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Second opinion in the Dr Phizackerley case

Many national newspapers picked up on the recent special commissioner’s decision in the Phizackerley case but we believe some conclusions reached may be misleading.

One of the most effective forms of inheritance tax planning for a husband and wife or couple in a registered civil partnership, who want to keep control of their assets during their lifetime, is to establish nil-rate-band discretionary trusts in their wills. Such a trust will come into effect on the death of the first of the couple to die and means that:

– On the first death, the nil-rate band of the deceased can be used, which will save IHT later because the assets are then not part of the taxable estate of the survivor.

– The deceased’s widow or widower will have potential access to the assets in the discretionary will trust, via the trustees, by virtue of him or her being a beneficiary under the trust.

This type of planning has been used successfully in the past by many couples, both in relation to arrangements where the deceased owns an interest in a house or those where investments are held.

Using loansWhere investments are held in a trust, the IHT benefits can be enhanced by providing access to the trust funds for the surviving spouse in the form of interest-free (or interest-bearing) loans repayable on demand.

If the assets subject to trust are stocks and shares or collectives, the trustees could raise cash to make the loan without any tax liability at that time by using their annual capital gains tax exemption or the 5 per cent taxdeferred withdrawal facility if the trust asset is a single-premium investment bond.

An interest-free loan (repayable on demand) to the spouse could be made by the trustees provided they have the requisite powers. Provided he or she spends the money (and no “compensating” value is received), his or her taxable estate will not increase but, on the survivor’s death, the loan will be repayable to the trust which means the deceased’s estate will be reduced and so the resulting IHT liability will also reduce.

The impact of section 103 and the Phizackerley decision

The reduction in the surviving spouse’s taxable estate is subject to an important condition. If the surviving spouse had previously made gifts to the deceased and the consideration for the loan (what the surviving spouse received in return for owing the money) derived from the gift, then those loans will not be deductible for IHT purposes under section 103(1) Finance Act 1986. Basically, this means that if property is transferred by way of gift to a person (A) by the deceased (while alive) (B) and, at a later date, this property (or property derived from it) is lent back to A, that loan is not deductible for IHT purposes on A’s death.

This section was the subject of the recent Special Commissioner’s decision in the Phizackerley case.

Dr and Mrs Phizackerley bought a house in 1992. Although the house was bought in joint names and owned on a joint tenancy basis, 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 both owned the property as tenants in common. Mrs Phizackerley died in 2000 leaving a nil-rate-band legacy to discretionary trusts, with the balance absolutely to her husband.

At the date of her death, the assets in her estate fell fully within her available nil-rate band of £210,000. Part of this property 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 the purchase price was left outstanding.

On his subsequent death, it was argued that the outstanding debt due to the trust should be deductible from his taxable estate. However, HM Revenue and Customs successfully raised the issue of section 103 Finance Act 1986 on the basis that, in this particular case, Dr Phizackerley had previously made a gift of the property to his wife out of which the debt arose and so that debt was not fully deductible and needed to be abated to the extent it arose from that disposition.

In this particular case, counsel on behalf of the taxpayer (Dr Phizackerley’s daughter) raised the argument that for section 103(4) Finance Act 1986 to apply, the disposition needed to be a transfer of value and it was argued that the “offending” disposition of the interest in the house was for the maintenance of Mrs Phizackerley and was therefore exempt (under section 11 IHTA 1984) and so no transfer of value took place. As a result, the debt should not be reduced. This argument was rejected by the special commissioner.

The impact of the decision

This case demonstrates that one has to be extremely careful when advising clients who have arrangements under which a surviving spouse is to take an interest-free loan from the trustees of a will trust established on the death of the first spouse to die in order to create a debt on that surviving spouse’s taxable estate.

In cases where the borrowing spouse had made lifetime gifts to the now deceased spouse and the borrowed amount derived from the gift, depending on the facts, that debt may not be allowed as a deduction.

A great deal of publicity was given to the case which, in our view, created unjustified anxiety about the viability of this planning.

Many readers would have seen the Saturday Telegraph front-page headline, Thousands of families are hit by inheritance tax setback. Another article on the same subject appeared in the Sunday Times under the heading, Brown hits trusts again.

The articles were, to say the least, confused. In one, mention was made of the key issue in the Phizackerley case, namely, the deductibility (or, in this case, not) of a debt on the estate of a deceased. Reference was made, in a way disconnected from this key point of the deductibility of the debt, to the importance of a prior gift by the debtor to the creditor.

The aspect of this case that the newspapers have focused on is the fact that although the house was held by Dr Phizackerley and Mrs Phizackerley as tenants in common, having previously been owned by them as joint tenants, it was Dr Phizackerley who provided all the funds for the purchase in 1992. In the actual fact, both parties agreed that “the funds must have been provided by the deceased” (Dr Phizackerley).

This, HMRC argued, was the disposition from which the consideration for the later debt derived, which meant the debt was not deductible when Dr Phizackerley died.

The newspapers’ comment on this homed in on the fact that although Dr Phizackerley provided all the cash for the purchase, this took no account of Mrs Phizackerley’s contribution to a marriage of many years, albeit non-financial.

Clearly, in light of this case, care should be exercised in cases where a couple are intending to make use of the debt will trust scheme with their private residence and one spouse makes a big and disproportionate contribution to the purchase of an asset which will facilitate a later loan back to the spouse who made the disproportionate contribution.

Here, a problem will only arise if it is the spouse who receives “the gift” who dies first. Even then, in cases where there are similar facts and it is desired to avoid any risk of a section 103 deduction problem, the residue of the estate can instead be left on life interest trusts and not absolutely to the surviving spouse. In such circumstances, it is thought that section 103 will not apply to cause the debt to abate because it is not owed by an individual.

However, this approach should be taken with caution because life interest trusts may bring with them other complications. A preferable and less contentious route may be the scheme based on a charge over the property on first death and not the creation of a debt.

Practical Planning

So how does the Phizackerley decision affect couples who use discretionary will trust planning in connection with a private residence or cash/investments?

Private residence

It will be appreciated that the Phizackerley case was decided on its own unusual facts. Most couples these days will have bought their homes in joint names some years ago and this would have involved a joint financial contribution from them each at different times. In these circumstances, the IHT advantages of the debt or charge schemes using a discretionary will trust of the family home should not be affected by the anti-avoidance rules in section 103 Finance Act 1986.

It is, we think, worth bearing in mind the HMRC quote on the matter as reported in the Telegraph that: “The decision was on the basis of the individual facts of the case. The special commissioners found that the particular circumstances fell foul of long-standing anti-avoidance provisions in the IHT regime” (our emphasis).

As states above, many couples will not have circumstances like these and their planning should not be affected by section 103 Finance Act 1986. Where there is doubt (and in any event), adopting an arrangement whereby the first to die leaves their interest direct to the survivor and a permanent legacy to a discretionary trust may offer a more certain outcome. The personal representatives of the deceased would then put a charge over the share in the property to satisfy the legacy. The charge would then diminish the value of the property for IHT purposes. In all cases, professional legal advice must be taken.

Cash/investments

The Phizackerley case will have no direct impact. All it does is confirm that section 103 will deny a deduction from the taxable estate of the surviving spouse in respect of loans received from the trust where prior lifetime gifts were made to the first to die.

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