STEP comments on Reforms to the taxation of non-domiciles draft legislation issued on 5 December 2016

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1 STEP comments on Reforms to the taxation of non-domiciles draft legislation issued on 5 December 2016 Inheritance Tax on UK Residential Property New Schedule A1 IHTA 1984 STEP is the worldwide professional association for those advising families across generations. We help people understand the issues families face in this area and promote best practice, professional integrity and education to our members. Today we have over 20,000 members across 95 countries, with over 7,000 members in the UK. Our membership is drawn from a range of professions, including lawyers, accountants and other specialists. What connects our members is that they all help families plan for their futures: from drafting a will or advising family businesses, to helping international families and protecting vulnerable family members. We take a leading role in explaining our members views and expertise to governments, tax authorities, regulators and the public. We work with governments and regulatory authorities to examine the likely impact of any proposed changes, providing technical advice and support and responding to consultations. STEP welcomes the opportunity to comment on the draft legislation issued on 5 December Close companies As we understand it, the intention is that an interest in a close company should not be excluded property if and to the extent that the value of that interest derives from UK residential property. It should not matter how many layers of companies there are. However, if there is a widely held company somewhere in the chain (e.g. a residential property fund which is structured as a company), the interest in the top company should still be excluded property. It is possible to read new paragraph 2(2) of schedule A1 as having the effect that if the widely held company (say an interest in a residential property fund) is not directly held by the top company (being a close company) but is held via a sub-holding company, the interest in the top company will no longer be excluded property. This is because the value of the interest in the top company is still indirectly attributable to UK

2 residential property by virtue of a qualifying interest i.e. the interest in the subholding company which owns the interest in the residential property fund. This could be remedied by requiring not only that the interest is attributable to a qualifying interest but also that it is not attributable to something which is not a qualifying interest. On a separate point, it is possible that a commercial lender (such as some Swiss private banks) could be a close company for the purposes of the new legislation. This would then impose an inheritance tax liability on the owners of the lender. We do not think it is likely that it was intended that a loan should be caught by the new rules if it is made by a commercial lender. One simple way of dealing with this (both for companies and partnerships) would be to exclude from paragraph 4 of schedule 13 in the draft provisions for Finance Bill 2017 any rights relating to a loan which is made in the ordinary course of the lender s business. This could, for example, be based on section 453(4) Corporation Tax Act 2010 (which prevents a bank from being a participator for the purposes of the close company rules). As the definition of dwelling for the purposes of schedule A1 is that used in paragraph 4 of schedule B1 TCGA 1992, it seems that close foreign registered trading companies which are undertaking property development and which have houses under construction or which are completed would seem to be caught by these rules and we do not think that this is in line with the policy behind these provisions. 2 Partnerships It seems odd that a widely held partnership is not excluded in the same way as a widely held company. If a residential property fund is structured as a partnership rather than a company, the holders of the interests in the fund (i.e. the partners) will still be exposed to inheritance tax whereas if they had held shares in a company, they would not. Would it not be possible to exclude partnerships in circumstances where there are not five or fewer partners who together (with their associates) hold more than 50% of the right to share in income profits, capital profits or voting rights? 3 Loans In order to prevent avoidance, the original proposal in the August consultation paper was that connected party loans would not be deductible in calculating the value on

3 which tax is charged under the new rules. The draft legislation however takes a different approach and allows loans to be deducted but brings the benefit of the debt within the scope of the new rules. In principle, we think that this is the better approach as it would be very difficult to define which loans should be deductible and which should not. Double tax The problem with the approach proposed in the draft legislation is that there is no link between the taxability of the debt and the availability of a deduction for the debt. This could therefore result in a double tax charge. This can be illustrated by an example. Suppose the deceased is a non-domiciliary living in the UK. He buys a UK residential property for 2 million. He borrows the 2 million from an offshore trust which he has established to fund the purchase. When the deceased dies, his estate will include the property subject to the debt due to the trust. However, as a result of section 103 Finance Act 1986, it is quite likely that the debt due to the trust will not be deductible. The 2 million value of the property will therefore be subject to inheritance tax. However, the benefit of the debt will also be subject to the new rules. As the deceased is both settlor and a beneficiary of the trust, there is a reservation of benefit and so the trust assets will be treated for inheritance tax purposes as belonging to the deceased on his death. The 2 million value of the loan made by the trust to the deceased will therefore also form part of his taxable estate on his death. Inheritance tax will be payable on 4 million in total. This problem could be avoided if the legislation were to include a provision which excludes the benefit of the debt from the new rules in circumstances where, if the borrower died at the date the inheritance tax charge arises, the debt would not be deductible from the value of the UK residential property (or from the value of any interest in a close company or partnership which is within the new rules). This would ensure that, one way or another, tax will be payable on the full value of the property but not on a figure which exceeds the value of the property. This problem also arises in other circumstances. Assume that non-uk resident/domiciled parents lend 1 million to their child who is resident but not

4 domiciled in the UK in order to buy a property in the UK. The parents do not take security over the property. The UK resident child has assets worth more than 1 million outside the UK. On the child s death, the effect of section 162(5) IHTA 1984 is that the debt must be deducted from the non-uk assets in priority to the UK property. The debt would not therefore be deductible for inheritance tax purposes on the death of the child but the benefit of the debt would be taxable on the death of the parents. We think there are particularly strong arguments for dealing with this problem where both the property and the value of the debt are taxed on the death of the property owner. As a general matter, we think there is much to be said in terms of fairness for aligning the taxability of the debt with the availability of a deduction for the debt against the UK residential property or against the asset which derives its value from UK residential property for inheritance tax purposes. Identification of loan We can foresee practical problems in identifying whether the rights of a creditor relate to a relevant loan for the purposes of paragraph 4(1)(a) of schedule 13 in the draft provisions for Finance Bill This requires an analysis as to whether the money which has been lent has been used (broadly speaking) to acquire, maintain or improve UK residential property. What however would the position be in the following example: A borrows 1 million from B. The proceeds of the loan are transferred into A s bank account which already holds 500,000. A buys a UK residential property for 750,000 using the funds in the bank account. B dies. How much of the loan made by B is a relevant loan? The possible answers are: 250,000 being the shortfall A has when comparing the purchase price ( 750,000) with the amount of money he already had ( 500,000). 750,000 (on a last in, first out basis).

5 500,000 (taking the funding for the purchase as being provided pro rata out of the loan and A s existing funds). The position is likely to be even more complicated if there have been ongoing maintenance costs and these are paid for out of an account which may have been partly funded in the past with a loan from a family member or a family trust and there have been numerous payments in and out of the account. On this latter issue, we think that this is a strong reason for excluding pure maintenance costs from the scope of the new rules and including only loans which are made either to purchase the property or to improve the property. On the first point, where loan proceeds are paid into an existing account, it seems to us to be fair only to treat this as a relevant debt to the extent that there were insufficient funds in the account to pay for the purchase/improvement prior to the making of the loan. This may be something which can be dealt with by guidance rather than trying to make specific provision for this in the legislation. 4 Collateral We are very concerned about the scope of the new rules where collateral is provided for a relevant loan. This will in most circumstances result in tax being charged on amounts which significantly exceed the value of the UK residential property. This can be illustrated by a number of examples. 4.1 A, who is resident and domiciled in Malaysia wishes to buy an investment property in London for 2 million. He borrows 1 million from his Malaysian bank which is secured on the portfolio of 5 million which he holds with the bank. On A s death, his estate pays tax on the whole value of the property (the debt is not deductible as it is not secured on the UK property) and is also taxable on the value of the collateral after deducting the debt. The total amount on which tax would be payable is therefore 6 million when the property is only worth 2 million. 4.2 B, who is resident but not domiciled in the UK purchases a property in the UK for 5 million. He borrows 3 million from the London branch of his Swiss bank which is secured on the property. He has a portfolio of 10 million with the bank in Switzerland but this is not given as security for the loan. However, under the bank s standard terms and conditions, B has given a pledge, in favour of the Swiss bank, of all of the assets he holds with the bank worldwide to secure any liability which he owes to the

6 bank at any time. The 10 million portfolio is therefore collateral (indirectly) for the loan taken out to purchase the property. On B s death, the bank debt will be deductible pro rata from the property and the portfolio as the loan is an encumbrance on both of these items of property (section 162(4) IHTA 1984). His estate will therefore be taxed on the net value of the property ( 4 million) plus the net value of the collateral ( 8 million). 4.3 C is also resident but not domiciled in the UK. He has purchased a UK residential property for 10 million. He has settled a non-uk resident trust which, through its wholly owned company, has a portfolio of 15 million. C borrows 5 million from the bank in Switzerland which manages the portfolio held by the company which is owned by the trust. The bank cannot take security over the property as it does not have the right regulatory permission to enter into a regulated mortgage. Instead, the company gives the bank security over its portfolio. On C s death, the bank debt is only deductible from the value of the UK property to the extent that it exceeds the value of any non-uk assets which he holds. C has 3 million of overseas assets and so 2 million of the debt is deductible from the value of the UK house. The collateral is caught by the new rules and so the value of the shares in the company owned by the trust are not excluded property to the extent of the value of the collateral. C s estate will therefore be taxable on the 15 million value of the collateral as well as on the net 8 million value of the property. The trustees will also be subject to ten year charges on the value of the 15 million of collateral. As we understand it, the main purpose of bringing collateral within the scope of the new rules is to prevent people side-stepping tax on the value of a relevant loan by entering into a back-to-back arrangement with a bank. This objective could be achieved by limiting the value of the collateral on which tax is charged under the new rules to an amount equal to the amount of the debt in respect of which the collateral has been provided which would be deductible from the value of the property (or to the value of the interest in the close company or the partnership

7 which derives its value from the property) were the holder of the property or the interest to die at the date of the inheritance tax event. Applying this to the examples above: A there would be no tax on the value of the collateral as the full value of the house is subject to tax on A s death. B 1 million of the collateral would be taxable as only 1 million of the 3 million bank debt is deductible from the value of the property. C there would be tax on 2 million of the collateral (on C s death and on the trust s ten year anniversary) as 2 million of the bank loan is deductible from the value of the property. 5 Two year rule/exit charge Paragraph 5 of new schedule A1 IHTA We assume that the purpose of paragraph 5 is to prevent death bed sales and avoidance of ten year charges. We do not disagree with these objectives but we do think that the anti-avoidance provisions are far too widely drawn than is necessary to achieve them. For example, a genuine sale to a third party of a UK residential property owned by a company within two years of the death of the owner of the company will not result in any charge to inheritance tax on the owner s death. However, if the owner sells the company rather than the company selling the property, there will be an inheritance tax charge if death occurs within two years. There seems no good reason for distinguishing between these two situations. Indeed, we find it hard to understand why there should be an inheritance tax charge on the death of a non-domiciled individual if a UK asset previously held by that individual has genuinely been sold to a third party within two years of the individual s death. This would not be the case with any other sort of UK property and so why should it apply to UK residential property? The purpose of the new legislation is to make sure that inheritance tax is paid if UK residential property is held through an overseas structure at the date of the relevant inheritance tax charge. It should not impose a charge when that property has been

8 sold to a third party (as opposed to just moved around between connected parties). Our suggestion would be that the continuing two year liability should only apply where there is a sale (whether of the property or of the interest in the company/partnership) to a connected person. Similarly, the two year tail should not apply to the repayment of a loan where the repayment results from the sale of the property in question to an unconnected person. 5.2 The provisions relating to property which is within the relevant property regime are very harsh and seem to be based on the fact that, without any changes to the existing relevant property regime, there will be an exit charge at the time of any disposal of the UK residential property or the interest in the company or partnership which holds the UK residential property or a repayment of any relevant loan or release of collateral in respect of any relevant loan. This is because, on the occurrence of any of those events, property in the trust will cease to be relevant property but the exemption in section 65(7) IHTA 1984 will not apply as the property does not become excluded property by virtue of ceasing to be situated in the UK. Clearly, attempts to avoid the ten year charge should be thwarted. However, to impose exit charges simply because the property is disposed of seems unfair. In our view, the right approach is as follows: extend section 65(7) so that, in normal circumstances, there is no exit charge if property becomes excluded property as a result of schedule A1 ceasing to apply to the property in question; treat settled property as continuing to be relevant property (and not excluded property) for two years after a disposal to a connected person or a repayment of a loan which does not arise as a result of a disposal to an unconnected person. This will ensure that ten year charges cannot easily be avoided by transactions between connected persons. We do want to stress again that, as we understand it, the purpose of this provision is to prevent avoidance and not to penalise non-domiciliaries where there is a genuine sale to a third party and the proposed rules as drafted do not achieve this.

9 6 Targeted anti-avoidance rule We continue to believe that the targeted anti-avoidance rule is much too wide. If an individual sets up a company to invest in UK residential property and arranges for the company to borrow from a bank in order to reduce the value of the property for inheritance tax purposes, even though the individual had funds available to fund the company himself, this appears to fall foul of the targeted anti-avoidance rule. This seems to us to be a straightforward choice which any taxpayer could make and should not in principle be something which is subject to such an anti-avoidance rule. If the taxpayer had instead acquired the property in his own name with the assistance of bank debt secured over the properties, there would be no question that the debt would be deductible and that tax would only be paid on the net value of the properties when the taxpayer died. This could be dealt with in a number of ways: 6.1 do not have a targeted anti-avoidance rule and rely on the GAAR; 6.2 import provisions similar to the GAAR so that the targeted anti-avoidance rule only applies if the result is unreasonable (using the double reasonableness test); 6.3 refer in the targeted anti-avoidance rule to tax avoidance rather than securing a tax advantage. The concept of tax avoidance involves considering whether the result is something which Parliament would not have intended and would not catch the sort of straightforward example outlined above. Submitted by STEP UK Technical Committee on 18 January 2017