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Open secrets

Last week, I looked at outright gifts and conditional gifts of an interest in property made by the first of a couple to die.

I concluded that the former is often unacceptable while the latter will rarely be effective for inheritance tax purposes as a surviving spouse who benefits from the conditions may be deemed to have an interest in possession.

If conditional gifts are likely to hit IHT problems as the inherited share of the property will be an asset of the estate of the surviving spouse, how about using a trust to give reassurance on security of tenure for a surviving spouse?

Settled gifts could be made to an interest in possession or discretionary trust. It is important that the trustees have the power to allow the beneficiaries to occupy the property rent-free. If it is used as the beneficiaries’ main residence, capital gains tax private residence relief will usually continue to apply on sale of the property.

Could the position be saved by a husband and wife leaving their half interests in the house to a discretionary trust under their will? The Inland Revenue’s view has always been that if, after the first death, the trustees give the survivor the right to exclusive occupation, this amounts to an interest in possession in the trust property (Statement of Practice 10/79). It is essential to appreciate the exact wording used:

“Many wills and settlements contain a clause empowering the trustees to permit a beneficiary to occupy a dwelling house which forms part of the trust property on such terms as they think fit. The Inland Revenue does not regard the existence of such a power as excluding any interest in possession in the property.

“Where there is no interest in possession in the property in question, the Inland Revenue does not regard the exercise of the power as creating one if the effect is merely to allow non-exclusive occupation or to create a contractual tenancy for full consideration. The Inland Revenue also takes the view that no interest in possession arises on the creation of a lease for a term or a periodic tenancy for less than full consideration although this will normally give rise to a charge for tax under IHTA 1984, s 65(l)(b).

“On the other hand, if the power is drawn in terms wide enough to cover the creation of an exclusive or joint right of residence, albeit revocable, for a definite or indefinite period, and is exercised with the intention of providing a particular beneficiary with a permanent home, the Revenue will normally regard the exercise of the power as creating an interest in possession. If the trustees in exercise of their powers grant a lease for life for less than full consideration, this will be regarded as creating an interest in possession in view of IHTA 1984, ss 43(3) and 50(6). A similar view will be taken where the power is exercised over property in which another beneficiary had an interest in possession up to the time of the exercise.”

So SP10/79 could be a threat where the widow or widower is one of the discretionary beneficiaries and continues to occupy the whole house following the death of the first spouse to die, even if the trustees do not do anything positive to grant the right to occupy under the trust. This is because the widow or widower may be treated as having an interest in possession, so the capital value of the trust fund should be included in his or her taxable estate. It has been reported that the Revenue is tracking cases where half a house is gifted into a trust and is subsequently occupied by the widow, in order to raise an assessment on the death of the widow.

At a conference of the Society of Trust and Estate Practitioners, the assistant controller of the Capital Taxes Office said where a home or a share in it is owned by a discretionary trust and an individual occupies it, this might constitute an interest in possession under the wide meaning in SP10/79 and such an argument would be “particularly strong if the individual was a beneficiary of the trust”.

The CTO appears to take the view that the discretionary trust could be described as a secret trust under which all parties understand that the surviving spouse will occupy the house for the remainder of her life.

The assistant controller has said: “As the tax significance is considerable, we are looking carefully to see whether the reality of the surviving spouse’s occupation of the whole property is in fact because of a conscious decision of the trustees – as has been flagged up for many years, see SP10/79 – or because the trust is discretionary in terms only and there is a secret or half-secret trust under which the survivor has and was always intended to enjoy the whole house.”

If the individual was not a trust beneficiary, the assistant controller suggested the trust might be a sham and the trustees might be committing a breach of trust by allowing such an individual to remain in the house. If this line of argument were pursued, exclusion of the surviving spouse from the beneficial class may not even be enough to avoid the interest in possession problem. Whether the Revenue is right on this point is another matter.

This potential problem may be exacerbated by the Trusts of Land and Appointment of Trustees Act 1996. Here, the position on the death of the first spouse to die where the deceased leaves his or her interest subject to a discretionary trust would be as follows:

There is an implied trust of land.

The half share passing on the death of the first spouse to die is held on discretionary trust, so no interest in possession is created as regards that portion under the terms of the trust. However, if actual occupation takes place, the CTO is likely to argue that a de facto interest in possession in favour of the surviving spouse exists.

Under section 12, the survivor has a right of occupation – although this does not extend to the right to occupy the whole of the property – and under section 13 the trustees may impose reasonable conditions on that occupation, such as discharging outgoings on the property.

There is a risk that the surviving spouse will enjoy an interest in possession in the entire property – the share in which he or she has an outright interest and the trust share in which there is an interest in possession so the arrangement may not work as an IHT-saving device.

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