property as tenants in common. Mrs Phizackerley died in 2000. leaving a nil-rate-band legacy to a discretionary trust with the balance to her husband absolutely. At the date of her death, the assets in her estate fell fully within her available nil-rate band of £210,000. Part of these assets was her half interest in the family home worth £150,000.
Following her death, her husband agreed to purchase the deceased’s interest in the property from the discretionary will trust for £150,000 index-linked. The property was transferred into his name and he gave the trustees an IOU for the purchase price.
On his subsequent death, it was argued that the outstanding debt of £156,013 (£150,000 before indexation) due to the trust should be deductible from his taxable estate. However, HM Revenue & Customs raised the issue of section 103 Finance Act 1986 which, as I made clear in last week’s article, precludes the deduction of a debt that was made out of property derived from the deceased, that is, property that was given by the debtor to the creditor. It should be noted that the meaning of “derived from the deceased” in this context is extremely wide.
In this particular case, because Dr Phizackerley had previously made a gift of the property to his wife out of which the debt arose, that debt was not fully deductible and needed to be abated to the extent it arose from that disposition.
However, counsel on behalf of the taxpayer (Dr Phizackerley’s daughter) raised the argument that for section 103(4) to apply, the disposition needed to be a transfer of value and, based on the facts, as there had been no transfer of value, the amount of the debt should not be reduced.
He argued that there was no transfer of value because the original gift from Dr Phizackerley to his wife was covered by section 11 IHT Act 1984 – dispositions for the maintenance of the family – because the house “provided a roof over his wife’s head”.
However, the special commissioner rejected this argument on the basis that this exemption did not apply. He said: “I do not consider that when a husband puts a house in joint names of himself and his wife during their marriage, it is within the ordinary meaning of maintenance. In spite of counsel’s persuasive argument, I do not consider that the disposition is for maintenance in this case.”
The case demonstrates that one has to be extremely careful when advising clients who are surviving spouses to take an interest-free loan from the trustees of a will trust established on the death of the first spouse in order to create a debt on that surviving spouse’s taxable estate. In cases where the borrowing spouse made lifetime gifts to the now deceased spouse, depending on the facts, the debt may not be allowed as a deduction. Any literature explaining the potential benefits of a will trust and certainly any client communication, should clearly express this caveat regarding prior gifts to the deceased testator by the borrower.
How strictly HMRC will apply this principle possibly depends on a number of factors, not least the amount of the lifetime gift and how long ago it was made.
It is important to note that in the Phizackerley case, a finding of fact was made that the gift of the money for the half share in the house was not made with reference to enabling or facilitating the giving of the consideration for the debt, that is, the half share of the home. This would enable s103(2) to apply so that the debt would not be reduced.
Counsel for the taxpayer reserved the right to contend this and will presumably now do so with this finding of fact and following the rejection of his primary argument on the application of section 11 IHTA 1984.