Closing the door on excluded property?
Closing the door on excluded property
Andrew Cockman, Director of AMC Tax Consulting Ltd, and Tax Consultant at Calibrate Law looks at the implications of changes to inheritance tax (IHT) rules in the Finance Act 2020 (FA 2020).
The first surprise for anyone not practising in this area is that the changes are retrospective. The second is that the draftsman has used terminology that lacks absolute certainty. The corollary is that the changes may have wider repercussions than intended. Finally, no account seems to have been taken of the wider F(No.2)A 2017 changes to the domicile rules. Was change on this scale necessary?
Prior to FA 2020, the general position was that trusts established by a settlor who was neither legally domiciled nor deemed domiciled within the UK were eligible to benefit from excluded property treatment, provided that only non-UK sited assets were held. There were special rules that dealt with transfers between settlements, and F(No. 2)A 2017 changed the situs rules in relation to enveloped UK residential property.
FA 2020 made changes to s48(3) and ss80-82, Inheritance Tax Act 1984 (IHTA 1984) to reverse the Court of Appeal decision in Barclays Wealth v HMRC  EWCA Civ 1512. The retrospective nature of the changes affecting all excluded property trusts was surprising because the fact pattern of the Barclays Wealth case was highly specific and unusual.
The Barclays Wealth case
Michael Dreelan was a UK resident entrepreneur domiciled in the Republic of Ireland. He established a Jersey resident discretionary trust (the 2001 Settlement) under which he and members of his immediate family continued to benefit. Further property was added before Michael became deemed domiciled in the UK for IHT purposes. In 2008 the trust assets, shares and other assets, were transferred by Michael and his three brothers, Thomas, Sean and Ciaran. The settlement was called the Dreelan Brothers Joint Trust (the DBJT). Again, this was a non-UK resident discretionary trust and the Trustee was the sole trustee. Each brother could benefit under a quarter of the trust fund, which was essentially a sub-fund.
The effect of s81, IHTA 1984 is that when property is transferred from one discretionary trust to another, it is treated as remaining in the first settlement for the purposes of the relevant property regime. This ensures that 10-year charges and the calculation of exit charges look back to the original time clock of the trust from where the assets were derived. Excluded property status could only continue in the recipient trust where its settlor was neither domiciled nor deemed domiciled within the UK at the time “when the settlement was made”. Under English law, a trust is generally treated as having been made when the trust was established; subsequent additions to it are just that and are not treated as being a new settlement. However, HMRC did not favour this interpretation and leant towards applying the test at the time an addition was made rather than when the original settlement was made.
Irrespective of the interpretation, there was no doubt that foreign property held within Michael’s sub-fund of the DBJT could not qualify for excluded property status because Michael had become deemed domiciled for IHT purposes before the DBJT was settled. The IHT status of the sub-fund came sharply into focus before the 10-year charge in relation to property held in the sub-fund fell due on 21 June 2011 (the 2001 Settlement having been established 10 years earlier).
To avoid this charge, all assets of the sub-fund were returned to the 2001 Settlement, which had been formed when Michael was not UK domiciled for IHT purposes. The aim was to come within the precise wording of the legislation to ensure that non-UK assets qualified for excluded property treatment. Accordingly, the Trustees refused to pay IHT on the 10-year anniversary date. This led to the dispute that was the subject of the litigation considered by the courts. It was necessary to determine what the legislation meant when it referred to the time “when the settlement was made”.
The High Court held that the term ‘settlement’ embraced both the establishment of the legal settlement as well as later additions made to it. But this interpretation was not totally satisfactory because it meant interpreting the term ‘settlement’ differently within s48(3), IHTA 1984; it was inherently implausible that this was what Parliament intended.
Henderson LJ, in giving the leading judgement in the Court of Appeal, said: “The time when the settlement was made will then be ascertained in accordance with the usual principles of trust law, and will normally be the occasion when the settlor first executed a trust instrument and constituted the trust by providing property to the trustee.”
This meant that non-UK sited property held by the 2001 Settlement qualified as excluded property, falling outside the 10-year charge.
The ruling flew in the face of HMRC’s interpretation of the legislative provisions. It was inevitable that HMRC would seek to reverse the decision. More surprising was that the legislation would be changed retrospectively. Possibly this could be justified on the basis that the Court of Appeal decision left open the possibility that additions of foreign property by deemed domiciled settlors to settlements they established before they became domiciled for IHT purposes could qualify for ongoing excluded property treatment. This was a door that HMRC would want to close. But was it necessary?
Historically, it would have been unusual for a deemed domiciled settlor to have added property because in most cases this could trigger an immediate 20% IHT entry charge. Furthermore, settlors who are deemed domiciled are unlikely to add any property to offshore trusts which benefit from protected status because such a move would taint them following the F(No. 2)A 2017 changes to the domicile rules.
Effect of the FA 2020 changes
Following Royal Assent, property transferred from one trust to another will only benefit from excluded property treatment where the settlor is neither UK domiciled nor deemed domiciled for IHT purposes at the time that transfer is made. Although these rules are fully retrospective, transfers made prior to Royal Assent benefit from the previous treatment under s81 and 82, IHTA 1984.
Interaction with the reservation of benefit rules
The gift with reservation (GWR) rules are a parallel set out of rules capable of being applied, typically, where a settlor has retained an interest under a discretionary trust through being a potential beneficiary. The interaction of these rules with the excluded property rules has not always been universally accepted, but HMRC now accepts that the excluded property rules prevail where the settlor was treated as being non-UK domiciled for IHT purposes when the trust was made (IHTM14396).
The savings provisions introduced alongside the FA 2020 changes do not apply to the GWR rules. This omission must simply have been an oversight on the part of the draftsman.
A transfer made between offshore discretionary trusts prior to Royal Assent where both trusts had been established at a time when the settlor was not UK domiciled for IHT purposes, but where the trust transfer was made when he was so domiciled, are now capable of coming within the GWR rules. This will be the case where a settlor can benefit under the terms of the recipient trust.
The type of transfers that could be caught are many and varied, including cases where:
- the offshore trustee wanted to consolidate the trusts with a view to saving costs;
- one trust was illiquid and needed funds, which were transferred from one trust to another;
- the way the assets were to be held in the future changed with different classes of asset being transferred from one trust to another.
While the FA 2020 changes do not apply where a transfer was made prior to Royal Assent, the net effect of the changes is to retrospectively open a door so that the GWR rules can now be applied. They will bring the assets transferred into charge on the settlor’s death where the settlor is eligible to benefit under the terms of the recipient trust. Trustees also need to identify any property in case the reservation is inadvertently lifted, causing a deemed potentially exempt transfer to arise.
When does property become comprised in a settlement?
The draftsman was aware this question posed potentially difficult issues. This is clear because the new rules provide that where income is accumulated, the addition is treated as becoming comprised in the settlement at the same time as the property producing the income first became comprised in the settlement. The mere fact that income accumulations were dealt with specifically suggests that other types of additions might be caught.
For example, under a loan the borrower receives an advance which can then be invested. Are the investments caught under these rules? If they are, the excluded property status of those assets would depend on the IHT status of the settlor at the time they were acquired under the terms of the loan. If this is a real concern, bearing in mind that these changes are retrospective in effect, it would be necessary to identify the property affected in case a charge to tax arises in the future.
The cases potentially caught are those where loans were received by trustees prior to FA 2020 at a time when the settlor was deemed domiciled for IHT purposes. So for example, a loan made by a deemed domiciled settlor to a trust holding non-UK sited assets established when he was not UK domiciled for IHT purposes might now come within the GWR rules as regards the assets acquired using the loan. The property acquired might also lose its excluded property status under the FA 2020 provisions as well.
If this really is a concern, just how far this goes is unclear. Does it also catch the acquisition of property using commercial loans? The uncomfortable answer is: “it might”.
Discussions with HMRC
HMRC met with stakeholders, including representatives from ICAEW, CIOT and STEP on 2 September 2020 to discuss questions and requests for clarification concerning these legislative changes. HMRC agreed that more could be done to provide certainty and clarity to affected taxpayers, and to work collaboratively with stakeholders to improve understanding of how HMRC interprets this legislation in what are often complex individual scenarios.
To that end it was agreed to take forward work across three areas:
- HMRC to clarify in guidance, working with stakeholders, its interpretation of how the legislation applies in certain more straightforward scenarios, clarifying any misunderstandings on how it interprets the legislation operating.
- HMRC and stakeholders to work together to update the available HMRC guidance on the treatment of loans in regards to settlements, and consequential application of the tax code. It was acknowledged there are some longstanding areas of uncertainty for taxpayers in this area, which predate the recent changes. This is especially true given the range of complex scenarios that may arise.
- HMRC and stakeholders to continue discussions to best understand if and how improvements could be made to ensure the interaction of settlements between trusts and the gifts with reservation of benefits rules are operating as intended.
To assist with future discussions with HMRC, ICAEW members are asked to provide Caroline Miskin (firstname.lastname@example.org) with:
- examples of difficult cases for the treatment of loans to settlements;
- specific issues concerning ss80 – 82, IHTA 1984 requiring clarification following the changes; and
- any further issues that you consider require clarity.
This article was first published in ICAEW’s TAXline magazine, October 2020.
This post is intended to be a guide for clients and other interested parties. The information is believed to be correct at the date of publication but should not be relied upon as a substitute for professional advice. No responsibility can be accepted by us for loss occasioned to any person acting or refraining from acting as a result of any material in these publications.