Another fine mess: imminent changes to the IHT excluded property rules
The Finance Act 2020 will include some subtle but significant changes to the rules regarding so-called ‘excluded property trusts’ in the inheritance tax (IHT) legislation. On a literal reading, these changes go much further than might be expected. In some cases they could have disastrous consequences for settlors or the trusts they have created, retrospectively changing the treatment of actions that, when they were taken, were tax neutral.
It may be advisable for trustees to take action to exclude settlors of affected trusts, or take other pre-emptive action, prior to the Finance Bill receiving Royal Assent, which could be as early as next week.
Trustees need to carry out an urgent review to identify trusts that have previously received
(1) an addition by way of gift,
(2) a loan, even from an unconnected third party such as a bank, or
(3) a trust-to-trust appointment,
if that step may have occurred at a time when the settlor had become deemed UK domiciled or indeed actually UK domiciled.
There are two main IHT regimes potentially applicable to trusts created by living settlors: the ‘relevant property regime’ (RPR) and the ‘gift with reservation of benefit’ (GWR) rules.
Under the RPR, trustees are subject to IHT charges of up to 6% every ten years after the creation of the trust, and on distributions from the trust. Under the GWR rules, where the settlor of a trust is an actual or potential beneficiary, the assets of the trust are treated as forming part of the settlor’s estate on death for IHT purposes. Where property of a trust is subject to tax under the RPR and also under the GWR rules, no credit is available for tax charged under the RPR when calculating the tax due under the GWR rules. The result of both regimes applying is a level of taxation that may be regarded as penal.
However, both sets of rules are effectively disapplied in relation to assets that qualify as ‘excluded property’ and are, as such, outside the scope of IHT.
Excluded property: current law
IHTA 1984, s 48(3) currently provides that non-UK situated assets comprised in a settlement are ‘excluded property’ if the settlor was neither UK domiciled nor deemed UK domiciled ‘at the time the settlement was made’. (There are certain exceptions, e.g. for trusts settled by individuals who are now ‘formerly domiciled residents’, but these are not considered further.)
On the face of it, this means that, under the current rules, property added to a settlement after the settlor has become actually or deemed UK domiciled is capable of qualifying as excluded property. As a matter of trust law, there is just one settlement and, provided that the settlor was non-UK domiciled and not deemed UK domiciled at the time of its creation, his domicile at the time of later additions is not, on a literal reading of s 48(3) in its current form, relevant.
However, HMRC’s published position has always been that additions made after the acquisition of an actual or deemed domicile should be treated as effectively creating separate settlements, made at the time of the addition, so that the added assets cannot qualify as excluded property. Whether this view has any statutory basis has always been doubtful, and a recent case (discussed below) provided strong support for the view that it is wrong.
Despite this, few advisers have ever recommended that settlors who have become actually or deemed domiciled in the UK should make additions by way of gift to settlements made by them before they became domiciled of deemed domiciled. Such additions attract an upfront IHT charge at an effective rate of 25% unless the assets are relieved (eg as a result of business property relief) and are therefore generally very unattractive, even if the assets benefit from excluded property status once within the trust.
Trust to trust appointments: current law
Further rules apply where property is appointed, ie distributed in exercise of a dispositive power, from one trust to another. Assets which become comprised in one settlement and cease to be comprised in another are deemed to remain in the first settlement for the purposes of the RPR.
Where assets qualifying as excluded property are so transferred, excluded property status will be lost for RPR purposes unless the settlor of the transferee trust was non-UK domiciled and not deemed UK domiciled ‘when that settlement was made’.
This means that, currently, where an individual has settled two trusts at a time when he was neither domiciled nor deemed domiciled in the UK, assets may be appointed back and forth between the two settlements without any implications for their excluded property status, regardless of the settlor’s domicile at the time of such appointments.
FA 2020 proposed changes: s 48(3)
The proposed changes have come about as a result of a Court of Appeal case known as Barclays Wealth. HMRC have made clear that the intent of the new legislation is to ‘reverse’ the decision in Barclays Wealth, which determined (inter alia) that ‘at the time the settlement was made’ in s 48(3) means just that: when the settlement was made in accordance with the usual principles of trust law, not each time assets are added.
(The court stopped just short of deciding that an addition of non-UK situs assets by a foreign domiciled but deemed domiciled settlor, to a trust created by him before the acquisition of a deemed UK domicile, would be excluded property, as the point was not relevant on the facts of the case. The logical implication of the decision, though, was that such an addition would be excluded property in the hands of the trustees.)
If FA 2020 is enacted as currently drafted, s 48(3) will be changed so that non-UK situated property held in a settlement will be only ‘excluded property’ if the settlor was neither UK domiciled nor deemed UK domiciled ‘at the time the property became comprised in the settlement’. This will put HMRC’s long-held view of the test to determine whether property of a settlement is excluded property on a statutory footing: the settlor’s domicile must now be assessed at the time of each addition of property to the settlement.
Contrary to normal practice (and widely accepted notions of legal fairness and the rule of law), this change is to be made retrospectively; i.e. the test for whether settled property is excluded property will (from the date of Royal Assent to the Finance Bill) be deemed to have always been the test contained in the modified s 48(3), rather than the original test. As explained below, the apparent implications of this are surprising and disturbing.
FA 2020 proposed changes: trust to trust appointments
The rules regarding whether excluded property status survives trust to trust appointments for RPR purposes will also be changed, so that there are different rules for appointments taking place before and after the date on which Finance Bill is given Royal Assent.
In each case, whether the transferred assets had excluded property status prior to the making of the transfer will be determined by the revised s 48(3), as described above. (Clearly, if assets did not qualify as excluded property within the transferor trust, or are retrospectively deemed not to have so qualified by the revision to s 48(3), an appointment to another trust will not change their status.)
For trust-to-trust appointments made on or after the date of Royal Assent, the transferred assets will only be capable of being excluded property for RPR purposes if the settlor of the transferor settlement is non-UK domiciled and not deemed domiciled at the time of the transfer.
So, in contrast to the current position, in future, an appointment of assets between two settlements created by the same foreign domiciled settlor will result in the loss of excluded property status for RPR purposes, if the settlor has acquired an actual or deemed UK domicile by the time of the appointment. It is very unclear why HMRC / the Government consider it appropriate to penalise appointments between trusts in this way.
Transfers made before Royal Assent will continue to be subject to the ‘old’ rules, where the RPR is concerned. Assets of the transferor trust qualifying as excluded property under revised s 48(3) will not have lost that status for RPR purposes as a result of a (pre-FA 2020) appointment to another trust, provided that the settlor of the transferee settlement was non-UK domiciled and not deemed domiciled when that settlement was made.
As noted above, the change to s 48(3) is retrospective – in that it will change the future tax treatment of trusts by reference to events that have happened in the past, when the relevant tax rules were different. The implications of this may be far-reaching, probably going much further than appreciated by HMRC or the statutory draftsman. There seem to be four potential problem areas, namely (i) additions and loans by settlors, (ii) loans made by third parties, (iii) trust-to-trust loans and (iv) trust-to-trust appointments.
Confusingly, in one of these scenarios the change to s 48(3) may cause excluded property to lose that status for the purposes of the GWR rules (only), whereas in the other scenarios, excluded property may be deprived of that status for the purposes of both these regimes.
To add to the complexity, the analysis may differ somewhat where gifts, loans or appointments have been made to a company held by a trust, rather than to the trust itself. For brevity, we focus below on transactions where property has been received at trust level.
Settlor additions and loans
As explained above, revised s 48(3) determines whether property of a settlement qualifies as excluded property by assessing the settlor’s domicile at the time the property became comprised in the settlement. If a settlor made additions to a trust by way of gift after becoming actually or deemed domiciled, the added property will not be excluded property.
This is, of course, the intended result of the change to s 48(3), and while the retrospectivity of the change is troubling, the loss of excluded property status in the above scenario is not at all surprising.
But, on a literal reading of the revised legislation, property will also have become comprised in the settlement if the settlor has made a loan to the trustees. The loan may not have added value to the trust, but the loan proceeds will have become comprised in the settlement. There seems, therefore, to be a problem if the settlor has made such a loan after becoming actually or deemed domiciled. Unless s 48(3) is interpreted purposively, such that only additions of property that result in an increase in the value of trust property fall within it, the loan proceeds (or anything now representing them) will not have excluded property status.
This point is seemingly relevant for both GWR and RPR purposes. For the purposes of the GWR rules, the property of the settlement derived from the settlor’s loan will be treated as if it had been given to the settlement by him – so the GWR rules will apply to it.
The after-the-event change of treatment of a gift to a settlement made by a domiciled or deemed domiciled settlor is, perhaps, excusable. HMRC’s view on such gifts was known, and a settlor making such a gift was undoubtedly taking a risk that the resultant property of the settlement would not be excluded property. But the after-the-event change of treatment of loans is very hard to justify. There was no reason to think that HMRC had any issue with such loans, and the legal analysis seemed clear.
Third party loans
It is common for trustees to receive loans from unconnected third parties, for example banks. Again, applying a literal reading of s 48(3), a loan to a trust is an event causing property to become comprised in the settlement. Where a third party loan has been made to a trust, it seems that whether the loan monies (or assets derived from them) are capable of being excluded property (once the Finance Bill has received Royal Assent) depends on whether the settlor was domiciled or deemed domiciled in the UK when the loan was made.
Property of a settlement that is attributable to a third party loan is not, self-evidently, derived from a gift made by the settlor, and there is no provision of the GWR rules that deems it to be so derived. Accordingly, if third party loan monies (or assets derived from them) are non-excluded property due to the change to s 48(3), that shouldn’t in itself create tax exposure under the GWR rules.
However, it is a different story where the RPR is concerned. If a third party loan has been received at a time when the settlor was domiciled or deemed domiciled in the UK, the change to s 48(3) may result in exposure to IHT at ten-yearly intervals, or on capital distributions, under the RPR. The analysis may be complex, as it will be affected by the issue of which assets of the trust the debt should be set against (and deducted from), in calculating IHT liabilities. This issue may in turn be affected by the security arrangements, if any.
The position is similar with trust-to-trust loans. Any such loan made to a trust at a time when the settlor was domiciled or deemed domiciled in the UK will seemingly (once the Finance Bill has received Royal Assent) create scope for non-UK situs assets of the borrower trust to lose excluded property status, for the purposes of the RPR.
Trust-to-trust loans are most common between trusts with the same settlor. In such cases, the GWR analysis is not entirely clear, but there is a good argument that (assuming that the settlor is a beneficiary of both trusts) there is a reservation of benefit over the assets of the lending trust, including its receivable due from the borrowing trust, but the settlor’s reservation of benefit in respect of the assets of the borrowing trust does not extend to the loan monies or assets derived from them. In this scenario, therefore, it is arguable that the potential problem created by the modification of s 48(3) applies for the purposes of the RPR but doesn’t create IHT exposure under the GWR rules.
Lastly, the proposed modification of s 48(3) may affect the IHT treatment of assets that have been subject to trust-to-trust appointments. Here, there should not be any impact on the RPR. However, the retrospective change to s 48(3) may render assets of the transferee trust non-excluded property for the purposes of the GWR rules, if those assets were appointed (or derive from assets that were appointed) to the transferee trust at a time when its settlor was domiciled or deemed domiciled in the UK. If so, it appears that they will lose their excluded property status, creating scope for a 40% IHT charge on them when the settlor dies.
In case an example is helpful, take the case of a foreign domiciled individual who created two settlor-interested trusts, holding non-UK situs assets, shortly before he became deemed UK domiciled. Five years ago, in the interests of reducing administrative costs, the two trusts were combined, ie all the assets of one of the trusts were appointed to the other trust. No additions of property had been made to either trust after the settlor became deemed domiciled. Applying the ‘old’ rules, as the settlor was neither domiciled nor deemed domiciled when the transferee trust was made, the transfer did not prejudice the excluded property status of the assets that were appointed from one trust to another.
As explained above, where assets become comprised in one settlement and cease to be comprised in another, the transferred assets are deemed to remain in the original settlement for the purposes of the RPR. But this is a statutory fiction, that is expressly limited in scope to the part of the legislation that is concerned with the RPR. As a matter of trust law / general law, the assets have ceased to be comprised in the transferor settlement and have become comprised in the transferee settlement.
Under the revised s 48(3), the transferred assets will only be excluded property in the hands of the trustees of the transferee settlement if the settlor of that settlement was neither actually nor deemed UK domiciled at the time they become comprised in that settlement, ie at the time of the appointment. In our example, the settlor had become deemed domiciled by the time of the appointment, so the transferred assets will not be excluded property for general IHT purposes. The settlor will therefore have IHT exposure under the GWR rules in relation to the transferred assets, from the date of Royal Assent to the FA 2020.
This is an extraordinarily illogical and unfair outcome, which surely cannot have been intended.
The apparent repercussions of the proposed backdated amendment to s 48(3) can be summarised as follows:
Settlor made addition or loan when he was UK domiciled / deemed domiciled
Loan made by third party (e.g. a bank) when settlor was UK domiciled / deemed domiciled
Trust-to-trust loan made when settlor was UK domiciled / deemed domiciled
Trust-to-trust appointment made when settlor was UK domiciled / deemed domiciled
Excluded property status lost for GWR purposes?
Yes, re the added/lent property
Technically, yes, but this should not create additional IHT exposure
Technically, yes, but this should not create additional IHT exposure
Yes, re the appointed property
Excluded property status lost for RPR purposes?
Yes, re the added/lent property
Yes, re the lent property
Yes, re the lent property
As noted above, the position may differ where the addition / loan was made to an underlying company of the trust, rather than to the trust itself.
It is important to note that in any such case, the settled property that is potentially affected by this issue is the property held by the trust, on the date of potential IHT charge, which is derived from the addition, loan or appointment. In some scenarios there will be no such property, and therefore no real IHT problem. For example, this may be the case if loans have been made to the trust to meet administration expenses.
Scope for correction?
The Finance Bill is currently due for its third and final reading in the House of Commons on 1 July 2020, after which it will need to pass through the House of Lords. It is therefore conceivable (and hoped) that the draft legislation will be amended before Royal Assent, to address the issues discussed above.
However, if the Bill is enacted in its current form, this could have a significant, unexpected impact on what are currently believed to be excluded property settlements. Regrettably, it seems relatively unlikely that the relevant part of the Bill will be amended. Hansard’s record of discussion of the proposed IHT provisions in Parliament makes clear that certain professional bodies have been informally consulted on the draft provisions and have already expressed concerns about the retrospectivity of the change to s 48(3) (although Hansard does not reveal the precise nature of the comments made by these professional bodies). It is apparent that such concerns have, so far, been disregarded by the Government.
The retrospectivity of the revision to s 48(3) seems conspicuously unfair, at least insofar as it affects transactions other than gifts to a trust by the settlor after becoming domiciled or deemed domiciled, in relation to which HMRC’s attitude has been well-known for years. Where IHT exposure is created by FA 2020 by reference to previous transactions (eg with third parties and other trustees), taken in good faith on the basis of the law as it then stood, there may therefore be scope to resist the imposition of tax on the basis of legitimate expectation or breach of human rights under the European Convention.
It is also possible that HMRC may seek to address the obvious unfairness caused by FA 2020 by issuing a ‘statement of practice’ or ‘interpretation’ in relation to the amendment to s 48(3), to the effect that they will not seek to apply the provision retrospectively other than in relation to gifts made by the settlor.
There can be severe difficulties in relying on HMRC ‘statements of practice’ / ‘interpretations’ that are clearly at variance with the legislation. Often, these are ultra vires and effectively worthless. However, in light of the legitimate expectation / human rights angle noted above, a ‘statement of practice’ / ‘interpretation’ along the lines suggested above could be enforceable by affected taxpayers.
That said, it is worth noting that there have been other cases where legislative change has brought about consequences other than those intended by HMRC and, despite lobbying from professional bodies, HMRC have declined to correct the legislation or make any concession in relation to those unintended consequences.
Clearly, it would be immeasurably preferable (and the legally ‘correct’ approach) for the legislation to be amended, prior to Royal Assent, so that the change to s 48(3) is not implemented retrospectively.
As discussed above, there is some hope that the problems apparently created by the retrospective change to s 48(3) will be addressed, by Parliament, in the courts or by HMRC practice. However, there is great uncertainty about how this will pan out. Trustees need to give urgent consideration to whether there is any action they should be taking now.
Loss of excluded property status for GWR purposes - forestalling
Excluding the settlor from benefitting from the affected settlement will eliminate any GWR issue created by the modification of s 48(3). However, if the exclusion takes place after the new rules have come into effect, it will be a potentially exempt transfer (PET), subject to IHT in the event of the settlor’s death within seven years. It would therefore be preferable to exclude the settlor prior to Royal Asset, to avoid the making of a PET.
Clearly, settlors cannot be excluded from affected settlements unless those settlements have been identified. It will therefore be essential for trustees of excluded property trusts with living settlors who are actual or potential beneficiaries to consider whether any appointments of assets have been made between excluded property trusts at a time when the settlor was actually or deemed UK domiciled, and whether there have been any other transactions which could result in new or additional exposure to IHT under the GWR rules.
In such cases, urgent advice will be needed, to consider whether the settlor should be excluded prior to the Finance Bill receiving Royal Assent. This decision will not always be straightforward. There are likely to be many cases where the best advice is to 'wait and see'. There could also be others in which there is little downside to excluding the settlor, and doing so will make sense in the interests of risk mitigation.
Loss of excluded property status for RPR purposes - forestalling
In cases where the modification of s 48(3) will result in trust assets that were previously excluded property being brought into the RPR, it is hard to see what forestalling action can be taken, save for a distribution of the affected assets to one or more individual beneficiaries so that the RPR ceases to be applicable. However, this relies on it being possible to identify the affected assets, which may well be difficult in practice. Any such distribution should be IHT-free if made before the Finance Bill receives Royal Assent.
HMRC have sought to re-write history with an unabashed retrospective change to the law. Their justification is that the change to s 48(3) simply ‘clarifies’ the law, by which they of course mean their interpretation of the law, an interpretation that was never convincing and which the Court of Appeal came close to rejecting.
It is doubtful whether retrospective legislation is ever justified or fair, and the issues described above show how dangerous and unfair it can be. On the subject of retrospectivity, the statements made by the Financial Secretary to the Treasury regarding the amendment to s 48(3), in the seventh sitting discussion of the Finance Bill, were little short of breathtaking:
‘The hon. Lady asks whether this measure is retrospective. As she will be aware, we do not believe that it is retrospective. The key point is that HMRC’s application of the legislation, and therefore the legal position, was widely accepted in practice before the Court of Appeal decision put that position in doubt […]
The effect of it is going to be that individuals have been liable [sic] to the tax owed in the spirit of the legislation […]
The hon. Lady asks whether there should have been more consultation. As I outlined in my speech, the Government have had this in the public domain for a considerable period and discussed it, with plenty of occasion for people to conform their tax affairs to what is, after all, only a reaffirmation of existing tax law through legislation …’
Whether HMRC appreciate the wide-ranging effects the proposed change to s 48(3) will have on the application of the RPR and the GWR rules is extremely doubtful. Certainly, apart from gifts to settlements made by domiciled / deemed domiciled settlors, the scenarios which will apparently be caught by the change don’t appear to have been within HMRC’s crosshairs.
This is, seemingly, yet another example of tax legislation being made without due care, consideration or consultation. It is a sad fact that the fiscal legislative programme in relation to non-UK domiciliaries in the last few years has been blighted by a Laurel-and-Hardyesque carelessness and incompetence. For affected taxpayers, the joke must surely be wearing thin.