STEP HONG KONG BRANCH NEWSLETTER July 2017 UK taxation of usufructs Paul Stibbard TEP, Rothschild Trust, London Introduction Taxpayers in many civil law jurisdictions use usufructs as a practical means of family wealth transmission. The question arises: what tax and legal complications may arise for those within the UK tax net who seek to use usufructs over foreign property for family wealth succession purposes? This would typically catch those who are either treated as UK domiciled or deemed domiciled, or those who are UK resident non-domiciled, but have not elected to be taxed on a remittance basis with respect to any capital gains arising on any disposal or deemed disposal of foreign property on the creation of a usufruct. One basic problem that arises is that the civil law usufruct is not generally recognised in UK tax legislation. The closest UK equivalent to a usufruct is a Scottish liferent. This typically involves the liferenter being granted the use of a property during his or her lifetime. On the death of the liferenter, the interest passes to a fiar, equivalent to the bare owner or reversioner. Inheritance tax (IHT) The rules in relation to non-trust structures are covered by Section 43(2) Inheritance Tax Act 1984 (IHTA). This provides: Settlement means any disposition or dispositions of property, whether effected by instrument, by parol or by operation of law whereby the property is for the time being:- (a) held in trust for persons in succession or for any person subject to a contingency or would be so held if the disposition were regulated by the law of any part of the UK; or whereby under the law of any other country, the administration of the property is for the time being governed by provisions equivalent in effect of those which would apply if the property were so held Subject to the argument whether the administration of the property in the other country is equivalent to provisions which would apply if the property were subject to English law, and whether the property is indeed held for persons in succession, HMRC has treated this as authority to tax the creation of a usufruct as if a trust had been created. HMRC, in IHTM27054, comments: You may come across a usufruct where an estate includes land and buildings in the EU or other foreign countries. It may be referred to as a usufruct or usufruit in French, or given another name such as a Niessbrauch in German. But no matter how it is labelled, it is important to identify the underlying rights of the arrangements and understand the circumstances that apply to the usufruct in each case. For example, another means of providing an income for life in Germany is a Leibrente which may be closer to an annuity than the rights under a usufruct. In HMRC s Trusts and Estates publication dated April 2013, HMRC further comments: HMRC has always been of the view that the definition of a Settlement in Section 43(2) IHTA means that a usufruct will more than likely fall to be treated as a Settlement for IHT purposes, although HMRC recognises that arrangements differ between jurisdictions and the circumstances of each need to be considered. The effect is to treat a usufruct as
giving rise to an interest in possession in the property concerned. Prior to March 2006, the consequence of this was that a usufruct retained by the transferor did not give rise to a loss to their estate as the transferor remained beneficially entitled to the property under section 49(1) IHTA If the usufruct was created in favour of another, the transaction would give rise to a potentially exempt transfer equal to the value of the property concerned Post March 2006, the consequences were rather different and the creation of a usufruct will now give rise to an immediate chargeable transfer equivalent to the value of the property concerned and to relevant property. It may give rise to a reservation of benefit in the property. If the usufruct is in favour of the spouse/civil partner, exemption will no longer be available. Following this, there have been a few articles indicating a lack of uniformity in HMRC s IHT treatment of usufructs on death. As an example, one case has been referred to dealing with the death of a UK domiciled lady who had created a usufruct over French property with the bare interest passing to her children. In that case, apparently, HMRC accepted the argument that a usufruct created in 2000, which was simple in nature, was extinguished on the lady s death and that no IHT was due on that French property. HMRC commented further to clarify any confusion over the issue of the IHT treatment of usufructs in its Trusts and Estates Newsletter in September 2015 in the following terms: HMRC can confirm its approach to the treatment of a usufruct remains as stated in the April 2013 Newsletter. Since April 2013, HMRC has dealt with a small number of cases where the estate included a usufruct and in each case, the facts were less than straightforward. HMRC applied its approach to the facts of each case as it understood them to be, and in each case, the difference between the value reported by the taxpayer and the value that emerged following HMRC s approach was not sufficient to warrant pursuit. So in accordance with its litigation and settlement strategy, HMRC adopted the value reported by the taxpayer. But HMRC remains of the view that, generally, a usufruct should be treated as giving rise to a settlement for IHT purposes and will pursue the collection of tax on that basis. Thus it seems implicit that HMRC look at the particular features of a usufruct to determine its tax treatment on the basis that it should be taxed upon similar lines to trusts in accordance with section 43(2). In order to compare the usufruct to the trust for the purposes of this analysis, it may be helpful to take as an example a usufruct which has the following attributes:- 1. The usufruct holder has the entitlement to enjoy the property s use during his lifetime. Although the right may be renounced, charged or seized, because of its connection to the usufruct holder, it will be considered in this article to be inalienable. 2. The interests of both the usufruct holder and the bare owner are registered on any property register. 3. The division of the property title to create such a usufruct may be created either inter vivos or on death. 4. On creation of such a usufruct, the civil law jurisdiction typically splits tax between the usufruct holder and the bare owner on the basis of an agreed formula
5. On the death of the usufruct holder, his interest, which ceases, would not be treated as an asset of his estate. Thus, no probate formalities would be required because the bare owner would gain the absolute title at the property register on production of the usufruct holder s death certificate, and payment of any transfer tax due. The use of usufructs for individuals within the UK IHT net has potentially been complicated by changes to the taxation of trusts introduced in the Finance Act (FA) 2006. Until the effective date of this legislation, such usufruct structures, set up during lifetime, were treated as equivalent to interest in possession settlements. Since 22 March 2006, the creation of an inter vivos usufruct would be treated as equivalent to a discretionary trust for IHT purposes. Any person who is domiciled or deemed domiciled in the UK by reason of section 267 IHTA, who owns foreign property, may, subject to relief under any applicable Double Tax Treaty for Estate Taxes, be within the IHT net, both with respect to lifetime events, and on death. To take an example, if an Italian domiciliary moved to the UK in 2005, retaining ownership of an Italian property, under the new tax rules which came into effect on 6 April 2017, he will be deemed domiciled as soon as he has crossed the threshold of 15 out of 20 years of tax residence. Thus, depending on the Italian tax analysis, he may be well advised to create a usufruct over the Italian property, giving the bare ownership to his children before becoming deemed domiciled. The advantage of doing so is that the Italian property may be treated as excluded property under section 48(3) IHTA on the death of the usufruct holder, and so be outside the UK IHT net. This compares with the position when the owner takes no action. In that case, after the UK resident Italian domiciliary becomes deemed domiciled for UK tax purposes, on his death, the whole value of the Italian property would fall into the UK IHT net. So, from a UK tax perspective since 22 March 2006, on death, the use of an immediate post-death interest in possession usufruct, permitted by FA 2006, provides a potential planning opportunity. Thus, if a UK domiciliary dies leaving French property in his estate, for example, without making a will, with the result that part of the property would vest absolutely in his children under French law. A liability to IHT would arise in that property which passed directly to his children. It may be open to the children, who are of full capacity, subject to French advice, to combine together to execute a French document which complies with the provisions of Section 142 IHTA, to create a usufruct interest in favour of his UK domiciled surviving spouse. Provided that this document was executed within 2 years of death, and registered with the HMRC within 6 months of its execution, no liability to UK IHT may arise with respect to the disposition of such property in this manner by reason of the exemption from IHT by reason of the surviving spouse s usufruct interest. On the death of the surviving spouse entitled to the usufruct interest, subject to relief under the UK/French Double Tax Treaty for Estate Tax, and/or any unilateral relief under section 159 IHTA, IHT would be assessed on the whole value of the property on the death of the surviving spouse. That result follows, on the basis of HMRC guidance indicating that a usufruct governed by French law should be treated in a similar manner to a Scottish liferent. The analogy to the Scottish liferent is helpful, not least because Section 142(7) IHTA indicates that property, which is subject to a proper liferent, shall be deemed to be held in trust for the liferenter. As an example, if a non-resident UK domiciliary father (F) creates a lifetime usufruct on 1 January 2007, giving bare ownership to his son (S), but retaining the usufructory interest, with French property worth 1 million, assuming his lifetime exempt band has already been exhausted, this would be treated as an immediate chargeable transfer of 1 million at 20 per
cent, giving rise to an IHT liability of 200,000. In addition, there would be a ten-yearly 6 per cent IHT periodic charge on the value of the French property on 1 January 2017 and on each 10 th anniversary of the creation of the usufruct thereafter, prior to its termination. It is worth highlighting that for property which qualifies for 100 per cent exemption from IHT, either as business property or as agricultural property, there would be no 20 per cent IHT charge above the IHT exemption threshold on the creation of the usufruct, nor on any of the ten-yearly charges on such anniversaries of its creation, nor to an exit charge at the time of its termination. However, if the property subject to the usufruct qualifies for 100 per cent relief at the time of its creation as business property or agricultural property, but thereafter ceases to qualify for such relief, then although there would be exemption from the 20 per cent IHT charge on its creation, there would be no such exemption to the ten-yearly IHT charges, nor to the IHT exit charge. Finally, on F s death, on 1 January 2018, for the sake of illustration, it is likely that HMRC would seek to assess not only a full charge to IHT at the death rate of 40 per cent on the basis of his reservation of benefit in the form of his retained usufruct interest pursuant to section 102A of the Finance Act 1986. There would also be an exit charge, levied on the basis of 4 completed quarters as a fraction of the forthcoming ten-year period since the last ten-yearly periodic charge or its creation (whichever last occurred), giving rise to a further IHT charge at rate of 4/40 of 6 per cent = 0.6 per cent on the value of the property released. He would only be able to avoid the full charge to IHT on his death if he released his usufruct interest, reserved no other benefit in the property and survived for a further seven year period thereafter. As a further example, assume a husband (H) dies owning a French property in his own name, (rather than having created a usufruct in his favour and vesting the bare ownership in his child). By his French will, he leaves a usufructory interest in his French property to his UK domiciled wife (W), with the bare ownership passing to his child. No IHT will arise on H s death because of the surviving spouse exemption (Section 18 IHTA). On W s death, the whole of the value of the French property in which she held the usufructory interest would fall within the UK IHT, and, subject to relief under the UK/French Double Tax Treaty, be liable to IHT at the death rate of 40 per cent. On the other hand, if she were to release her usufructory interest in the French property, retain no benefit in the property thereafter, and survive for seven years from the date of such release, no IHT charge would arise in the event of her death. Taper relief on the amount of the 40 per cent IHT payable on death would be available after the 3 rd, 4 th, 5 th and 6 th anniversary of such release of her interest at the rate of 20 per cent, 40 per cent, 60 per cent and 80 per cent, (resulting in effective IHT rates of 32 per cent, 24 per cent, 16 per cent and 8 per cent because of such taper relief) respectively. Capital gains tax Whilst for IHT purposes, the usufruct may be taxed upon similar lines to a trust, as described above, for CGT purposes, such usufruct is treated more as an interest in land, not dissimilar to co-ownership. As an example, so far as French property is concerned, it may be helpful to consider Article 6(2) of the UK/French Double Tax Treaty. This provides that, for CGT purposes, a usufruct is an interest in land. Thus the creation of a usufruct would cause the owner to make a part disposal of the property over which the usufruct was created. Double Taxation Relief and International Tax Enforcement (Taxes on Income and Capital)
(France) Order 2009, Article 6(2) provides:- The term immovable property shall have the meaning which it has under the law of the Contracting State in which the property accessory to immovable property, livestock and equipment used in agriculture and forestry, rights to which the provisions of general law respecting landed property apply, usufruct of immovable property and rights to variable or fixed payments as consideration for the working or the right to work, mineral deposits, sources and other natural resources: ships, aircraft and railway vehicles shall not be regarded as immovable property. The UK tax analysis is further complicated by the fact that HMRC does not regard a usufruct created under French law as being a trust for CGT purposes. (See HMRC Manual CG31305). This deals with the position (updated to 18 July 2016) on Death, Personal Representatives and non-trust life interests. HMRC comments: The law of many other countries provides for various kinds of interest which are unknown to the law of England and Wales The principles laid down in Memec Plc v CIR 71 TC77 and R v CIR ex parte Bishopp, in particular the remarks at 71 TC 112: What, in my judgment, we have to do in the present case is to consider the characteristics of an English or Scottish partnership which make it transparent and then to see to what extent those characteristics are shared or not by the silent partnership in order to determine whether the silent partnership should be treated for corporate tax in the same way. HMRC continues:- If the correct analogy is that the particular arrangement has the characteristics of settled property, then it is treated as such. So a case involving Hindu Undivided Property would be regarded as a discretionary trust rather than an unincorporated association. A usufruct governed by French law would be regarded as a non-trust arrangement as it is broadly similar to a Scottish Proper Liferent. Scottish liferents are expressly referred to in Section 63 Taxation of Chargeable Gains Act 1992 (TCGA). This provides: On the death of any such liferenter, the person (if any) who, on the death of such liferenter, becomes entitled to possession of the property as heir shall be deemed to have acquired all the assets forming part of the property at the date of the deceased s death for a consideration equal to their market value at that date. In CG31301 (also updated to 18 July 2016), the HMRC in relation to Death, Personal Representatives and non-trust life interests states: There are two ways in which a liferent can be set up. In the first case, where the interest is known as an improper liferent, the property is vested in trustees who administer the property and pay the income to the liferenter. In general the trustees have the power to sell the property in question and replace it by other property On the death of the liferenter the provisions of sections 72 [Termination of life interest on death of person entitled], 73 [Death of life tenant: exclusion of chargeable gain] and 74 [Effect on sections 72 and 73 of relief under section 165 or 260] TCGA apply as appropriate. (CG36450) In the second case, the title to heritable property (land and/or buildings) is held by the liferenter. In this situation he or she is a proper liferenter. A proper liferenter cannot dispose of a greater title than his own. He cannot dispose of the property in his will. On his
death the property passes to a fiar. Where property in Scotland passes to a person for life under a will, and there is no suggestion that it is to be held by trustees, he has a proper liferent. A proper liferent does not make the relevant property settled property. Section 43(4)(c) IHTA provides that it is settled property for IHT purposes. TCGA does not go so far but section 63 provides that the person entitled to possession on the death of a proper liferenter shall be deemed to have acquired all the assets forming part of the property at their market value at death. The disposal or termination of a proper liferent may qualify for private residence relief under Section 222 TCGA as it is an interest in land. Thus, in so far as a usufruct is equivalent to a Scottish liferent, the bare owner would obtain the benefit of a CGT free uplift on the usufruct holder s death, and may qualify for private residence relief under section 222. It can be seen that if a UK resident deemed domiciliary creates a usufruct over his French property in his own favour, this may lead to a part disposal for UK CGT purposes. This may entail an examination of French law to ascertain the nature and value of the interest retained. That may depend upon the age of the owner at the time that he creates such usufruct interest. If, for example, French law determines that the value of his retained usufructory interest is 30 per cent, then the part disposal rules outlined in section 42 TCGA would apply. That would potentially mean that he had disposed of 70 per cent of the value of the property, with the chargeable gain being calculated with reference to a disposal of that fraction of the property as having taken place. It is then necessary to consider the CGT position in the event of the death of the usufruct holder. It is clear from the extracts from CG31305 and 31300 that, where a deceased possessed a non-trust life interest, this should be compared, inter alia, to the Scottish proper liferent, such that an uplift in the value of the entire property may still be available on the death of the usufruct holder. Conclusion The major point to appreciate is that, notwithstanding the UK s decision to serve Article 50 Notice to leave the EU (Brexit), given the increasing incidence of cross-border property acquisition, whether of homes, farms, businesses or otherwise, there is a serious risk that the number of unexpected cross-border tax and legal problems that may arise may increase both in magnitude and complexity. This is all the more so due to the increased focus over the most recent period in both the UK and elsewhere in the EU to seek to levy more taxes on transactions in higher value real estate and their holding structures. It may readily be seen that it is of critical importance for any person within the UK tax net, either concerned to create a usufruct interest over property in a civil law jurisdiction, or having a benefit under such an existing arrangement, to take advice in both jurisdictions as to the tax consequences of their position. This is particularly the case for lifetime usufructs created post 22 March 2006. Put simply, the likely mismatch in treatments, both with respect to tax on capital gains and inheritance tax treatment, may, in particular circumstances, lead to unforeseen tax complications.
On a more positive note, the main planning options would appear to be either for (a) those with foreign property, who are or intend to become resident in the UK in the period prior to becoming deemed domiciled; (b) those whose foreign property is already within the UK tax net by reason of being domiciled here for IHT purposes, contemplating the creation of a usufruct over property in civil law jurisdictions on death, (or by means of a deed of variation of the devolution of estate property within two years post death); or (c) those owning property which qualifies for 100 per cent exemption from IHT by reason of business property relief or agricultural property relief. Outside those main categories, it is worth noting that, subject to potential reservation of benefit problems, there may also be scope to create post 22 March 2006 lifetime usufructs over property with a value below the IHT threshold, particularly where the person creating such usufruct ceases to enjoy any benefit from such property subject to the usufruct more than 7 years prior to his death. Finally, it is often presumed that the issue of usufruct rights is primarily relevant, in a UK tax context, to civil law jurisdictions in Europe. This is not strictly accurate. By way of example, usufruct rights are relevant in other regions, including Cuba, Louisiana and Quebec in the Americas and Cambodia, Macau, Philippines, Thailand and Turkey in Asia. NOTE: This article is based on a lecture given to the International Academy of Estate and Trust Law in Chicago on 23 May 2017.