Foreign domiciliaries and trusts. IHT changes to residential property. Speaker: Giles Clarke. A. Deemed Domicile

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1 Foreign domiciliaries and trusts IHT changes to residential property Speaker: Giles Clarke A. Deemed Domicile Introduction Until 5 April 2017, a non UK domiciliary could only be deemed to be UK domiciled for the purposes of one tax, namely Inheritance Tax. On 6 April 2017 this changed, and deemed domicile status also now applies for the purposes of income tax and capital gains tax. At the same time the rules on what constitutes deemed domicile for IHT were altered. Income tax and CGT Deemed domicile is imposed by s 835BA. There are two categories of deemed domiciliary, of which the first may be referred to as returners, and the second as long stayers. The income tax and CGT rules do not provide that individuals satisfying the requisite conditions are ipso facto deemed UK domiciled. Instead s 835BA sets out what constitutes deemed domicile and provides that that status has effect for the purposes of the provisions that specifically apply the rule. It follows that if legislation refers to domicile simpliciter, it is referring to actual domicile only and not comprehending deemed domicile. In reality this point is of limited practical significance for one of the provisions which applies the deemed domicile rule is ITA 2007 s 809B, the section entitling non-domiciliaries to the remittance basis on making a claim (see s 809B(1A) para 46.7). The effect of such application is that a claim is not competent, and thus the remittance basis is precluded, where the non-domiciliary is deemed UK domiciled. Returners Under this head, deemed UK domicile is imposed on an individual for a tax year if in that tax year the following conditions are met (s 835BA(3): (1) He is UK resident (2) He was born in the UK (3) He has a UK domicile of origin Anyone familiar with the common law might be forgiven for concluding such an individual is UK domiciled as a matter of general law for the fact of his return to the UK makes it difficult to show he had the requisite intention to acquire a domicile of choice elsewhere. But in

2 reality it is possible to have the requisite intention and for circumstances then to compel a genuine and unforeseen change of mind. Most cogently, it is reasonably plain that historically HMRC were perhaps more ready to concede the acquisition of a foreign domicile of choice than the present law, as represented by cases such as IRC v Bullock [1976] STC 409, would warrant. In such cases the returner rule avoids the need for lengthy and possibly embarrassing debate as to whether the earlier ruling was justified. A point to stress with returner deemed domicile is that the status applies from the first year of residence. There is no relief for the initial year of residence or inadvertent residence. Where the return was in or prior, deemed domicile status applies from 6 April A point also to stress is that birth in the UK does not of itself engage the returner rule and nor on its own does a UK domicile of origin. Both elements have to be present for the rule to be engaged. Long stayers Under the long stayer rule, deemed domicile is imposed where the individual has been UK resident in 15 out of the 20 prior tax years (s 835BA(4)). No special rules operate in determining residence and so for and post the matter is determined by the statutory rules. But in and prior the former rules based on case-law have to be applied, one unfortunate aspect of which is that the case-law is still evolving. This is illustrated by HMRC v Glyn [2016] STC 1020, where an individual who believed he had followed HMRC s then published practice to the letter was found capable to have remained UK resident. As a result there are likely to be some individuals who do not consider they are within the long stayer rule but in fact are. A point to stress is that the 20 years which have to be looked at end in the year preceding the subject year. This has the following consequences: (1) In the 15 th year of residence itself, the individual is not deemed UK domiciled. (2) In the 16 th year he is. (3) That status obtains in the 16 th year even if the individual gives up UK residence in that year or gave it up during the 15 th year. In the latter event he will have been resident for part of the 15 th year and so resident in that year. Long stayers who have acquired deemed domicile status can lose that status by emigration. But the 15 out of 20 year rule means that non-residence for at least six tax years is required, i.e. return can only be in the 7 th tax year after departure. Return in the 6 th year means the individual was still UK resident in 15 out of the 20 prior years. In a transitional relief the long stayer rule does not apply to individuals who emigrated before 6 April 2017 and have not been UK resident since then (s 835BA(5)). This is of little practical significance as income tax and CGT are not in general charged on the foreign income and gains of non-residents.

3 Inheritance Tax The IHT legislation now prescribes four circumstances in which a non-domiciled individual may for IHT purposes be deemed to be domiciled in the UK. One concerns spousal elections. The others are as follows (IHTA 1984 s 267(1)): The three year rule The returner rule The long stayer rule The three year rule The three year rule applies to individuals previously domiciled in the UK (s 267(1)(a)). Such an individual is deemed to remain UK domiciled until three years after he has in fact lost his UK domicile. As a matter of construction, the reference to three years is a reference to calendar years and this is accepted by HMRC (IHTM 13024). The domicile that has to be lost more than three years previously is actual UK domicile. It cannot as a matter of construction be deemed domicile, for otherwise the three year rule would impose constant and recurring deemed domicile. The three year rule is thus in issue with those who have an actual UK domicile. For immediate emigrants, the rule is not of impact, for the long stayer rule described below imposes deemed domicile for the three tax years following departure. But if thereafter the emigrant retains his actual UK domicile, he does not shed UK domicile for IHT purposes until three years after he has acquired a domicile of choice in the new country. One of the oddities of the three year rule is that it presupposes there is a precise date on which the individual acquires the new domicile of choice. But as explained in the previous chapter, domicile is not like nationality, i.e. acquired by an administrative process. Instead it is a matter of inferring intention, the requisite intention sometimes being formed over a long period. As far as the three year rule is concerned, the three years only start to run from when the necessary intention-forming process is concluded. The returner rule The returner rule is in the same terms as its equivalent for income tax and CGT, albeit the IHT legislation uses the term formerly domiciled resident (IHTA 1984 ss 267(1)(aa) and 272). That term is in fact misleading, for as the definition of the term makes clear it is not previous UK domicile alone which engages the rule. What is also required is that the individual was born in the UK and that his former UK domicile was a domicile of origin. In one respect the income tax and CGT definition is relaxed. For IHT purposes, the returner is not deemed UK domiciled unless he was UK resident in one or both of the two prior tax

4 years. This means one year s residence does not result in deemed UK domicile for IHT purposes even though it has that result for income tax and CGT. As with income tax and CGT, the returner rule applies with effect from 6 April 2017 if the returner returned before that date. Any excluded property settlement the returner made when non-domiciled loses excluded property status so long as the returner rule applies, i.e. so long as the returner remains UK resident (IHTA 1984 s 48(3E)). Should the returner leave the UK, he sheds deemed domicile in the tax year following his departure. This means his non UK domicile is restored with effect from the start of the tax year following his departure. But self-evidently such restoration does not occur should the return mean the returner s UK domicile of origin has revived or should the return have been long enough to engage the long stayer rule. In practical terms the most difficult impact of the returner rule is on pre-existing excluded property settlements made by the returner. Any relevant property charges resulting from the loss of deemed domicile are the responsibility of the trustees and yet they may be unaware either that the returner was born in the UK and had a UK domicile of origin or that he has returned. It is a point that needs to be picked up in due diligence procedures. The long stayer rule The long stayer rule is also in the same terms as its income tax and CGT counterpart. As with those counterparts, the rule is not engaged unless the individual is UK resident in or a subsequent year (F(No 2)A 2017 s 30(10)). In one respect the IHT long stayer rule is less onerous than its income tax counterpart. The rule is not engaged in any given tax year unless the long stayer is UK resident in that tax year or was UK resident in one or more of the three prior tax years (s 267(1)(b)(ii)). This means that a long stayer leaving the UK loses deemed domicile for IHT purposes after three complete tax years non-residence, provided he does not return in the fourth year. If he completes four full years non-residence he has lost deemed domicile for IHT purposes and this is so even if he returns to the UK and even if the return is within the six years that result in retention of deemed domicile for income tax and CGT. Deemed domicile under the long stayer head does not affect the excluded property status of settlements made before the acquisition of deemed domicile. Should the settlement have been made before 6 April 2017, the issue of whether the settlor was deemed UK domiciled when he made the settlement is determined by pre 2017 law (F(No2)A 2017 s 30(11)). Under that law, deemed domicile was acquired where the individual was UK resident in 17 out of the 20 tax years ending in and including the current year (IHTA 1984 s 267(1)(b) as originally enacted). Both the current year and the year of arrival were included as years of residence and so deemed domicile tended to be reached after rather less than 17 years residence. In practice therefore the old 17 year rule was only slightly more generous than the present 15 year rule.

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6 B. Trusts 1. CGT i. The general rule under TCGA 1992 s 86 - Does not apply to non-domiciliaries (s 86(1)(c)) - Does apply to those deemed to be UK domiciled (proposed s 86(3A)) ii. Disapplication of s 86 (proposed sch 5 para 5A) - Settlor neither domiciled nor deemed UK domiciled when the settlement is created (Condition B) - Settlor not domiciled in the UK nor deemed UK domiciled by virtue of Condition A in the tax year when the gain arises (Condition C) - The settlement has not been tainted after 6 April 2017 at a time when the settlor is deemed UK domiciled (Condition D) 2. Income Tax i. Protected foreign source income (proposed ITTOIA 2005 s 628A and ITA 2007 ss 721A and 729A) - Relevant foreign income - Settlor neither UK domiciled nor deemed UK domiciled when the settlement is created - Settlement not tainted after 5 April 2017 at a time when the settlor is deemed UK domiciled ii. Settlement code - ITTOIA 2005 ss 624 and 629 do not apply to protected foreign source income - Protected foreign source income not taken into account for the purposes of the capital sum charge in s As respects retained trust income arising between and trustees of the settlement are not relevant persons (s 628C) iii. Transfer of assets - Transferor charges apply only either (new ss 721(3B) and 728(1A)) (a) If the transferor is UK domiciled or deemed UK domiciled under Condition A; or (b) If and to the extent the income of the person abroad is not protected foreign income (i.e. is UK income)

7 3. Tainting - Income of an underlying company is also protected foreign source income if (ss 721A(3) and 729A(3) - Foreign source income of the trust/company for not taxable if remitted after 6 April unless it has first been distributed by the trust (proposed ss 726(6) and 730(6)) i. The core concept (TCGA 1992 sch 5 para 5A(5); ITTOIA 2005 s 628A(8); ITA 2007 ss 721A(2)(f), (3)(h)) - Property or income (a) Provided directly or indirectly (b) For the purposes of the settlement (c) By the settlor or by another settlement of which the settlor is settlor or a beneficiary (d) After 5 April 2017 (e) When the settlor is domiciled or deemed UK domiciled - Addition of value to property comprised in the settlement is deemed to be a direct provision of property ii. Exceptions (sch 5 para 5B(2)) (a) Transactions on arm s length terms (b) Transactions with no gratuitous intent (c) (e) Loans (f) Liability incurred before 6 April 2017 (g) Settlement s expenses relating to administration and taxation iii. Loans - On arm s length terms if interest at the official rate is payable at least annually - If the loan is on arm s length terms (a) Making the loan does not taint the borrower (b) Payment of interest does not taint the lender - A loan to the trust on arm s length terms results in tainting if (a) The interest is capitalised; or (b) It is not paid in accordance with the loan agreement; or (c) The loan agreement is varied - Repayment of a loan does not taint the lender

8 - Tainting occurs if, when the settlor becomes UK domiciled, a loan is outstanding and (a) The loan is then non arm s length; and (b) It is repayable on demand thereafter - An exception where the individual becomes deemed UK domiciled on 6 April 2017 if either iv. Expenses (a) The loan is repaid before 5 April 2018; or (b) Interest at the official rate is paid from 6 April Must be the settlement s expenses relating to taxation and administration - Must exceed the settlement s income for the year - Provision must not exceed the excess (or, if greater, the amount which may be paid out of income) 4. Capital payments and benefits: valuation i. Application - Capital payment rules in TCGA 1992 s 87 and sch 4C - Non transferor benefits charge (ITA 2007 ss 731 5) ii. Loans (ss 97A and 742C) - Benefit equals interest at the official rate insofar as no interest is charged or the interest is less than the official rate - Interest must in fact be paid in the tax year if the charge is to be avoided iii. Movable property (ss 97B and 742D) - Rule applies where movable property is made available without title being transferred - Benefit equals interest at the official rate on the cost of the property to the person making it available or (if greater) the market value of the property when that person acquired it - Actual consideration paid by the beneficiary is deductible as are sums paid by him for repair, insurance, maintenance or storage iv. Land (ss 97C and 742E) - Benefit is the rental value of the land - Rental value: rent payable on a yearly letting on basis tenant pays rates and council tax and the landlord bears repairs, insurance and maintenance

9 - Rent paid by beneficiary may be deducted, and also sums he pays for insurance, repairs and maintenance 5. Transfer of assets benefits charge: new rules i. Application to transferors - Achieved by restricting the disapplication of s 732 in s 732(1)(d) to cases where the transferor is UK domiciled or deemed UK domiciled under Condition A ii. Close family members (proposed s 733A) - Term means spouse and minor children (s 733A(7)) - Rule operates if: (a) Close family member receives the benefit (b) That individual is non-resident or a remittance basis user who does not remit - Settlor charged on the s 732 income if he is UK resident and not UK domiciled or deemed UK domiciled under Condition A iii. Remittance basis - No change to ss 735 and 735A - This means that a tax charge can arise if (a) The taxpayer is not UK domiciled and not deemed UK domiciled (whether the transferor or the non-transferor) (b) The benefit is not remitted (c) The matched relevant income is remitted - The FIFO rules in 735A apply for the purposes of matching

10 C. The new IHT see-through provisions for UK Residential Property Introduction Schedule A1 of IHTA 1984 removes excluded property status from certain non UK assets whose value is related to UK residential property. As it deals with excluded property status it is relevant only to individuals who are neither domiciled nor deemed domiciled in the UK and to settlements created by such individuals. It is material both where the individual is resident in the UK and where he is not and indeed the majority of those affected are nonresident individuals and trusts created by such individuals. Schedule A1 is enacted by schedule 10 of the autumn Finance Bill. It took effect on 6 April 2017 (Sch 10 para 9). UK residential property interest The key concept in Sch A1 is the UK residential property interest. The basic meaning of this term is an interest in land consisting of a dwelling (Sch A1 para 8(1)(a)). But the term also comprehends an interest in land that includes both a dwelling and land used for other purposes. Here the interest is a residential property interest to the extent of the dwelling, the extent being determined on a just and reasonable basis (Sch A1 paras 8(1)(b) and 8(2)). Contracts for off plan purchase are included as well. The terms dwelling, interest in land and contract for off plan purchase are given the same meanings as under NR CGT (Sch A1 para 8(3)). As the terms bear their NR CGT meanings, the same exclusions for student and institutional accommodation apply. As with NR CGT, the term dwelling comprehends both houses or flats used by the ultimate owner or beneficiaries and those let to tenants or licensees, whether on an arms length basis or otherwise. The incorporation of the NR CGT definitions might lead to the conclusion that the definitions exclude interests in dwellings held as trading stock by dealing or developer companies. In reality there is no such limitation. Further the NR CGT rule as to construction applies, namely that the term dwelling includes any building in the process of being constructed as a dwelling or adapted for such use (TCGA 1992 Sch B1 para 4(1)). This means that development sites become residential property interests once building starts and remain included in the owner s residential property interests until sold. In some such cases the impact of Sch A1 may be reduced or eliminated by business property relief (IHTA 1984 ss ). But it needs to be kept in mind business property relief does not apply where the company s main business the making or holding of investments. Nor does it apply where the company s main business is dealing in land or buildings rather than developing them (s 105(3)).

11 Assets caught Once the UK residential property interest has been identified, Schedule A1 applies to certain classes of asset in some way connected with the interest. The assets concerned are as follows: (1) Interests in close companies (2) Interests in partnerships (3) Loans which fall within the term Relevant Loan (4) Proceeds of disposal during the two years following the disposal (5) Collateral for a relevant loan Close companies The term close company has the same meaning as for corporation tax save that non UK resident companies are included (Sch A1 para 9(1)). A person s interest in a close company connotes the rights and interests he has as a participator, the term participator also bearing its corporation tax meaning. In referring to participators, Sch A1 makes it clear both shareholders and loan creditors are comprehended. Single companies An interest in a close company is caught by Sch A1 if and to the extent its value is directly attributable to a UK residential property interest (Sch A1 para 2(2)(a)). Since under the Interpretation Act the singular includes the plural, an interest in a close company is also caught to the extent its value is attributable to multiple residential property interests. By postulating the value is directly attributable to the residential property interest(s) this head of charge appears to focus on cases where the close company in which the participation is held itself owns the residential property interest or interests. Groups Group structures are caught by the subsequent head of charge in that a participator s interest in the close company is also caught by Sch A1 if its value is attributable to UK residential property interests not directly but by virtue of one or more interests in other close companies (Sch A1 para 2(2)(b)). This is a somewhat opaque way of dealing with group structures but appears to cover any group no matter how many subsidiaries are interposed between the residential property interest at the bottom and the company at the top in which the participation is held. Valuation: shareholdings As indicated above, the use of the term participator makes it clear that both shareholders and loan creditors are caught. In relation to shareholders, there are two key valuation points.

12 The first is that the value exposed to IHT is the value of the shareholding and not the value of the underlying UK residential property interest. Even in the simplest case of a single shareholder owning 100% of the company the value of the 100% shareholding is unlikely to be the same as that of the underlying residential property. Thus the valuation of the shares may make some discount for possible liabilities and potential liquidation costs. Much greater discounts apply where the participation is less than 100%, and particularly where it is a minority holding of less than 50%. In this connection it is to be noted there is no aggregation for holdings of connected persons, and so full minority discounts apply even if all the shareholders are relatives or different trusts with a common settlor. The one exception is that spousal participations are aggregated, in accordance with the general IHT related property rule (IHTA 1984 s 161). The second point is that even before discounts are applied to any particular shareholding, the company as a whole has to be valued and here two issues may have to be addressed. The first is the position if the company owns other, non-residential property assets, and the second is if it has debts or other liabilities. As respects the non-residential assets, Sch A1 lays down no rules beyond the basic formula, namely the charge is on the shares to the extent their value is attributable to the UK residential property interests. This indicates a pro rata approach should be taken, i.e. the proportion of the value of the shares exposed to IHT corresponds to the proportion the value of the residential property bears to the other assets. Liabilities, by contrast, are covered by Sch A1. The rule is that in applying Sch A1, the liabilities of the company are attributed rateably to all its property regardless of whether they are in fact attributable to a particular item of property (Sch A1 para 2(5)). This inter alia means that debts are attribute rateably even if secured on a particular asset or incurred to buy a particular asset. Valuation: loans Where the participation is a loan, the valuation exercise is in one sense simpler for the general IHT rule as to the valuation of debts requires face value to be used unless on the facts the company is not in a position to make repayment (IHTA 1984 s 166). However this rule would not prevent a discount from face value if the loan is for a fixed term at nil or noncommercial interest. More importantly, apportionment is required in the same way as with shares if and to the extent the creditor company has assets other than the residential property. Contact and completion Sch A1 contains no provision covering the position where a company s acquisition or disposal of the UK residential property interest is between contract and completion. It may be suggested the value of participations in the company is not attributable to residential property being acquired until completion and remains so attributable on sale until the sale is completed.

13 De minimis The compliance burden imposed by Sch A1 on minority shareholders is considerable for small shareholders may have limited information rights and even where there is transparency, determining what proportion of the value of their shares is attributable to residential property may be complex where the company or group owns multiple asset classes. Sch A1 makes a modest concession to all this in that it excludes from charge any interest in a close company whose value is less than 5% of the total value of all the interests in the company (Sch A1 para 2(3)(a)). It is to be noted that the comparison required here is not between the value of the subject interest and the value of the company as a whole. Instead all the interests in the company have to be valued separately, and it is then the aggregate of those separate values that has to be compared with that of the subject interest. This means the 5% de minimis is more likely to be in point where another shareholder has control than where no single shareholder has control. The 5% de minimis is not as generous as appears for in contrast to Sch A1 generally, application of the de minimis requires connected party holdings to be aggregated (Sch A1 para 2(4)). For these purposes connected bears its normal IHT meaning. This is the same as the CGT definition, save that nephews, nieces, uncles, and aunts count as connected and the terms settlement settlor and trustee bear their IHT meanings (IHTA 1984 s 270). Groups and other complex structures As indicated above, Sch A1 catches participations whose value is attributable to residential property held through one or more subsidiaries. In fact it goes wider, for Sch A1 applies even if the top company (or one of its subsidiaries) owns only a minority interest in the property owning company. Indeed, Sch A1 can apply on a chain of companies even if none owns more than a minority interest in the one immediately below it. Thus Sch A1 is engaged if the top company, A, owns 10% of company B, company B owns 10% of company C, and company C owns the residential property. It is engaged even if such a chain of ownership is considerably longer and even if some or all of the companies concerned own other assets. The compliance implications are formidable and there is only a glimmer of relief. This arises from the 5% de minimis which applies not only at the level of the participation in the top company but also at the level of each participation of one company in another. But this would not protect structures of the kind postulated above with a series of say 10% holdings unless (possibly) some or all of the companies in the chain had an unconnected controlling shareholder or substantial debts. A difficult issue, assuming the de minimis is not in point, is how the valuation exercise is conducted with a chain of minority holdings. Here it may be suggested that the assets value of each company in the chain reflects the minority valuation of the holding which is its asset. In the result minority discounts are made at each stage in the chain and so, assuming a 50%

14 minority discount and no other assets, the value of the top company in the 10% example cited above would be just 25% of that of the property owned by company C. So just 2.5% of value of the property would be reflected in the value of the top company. Other assets An interest in a close company can be caught by Sch A1 even if neither it nor any subsidiary owns UK residential property. This result follows because the value of a participation treated as attributable to a residential property interest if it so attributable by virtue of a partnership interest, a relevant loan, or assets held as collateral (Sch A1 para 2(2)(b)). In its reference to partnership interests, it catches structures where one or more of a chain of entities is a partnership. In referring to relevant loans and collateral, it embraces situations where a close company has made a relevant loan or provided collateral to fund the acquisition of UK residential property by an individual or a trust. The meaning of relevant loan, and the extent to which collateral is caught, are as discussed below. Interaction with close company apportionment rules Transfers of value by close companies have always been within the scope of IHT, in that the value transferred is apportioned to the participators in the company (IHTA 1984 ss ). In relation to individual participators the apportioned transfer does not enjoy excluded property status unless the company s asset enjoys that status (s 94(2)(b)). With trust participators, by contrast, excluded property status is secured provided the participation in the company is foreign situs (s 99(2)). Sch A1 does not impact on these rules directly. However a transfer of value of UK residential property which is apportioned to trustees is no longer protected from IHT, as Sch A1 means the company shares do not have excluded property status. But where the residential property is only one of the company s assets, the IHT exposure is only partial. A difference between the apportionment rules in ss and the rules in Sch A1 is that the former exclude loan participators whereas the latter does not. Partnership interests The reason why partnership interests are included in Sch A1 is that for IHT purposes, the general law applies in determining what each partner owns. As a result the partner s asset is his interest in the partnership rather than an aliquot share in each partnership asset. The situs of this asset is where the partnership business is carried on. In theory at least, it is thus possible to constitute a partnership owning UK residential property where the asset each partner owns is non UK situs and thus in the absence of Sch A1 excluded property. In such a case Sch A1 operates in the same way as if the partner s interest were a participation in a close company. It cannot therefore enjoy excluded property status if and

15 to the extent its value is attributable to a UK residential property interest (Sch A1 para 2(2)). As with company participations the attribution can be either direct, or indirect through one or more close company participations. Structures where one partnership is partner in another are also comprehended (Sch A1 para 2(2)(b)(ii)). The term partnership has the same meaning as it bears for ATED. The term thus embraces partnerships within the meaning of the Partnerships Act 1890, the Limited Partnerships Act 1907 and the Limited Liability Partnerships Act 2000, together with firms or entities of similar character formed under non UK law (Sch A1 para 10). Relevant loans The provisions of Sch A1 dealing with relevant loans are of some complexity. Definition of loan Sch A1 does not include a comprehensive definition of the term loan. But it does provide that the term includes: (a) (b) An acknowledgement of debt; or Any other arrangement under which a debt arises. The term thus includes outstanding purchase price. When is a loan relevant Determining whether a loan is a relevant loan requires the focus to be on what the money made available under the loan was used for and who the borrower was (Sch A1 para 4). Uses The uses which make a loan a relevant loan are as follows: (1) The acquisition of UK residential property interest. (2) The maintenance or enhancement of such a property interest. (3) The acquisition of a participation is a close company that is itself to any extent within Sch A1 i.e. whose value is to any extent attributable to a UK residential property interest. (4) The acquisition of a partnership interest within Sch A1. The use can be either direct or indirect. Indirect use connotes any one of the following: (1) The money lent is initially used to acquire another asset, and it is the proceeds of sale of that asset that are used in a way that makes the loan a relevant loan (Sch A1 para 4(2)(a)). (2) The money lent is used by the borrower to make a loan and that loan by the borrower is a relevant loan (Sch A1 para 4(2)(b)).

16 (3) The money lent is used to repay a pre-existing relevant loan (Sch A1 para 4(2)(b)). As indicated above, a loan is a relevant loan if it is used to acquire the acquisition of a close company interest or participation that is already within Sch A1. In fact in the majority of such cases the participation or interest will not be within Ach A1 at the time of acquisition, for the acquisition will be by way of shareholder loan or share subscription to enable the company or partnership to buy a property it has identified but not bought. But such cases are caught by para 4(1)(b) of Sch A1. Under this provision the loan is still a relevant loan if it is used both: (a) (b) To finance the acquisition of the participation or partnership interest; and The acquisition by the company or the partnership of either a UK residential property interest or a participation or interest in another company or partnership owning UK residential property. Borrowers A loan is not a relevant loan unless the borrower is one of the following (Sch A1 para 4(1): (a) (b) (c) An individual or individuals A partnership The trustees of a settlement acting as such The residence status of the borrower is immaterial and thus a loan from one non-resident to another is a relevant loan if it otherwise meets the conditions of Sch A1. Companies are not on the list of borrowers and it may be thought this means loans to companies escape Sch A1. This is indeed the position where the borrowing company is not close. But where the borrowing company is close, the loan is a participation and so caught by the rules described above. But the distinction between corporate and non-corporate borrowers is not wholly immaterial. For non-corporate borrowers, the test of whether the loan is a relevant loan turns on what the money lent is used for. Thus where the borrower owns residential property and other assets, the loan is only a relevant loan if used to acquire, maintain or enhance the residential property. But with a corporate borrower, the rule is liabilities are allocated to the company s assets pro rata and so a loan participation is caught according as to what proportion of the company s assets is residential property. The use the company made of the borrowed money is immaterial, a situation of advantage to loan participators if the use was residential but to their disadvantage if it was not. Ceasing to be relevant A loan ceases to be a relevant loan on the disposal of the residential property interest which renders it relevant (Sch A1 para 4(4)). Thus a loan which directly funds a residential property acquisition ceases to be relevant when the borrower sells the property. This is so even if he does not then repay the lender. In such a case the loan would resume its status

17 as a relevant loan should the borrower use the proceeds to buy another UK residential property. Termination of relevant loan status turns on disposal of the relevant property interest even where what the loan was used for was the acquisition of a company participation or partnership interest. The focus is on the disposal of the residential property interest which brought the participation or partnership interest within Sch A1. In what may be a gap in the legislation relevant loan status is not lost should the borrower dispose of the participation or partnership interest itself. Double tax In theory a relevant loan could result in the same value being exposed to IHT twice, once by reason of the relevant loan and once by reason of the underlying UK residential property. But this result is avoided provided the conditions for the loan to be a deductible liability of the borrower are met. In general deduction is not precluded by IHTA 1984 s 162A as by definition the loan is not incurred to acquire excluded property. A greater difficulty is posed by the general rule as to encumbrances in IHTA 1984 s 162. These ensure the loan is deductible if the loan is secured on the residential property. But real issues may arise if it is not so secured. The two year rule The two year rule takes Sch A1 to assets which, at the moment of charge, have no connection with UK residential property (Sch A1 para 5). The two year rule removes excluded property status from the following: (1) The proceeds received on the disposal of a close company participation, a partnership interest or a relevant loan. (2) Sums received on repayment of a relevant loan. (3) Property which directly or indirectly represents such proceeds or sums. There are two important limitations on the two year rule. First, as the term two year rule implies, Sch A1 ceases to be in point once two years have elapsed from when the disposal or repayment occurs (Sch A1 para 5(3)). Unfortunately the term disposal is not defined and it is unclear whether contract or completion is connoted. Sch A1 forms part of the IHT code and so the CGT rule that the date of contract is the date of disposal is not in point. There is no provision comparable to the ATED rule focusing on completion and substantial performance (see FA 2013 ss 121 and 122). The second limitation is that the two year rule is only engaged if at the time of disposal or repayment the loan is a relevant loan or the participation or partnership interest is within Sch A1. This means that if by then the residential interest or interests which caused Sch A1 to be engaged have all then been sold, the two year rule is not in point. However in the case of multiple residential properties owned by a company or partnership, it appears all have to be sold. This result follows because until all are sold the participation or interest is still within Sch A1, albeit to a limited extent.

18 The charge is not on the consideration or repayment proceeds in the abstract, but on the property or money which constitutes such consideration or proceeds. This means that Sch A1 is not engaged to the extent the consideration or proceeds are spent prior to the occasion of a charge. But if the spending is on buying other assets, the third head of charge listed above fastens on such assets. In determining whether the consideration or proceeds have been spent it appears that a tracing rule applies. Thus an individual who uses the proceeds of UK residential property to pay for terminal medical care ensures those proceeds are not exposed to Sch A1 should he die within two years of the sale. But they are so exposed if he uses other resources to pay his medical bills or those bills are paid by a third party. Where tracing is into other property, the two year rule cannot result in greater value being exposed to IHT under Sch A1 than the amount of the proceeds of sale or loan repayment (Sch A1 para 5(3)). Should the replacement property fall in value, it is the lower value that is charged. Collateral The rules relating to collateral are a second instance of Sch A1 extending IHT exposure to assets with no value derived from UK residential property. The rule The collateral rule requires a loan to be identified which is a relevant loan. The definition of relevant loan, discussed above, is not expressed in terms of loans owned by persons chargeable to IHT, so a loan made by a non-close company can be a relevant loan as much as a loan made by a close company or an individual or trust. For this reason any bank loan is capable of being a relevant loan, albeit not itself resulting in exposure under Sch A1 save in the unlikely event the bank is privately owned and close. Once the relevant loan is identified, para 3(b) of Sch A1 brings within the scope of IHT any money or money s worth held as security, collateral or guarantee for the loan. The same applies if the money or money s worth is simply made available as security, collateral or guarantee for the loan. Meaning of terms There is no definition of any of the terms used in para 3(b). collateral or guarantee therefore bear their normal meanings. The words security, When looked at closely, para 3(b) reads as if some words are missing. Thus money or money s worth would not strictly be said to be held as collateral but as collateral security this term embracing assets which are not the primary security but are pledged or charged in support of the relevant loan primarily secured on the residential property. So too money or money s worth would not strictly be said to be a guarantee but security

19 provided by the guarantor in support of a guarantee he has given to support the borrower s debt incurred to buy residential property. An issue of some difficulty is whether the language of para 3(b) catches assets which are not pledged or charged to the lender but could be available to the lender by set-off should he need to enforce repayment. Set-off is a contractual right and the difference between it and a pledge or charge is that pledged or charged assets cannot be withdrawn in the discretion of the borrower or guarantor whereas set-off assets can be. Set-off only operates against such assets of the borrower or guarantor that the lender happens to hold when the right of set-off is asserted. The language of para 3(b) is far from perfect and lacks clarity. But the use of the words held, made available and security indicate what the draftsman had in mind was pledged or charged assets only. If so assets potentially available in set-off are not caught. Extent of liability The money or money s worth exposed to IHT under para 3(b) cannot exceed the value of the relevant loan. In the case of loans by non-close companies this results in a single exposure to IHT, namely at the level of the security or collateral, rather than at the level of the relevant loan. But where the creditor under the relevant loan is a person within charge to IHT, there is double exposure, once on the value represented by the relevant loan and once on the security or collateral. This double exposure obtains whether the security or collateral is provided by the borrower or by a third party guarantor. The exception As described above a loan is not a relevant loan unless the borrower is an individual, a partnership or a settlement. Loans to close companies are not relevant loans and as a result security or collateral for such loans is not within Sch A1. The two year rule The two year rule described above does not apply to collateral. Thus collateral escapes from Sch A1 once released. Tax avoidance Sch A1 contains two rules to counter avoidance. TAAR Arrangements are disregarded if their purpose or a main purpose is to secure a tax advantage by avoiding or minimising the effect of Sch A1 (Sch A1 para 6). The term tax advantage has the same meaning as in the GAAR (para 6(2); see para 98.5). This TAAR is somewhat wider than its equivalents elsewhere in the UK tax code, for as well as catching arrangements designed to avoid tax under Sch A1 it also catches arrangements which

20 minimise such tax. However it may be suggested minimise should be construed eiusdem generis with avoidance and thus would not catch transactions properly described as mitigation. Treaties A double tax treaty cannot prevent a transfer from being chargeable as a result of Sch A1 unless: (1) Tax of a similar character to IHT is charged by the treaty partner; and (2) The effective rate of that tax is not 0% (Sch A1 para 7). Enforcement The statutory charge securing any IHT payable is imposed not merely on the foreign situs assets brought within IHT by Sch A1, but also on the underlying UK residential property which causes Sch A1 to be engaged (IHTA 1984 s 237(2A)).

21 D. Cleansing F(No 2)A 2017 has introduced a time-limited relief enabling mixed funds to be cleansed (F(No 2)A Sch 8 para 44). This is time-limited in that any offshore transfer to take advantage of it must be made in or (para 44(2)(a)). However it is not necessary that any cleansed funds resulting from the transfer be brought to the UK before 6 April Eligible individuals The relief is expressed in terms of a given individual, described in the legislation as P (Sch 8 para 44(1)). To secure the relief P has to be a qualifying individual, but that means merely that he must have claimed the remittance basis in or some prior year (para 44(3)). In contrast to CGT rebasing (see para 49.24) this relief is not confined to those who became deemed UK domiciled on 6 April 2017 and nor is there any requirement as to length of residence in the UK prior to 6 April One category of former remittance basis user is however excluded from the cleansing relief. Individuals so excluded are those who are now deemed UK domiciled by virtue of being returners, i.e. those who were born in the UK and have a UK domicile of origin. It does not matter that the individual did not claim the remittance basis in or indeed that he had an actual UK domicile in All that is required is that he was non-domiciled and claiming the remittance basis in some year prior to 6 April But those non-domiciliaries who never claimed the remittance basis between and cannot secure the cleansing relief as eligibility to the relief is expressed in terms of ITA 2007 ss 809B, s 809D or s 809E applying (para 44(3)(a)). Those sections came into force only on 6 April But an exception is where the remittance basis was available without need for a claim in any year between and (para 44(3)(a); see further ITA 2007 ss 809D and 809E and paras and 46.12). Eligible funds To attract cleansing relief, the mixed fund must be an account. Further the transfer must be a transfer of money (para 44(2)(b)). The term money is not defined, and the definition in s 809Z6 is not applied. Money must therefore bear its general meaning and thus principally connote credit rights against banks i.e. bank accounts. It follows that cleansing relief applies and applies only to bank accounts. There is however no objection to non-cash assets being sold and converted to credit balances at banks and then attracting the relief. In some cases it is a matter of judgement as to whether the transactional costs of doing so justify the benefits of cleansing.

22 Eligible transactions To be eligible for the relief the transaction must be a transfer from one account to another (para 44(2)(c)). The transferee account must not be a UK account or otherwise be such that payment into it constitutes remittance. This is not stated expressly in the legislation but follows because the relief applies only to offshore transfers (para 44(2)). That term connotes a transfer which is not a remittance. To secure the relief, the transfer has to be nominated by P (para 44(2)(d)). The form of the nomination is not prescribed by the legislation and in particular it is unclear whether the nomination is merely something kept on file or has to be notified to HMRC. What is clear is that only one transfer from the transferor account to the transferee account can be nominated (para 44(2)(e). The nominated transfer need not be the first transfer between the accounts, but once one such transfer is nominated no other transfer between the accounts can be nominated. What is not precluded is transfers involving other accounts. Thus more than one transfer by the transferor account can be nominated, provided all are to different transferee accounts. So too a single transferee account can receive transfers from several transferor accounts. The relief The relief operates by disapplying the offshore transfer rule in s 809R(4), i.e. the rule that specifies that the transfer contains a pro rata proportion of each kind of capital and income in the transferor account (see para above). Instead, the nomination is required to specify which category or categories of capital or income are comprised in the transfer, and the amount of the category or categories so comprised (para 44(4)). The only limitation on this nominating power is that the amount of a given category nominated cannot exceed the amount of that category in the transferor account immediately before the transfer (para 44(5)). Once made, a valid nomination then overrides the offshore transfer rules and so determines what has gone into the transferee account. The drafting difficulty There is a drafting difficulty with the relief. This arises because of the requirement that a transfer attracting the transfer be an offshore transfer. That term is defined for the purposes of the relief as having the same meaning as in ITA 2007 s 809R(4) (para 44(6)). But s 809R(4) is not a definition section but instead is the operative provision prescribing what happens on an offshore transfer. As described above (para 53.10) an offshore transfer is defined in s 809R(5) as any transfer which is not a s 809Q transfer i.e. any transfer which is not a remittance. But then s 809R(6) deems any transfer to be an offshore transfer if remittance does not occur before the end of the tax year in which the transfer occurs and is not then expected to occur thereafter.

23 On the face of it this deeming provision makes cleansing relief difficult to operate, for if what is nominated as transferred is clean capital, by definition remittance is to be expected. A technical solution to this difficulty is for the nominated transfer to extract everything except clean capital, so that it will indeed be correct to say that remittance of what is transferred is not expected. The alternate to is to treat the reference in para 44(6) to the meaning of offshore transfer refers only to the basic definition in s 809R(5) and not to the deeming in s 809(6). At a purposive level this alternate is compelling. But it is a matter for regret that the draftsman did not see fit to make the point explicit. The foreign currency difficulty In practice, the bank accounts used in cleansing relief may be non-sterling, or, even if those accounts are sterling, earlier accounts through which the income and gains have passed were not. In these circumstances, securing cleansing relief requires clarity as to the applicable rules where foreign income and gains pass through non-sterling accounts before being remitted. As indicated in para 53.12, those rules are far from clear and many advisers consider HMRC s approach wrong and inoperable. Unless and until the issue is resolved by clear and comprehensible practice agreed with HMRC, cleansing relief will be difficult to operate. Excess income and gains Another practical difficulty concerns mixed funds whose present value is less than the aggregate income gains and capital from which they are derived. Here the normal offshore transfer rules work well enough, for the pro rata approach means each element of income and gains has to be scaled down proportionately. But when it comes to cleansing it is necessary to identify particular items of income and gains and it is not clear whether the amount so identified should the original amount or the scaled-down amount. The over nomination risk The above issues are far from theoretical on account of the rule that the amount of a particular item of income or capital specified in the nomination cannot exceed the amount of the item in fact in the transferor mixed fund. It appears the nomination is invalid if this rule is breached and if so the apparent cleansing transfer will be an ordinary s 809Q or offshore transfer. As such a subsequent remittance which in reliance on the nomination is believed to be clean capital may not turn to be such at all. This over nomination risk means the difficulties canvased above are important. Until they ae clarified by clear and agreed practice, remittance in reliance on cleansing relief should be avoided in any case where basic mixed fund treatment is unclear. Relevant person mixed funds