Pride and prejudice? The double trust scheme, in the dock

So-called double trust schemes became popular around twenty years ago. There were a number of variants, but in essence the planning involved the following steps:

• An individual settled two trusts with nominal capital.
• The settlor sold property (typically, a home which he/she occupied) to one trust, for market value consideration which was left outstanding as a debt. The settlor was a beneficiary of this trust.
• The benefit of the debt was then given to the second trust. The settlor was not a beneficiary of the second trust.  Normally, the second trust was for the benefit of the settlor's children. It was drafted so that, under the inheritance tax (IHT) rules then in force, the gift of the benefit of the debt to the second trust did not give rise to an IHT charge for the settlor.

The idea was that on the settlor's death, the IHT exposure with respect to the property of the first trust would be limited to the net value of such property, after deduction of the debt due to the second trust. The settlor's death would not be a taxable event in relation to the second trust, as the settlor was not a beneficiary of it, and accordingly the gift with reservation of benefit (GWR) rules would not apply. The intended net result was that, on the settlor's death, IHT would only be payable on any increase in the value of the property held by the first trust since the arrangements were put in place.

It is a truth universally acknowledged that HMRC has never accepted the efficacy of the double trust scheme. Rather remarkably, it has taken two decades for a case on the IHT treatment of the scheme to reach the First-tier Tax Tribunal. That has now happened, in the form of Pride v HMRC [2023] UKFTT 316 (TC).

Section 102

HMRC has always contended that double trust schemes do not work, because there is a reservation of benefit with respect to the property of the second trust (under section 102 of the Finance Act 1986). The essence of the HMRC argument is that although the settlor is not as a formal matter a beneficiary of the second trust, the settlor benefits from the second trust in practice, because its trustees refrain from seeking repayment of the debt due from the first trust. Accordingly, the benefit of the debt held by the second trust is not enjoyed to the entire exclusion of the settlor, and as such it is caught by the GWR rules (IHTM44104). The result, per HMRC's argument, is that the value of the debt is included in the settlor's estate, under those rules, on his/her death.

On the particular facts of the Pride case, this argument was rejected by the Tribunal (in the author's view, correctly). In Pride, the debt was repayable on the expiry of a fixed term, and did not mature until after the settlor's death. Although the trustees of the second trust could in principle have sought early repayment, under the terms of the debt that would have carried a heavy financial penalty, and would not have been in the interests of the beneficiaries. The GWR rules did not, therefore, apply.

Section 103

A more difficult and interesting point is whether, on the settlor's death, the first trust's debt to the second trust was disallowed under a separate IHT anti-avoidance rule, contained in section 103 of the Finance Act 1986. Simplifying slightly, this rule is applicable where:

• An individual has died.
• In his/her lifetime, the individual made a gift.
• On his/her death, the individual had a liability which would otherwise be deductible in arriving at the value of his/her estate.
• The liability took the form of a debt incurred by the individual.
• The consideration given for the liability was derived from the subject-matter of the gift, or was provided by a person whose assets at any time included the subject-matter of the gift.

Where the rule applies, the liability is abated (or in more modern parlance, is disregarded).

This is quite abstract and obscure. It helps to understand the paradigm situation to which section 103 is intended to apply. This is where an individual has given money to a child and the child has then loaned that money back to the individual. Absent section 103, this simple arrangement would allow the individual to access the wealth that he/she previously owned, but without any of the IHT consequences of such ownership. Section 103 thwarts such Johnsonian cakeism.

In Pride, the first trust was a life interest trust for the settlor, whose assets were (under the IHT rules then in force) treated as assets owned by the settlor. The Tribunal therefore considered it legitimate, taking account of previous authorities on the interpretation of deeming provisions, to proceed on the basis that when the first trust incurred a debt, that debt was incurred by the settlor.

The essence of the previous authorities is that when construing a deeming provision, which directs the reader to treat some deemed state of affairs as real, a court should apply the statutory fiction to the consequences which would inevitably flow from the fiction being real. However, the deeming should not be taken so far as to produce unjust, absurd or anomalous results.

In Pride, it seems not to have bothered the Tribunal that in the real world, the first trust's debt was originally due to the settlor, so that the Tribunal was deeming the settlor to have incurred a debt to herself. The Tribunal dismissed this as a "slight oddity".  But it is surely more than that. 

The difficulties in the Tribunal's analysis are compounded when one considers that, for section 103 to bite, the first trust would need to have had assets which included the subject-matter of a gift made by the settlor. For section 103 to apply here, two propositions would need to be correct, simultaneously:

1. When the first trust incurred a debt, the settlor incurred a debt.
2. The consideration for the debt was derived from the subject-matter of a gift made by the settlor.

These propositions seem to be mutually exclusive, as proposition (1) depends on the first trust and he settlor being conflated, whereas proposition (2) depends on the settlor and the trust being treated as separate persons. It is surely impermissible to apply a statutory fiction in a manner which produces logical contradictions.

The correct analysis, it is suggested, is that even if it is correct to treat the debt incurred by the first trust as a debt that was incurred by the settlor (which is debatable), the consideration for that debt was not property derived from a gift made by the settlor. The transaction whereby property was acquired by the first trust was a sale, not a gift. The first trust did not have any property that was derived from gifts made by the settlor, except for the nominal capital with which it was initially created. The consideration for the debt was clearly not derived from that nominal capital.

Section 175A

The Tribunal's determination on section 103 therefore seems dubious. However, there was a further, alternative ground for its decision that the first trust's debt to the second trust should be disallowed. This was by reference to section 175A of the Inheritance Tax Act 1984. 

Section 175A provides that in determining the value of a person's estate immediately before his/her death, a liability can by default only be taken into account if it has subsequently been discharged out of the estate in money or money's worth. This essentially requires any debt to have been repaid out of the estate, if it is to be allowed as an IHT deduction. 

Exceptionally, a debt which has not been repaid out of the estate can be allowed as an IHT deduction, but only where there was a "real commercial reason" for leaving the debt unpaid, and there was no purpose of securing a tax advantage. A person is deemed to have a "real commercial reason" for leaving a debt unpaid where it is shown that the debt is to another person dealing with the first at arm's length, or that if the debt were due to such a person, that other person would not require the debt to be repaid. It is implied that unless either of these things can be shown, the person is deemed not to have a "real commercial reason" for the non-payment of the debt.

In Pride, section 175 was relevant on the basis that the property of the first trust, of which the settlor was life tenant, was deemed to be part of the settlor's estate. The trustees of the second trust had released the debt due to them from the first trust, approximately a year after the settlor's death. The trustees had apparently received legal advice that because "there was an identity of interest in the two trusts" the debt need not be repaid by the first trust but could instead be released by the second. That appears to have been very questionable advice, which fatally prejudiced the ability for the trustees of the first trust to claim an IHT deduction for the debt.

Context

It will be interesting to see whether the taxpayers appeal. Also of great interest is the rumour that there is another double trust scheme case which is due to be litigated on similar points. It will be fascinating to see whether this second case reaches the Tribunal, and whether the taxpayers' arguments in that case are any stronger. It would not be altogether surprising to find that HMRC has carefully picked cases to litigate which, like Pride, were fatally prejudiced by defects in implementation.

Find the case here: Pride v HMRC [2023] UKFTT 316 (TC)