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Losing interest

When considering the use of the private residence in planning to reduce the overall inheritance tax liability borne by a family, a married couple should consider how they can ensure that up to the nil-rate band is left to other than the surviving spouse when the first of them dies.

There will often be a requirement to provide some security for the surviving spouse, especially when the property subject to the gift is a share in the private residence. Providing the spouse with an interest in possession or making the children’s legacy conditional, say, on the surviving spouse having sole rights to occupy or authorise sale of the property, will not achieve the objective.

Leaving the share in the property subject to a discretionary trust can work but there can be problems where the surviving spouse is sole occupier of the property. Inland Revenue Capital Taxes is keen to assert that, under statement of practice 10/79, the surviving spouse has an interest in possession in the property. This danger is at its strongest if the power to permit a beneficiary to occupy is sufficiently wide to cover the creation of an exclusive joint right of residence for a definite or indefinite period and is exercised with the intention of providing the surviving spouse with a permanent home. The Revenue will contend that a beneficiary with an exclusive right has an interest in possession.

Even if the surviving spouse is not a beneficiary, the Revenue may argue that they have a de facto interest in possession. It seems to take the view that the discretionary trust is a secret trust under which all parties understand that the surviving spouse will occupy the house for the remainder of their life and is thus something of a sham.

Under SP10/79, the Revenue says it will not argue that an interest in possession exists where the beneficiary is given a right to non-exclusive occupation or a contractual tenancy for full consideration or where a lease is created for a term or where there is a periodic tenancy for less than full consideration. The risk is that the Revenue will determine that an exclusive or joint right of residence, albeit revocable, for a definite or indefinite period has been created with the intention of granting the beneficiary a permanent home. A lease for life for less than full consideration would also give rise to an interest in possession.

Thus, where a discretionary trust gives the trustees wide powers to buy property for the occupation of a beneficiary, any tenancy should be at will, without any lease or tenancy agreement. This means the surviving spouse will depend on the trustees allowing continuing residence. There will be some form of tenure risk but no more than under the normal discretionary trust route. A tenancy at will should avoid any contention that the trust assets have been diminished in value (for the purposes of the exit charge under section 65 IHT Act 1984) or an interest in possession has arisen. If a tenancy at will is used, it will not be possible to claim principal private residence relief for any capital gains made on the sale of the property.

Due to potential problems with schemes where an interest in the private residence is left to a discretionary trust on the first death, the so-called debt scheme has been introduced as an alternative. The objective is to ensure the surviving spouse inherits the whole property but its value is depressed for IHT purposes in their estate. The debt scheme could be useful where a married couple have insufficient liquid assets to each satisfy a nil-rate band legacy but do own a valuable private residence.

Under the debt scheme, a husband and wife make provision in their wills for a nil-rate band gift to a discretionary trust. Having placed the property into ownership as a tenancy in common, the deceased’s share passes to the surviving spouse free of IHT. The will gives the personal representatives power to satisfy the nil-rate band gift by means of a debt. Where some liquid assets or investments are available, these will pass to the nil-rate band trust on death, with the balance of the nil-rate band made up by the debt or a charge.

The spouse has security without any IHT drawbacks or loss of principal private residence relief. The relevant powers in the trust can be drafted to enable this situation to be preserved even though the original residence is replaced by another. Although the main aspects of the scheme could, in theory, be applied to a nil-rate band gift to the ultimate beneficiaries, it is preferable to use it in conjunction with a discretionary trust. The scheme is a simple one but there are several points to bear in mind, particularly when the time comes for the powers to be exercised. Legal advice is of paramount importance.

The surviving spouse continues to own the residence with a debt or charge equal to the value of the nil-rate band used. On their death, the debt must be repaid (or, on sale of the property, the charge satisfied), reducing the taxable estate and IHT. Effective control of the house is retained, CGT on a future house sale is avoided and the surviving spouse can still occupy the private residence.

The debt scheme will work only if the recipient of the gift of residue, to include the share in the house, is also the debtor, whether the surviving spouse or trustees of a will trust. Otherwise, on the second death, the debt may be disallowed under section 5 IHTA 1984. Another difficulty is section 103 FA 1986, which could disallow the debt if, at some time during their lifetimes, the survivor made a gift to the deceased. It is essential to check if substantial interspouse gifts have been made.

Problems only arise if it is the donor spouse who survives.

One solution to avoid disallowance of the debt is for the personal representatives to place a charge on the house prior to appropriation of it to the surviving spouse. Alternatively, the home could be left to a life interest trust for the survivor and the trustees of that trust could give the charge.

The charge could be index-linked or expressed as a proportion of the property value. Appropriate enabling provisions should be included under the will. This will ensure the value-depressing effect of the charge continues to maintain its impact. If the charge is expressed as a proportion of the property value or follows increases in a relevant index of home prices, it is likely to be classed as an excluded indexed security. This means that the amount by which the charge exceeds its original level will only be subject to CGT when it is satisfied. The chargeable gain will be reduced by taper relief where appropriate.

I will consider the matter of stamp duty land tax next week.

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