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15 December 2016

The non-dom tax reforms: inheritance tax on UK residential property

The various papers released by the Government on 5 December 2016 included a further draft of inheritance tax legislation dealing with what the Government calls “overseas property with value attributable to residential property”.

This is the latest act in a complex drama that has been playing out since the Summer Budget 2015.  Although the new draft is the most comprehensive that we have seen so far, there are some significant loose ends. These will, the Government has promised, be tied up when the Finance Bill as a whole is published “next year”.  Worryingly, “next year” might mean just a matter of weeks before the legislation is actually enacted.

The lack of certainty as to how the final rules will work is frustrating and anxiety-inducing for clients and their advisers.  However, perhaps it is a good thing that the Government has acknowledged that we still do not have final form draft legislation.  A further round of revisions means that the Government still has a chance to reflect on the more controversial points in the draft legislation.

Summary of the draft proposals

The new draft provisions are a wholesale re-write of the draft legislation that was released in August 2016.  In this version, it seems that the Government is attempting to address various issues that were raised in the responses to the August 2016 consultation process.  

The Government’s intention is to create a new category of property for the purposes of the UK inheritance tax code: non-UK property which is non-excluded.  Under current law, foreign assets of a non-UK domiciled individual, or of a trust created by such an individual, are excluded property and, as such, are outside the scope of inheritance tax.  However, when the new rules come into force on 6 April 2017, certain assets that are currently excluded property (because they are non-UK situated) will fall within the new category of non-excluded property, and will be within the scope of the tax. 

Very broadly, these non-excluded assets derive their value from, or have a connection with, UK residential property.  The aim of the proposed new rules is to stop non-UK domiciled individuals benefiting from various structures and arrangements which, under current law, can be used to reduce or eliminate exposure to inheritance tax where a UK residential property has been acquired.  Government policy here is not to differentiate between a UK residential property purchased for the non-UK domiciliary’s own use and such a property purchased for commercial letting to third parties.  In either case, avenues for inheritance tax mitigation are to be blocked.

The draft legislation provides for various classes of foreign assets in the newly created category of non-excluded property: shares or other interests in closely held non-UK companies that derive their value from UK residential property; interests in non-UK partnerships that derive their value in the same way; and relevant loans.  As ever, the subject of loans is the most troubling; more on that later.

In addition, the Government has included, within the concept of non-excluded property, certain sale proceeds and loan repayments, for a two year period running from the date of the sale or repayment.  For example, the proceeds of sale of shares in a non-UK company which owns UK residential property will, according to the draft legislation, be non-excluded property for a two year period running from the date of the sale.  Similarly, if such a company makes a loan repayment, the sum received will be non-excluded property for two years from the date of the repayment.  Bizarrely, though, it appears that this “two year rule” will not apply to the proceeds of sale of directly-held UK residential property.  The “two-year rule” will seemingly also not apply when the non-excluded property has been held by a trust.

This aspect of the draft legislation is problematic in various ways.  For example:

  • Where sale proceeds / loan repayments are personally held, they will continue to be treated as non-excluded property for two years. Imagine, for example, non-UK executors dealing with the estate of a non-UK resident and non-UK domiciled person who died without any UK assets.  There is no link to the UK: it is implausible that the executors will have even heard of the new rules relating to sale proceeds, let alone know whether various non-UK assets are derived from the sale proceeds of the shares in a non-UK company that has been sold within the last two years. How is enforcement/compliance to be effective in these circumstances?
  • Where sale proceeds / loan repayments are held in trust, the draft provisions are meant to trigger an inheritance tax liability if the sale proceeds/loan repayments, or assets derived from them, are distributed out of the trust.  The draft provisions themselves, on the other hand, imply that an inheritance tax charge is triggered as soon as there is a disposal of non-excluded property within the trust.  There is a clear inconsistency between the Government’s policy here and the drafting intended to implement that policy, and we would expect the Government to have another look at these provisions.

Thankfully, the draft legislation no longer includes the difficult and unnecessary “change of use” provisions that were included in the August 2016 version of the draft legislation.  The Government seems to have listened to respondents regarding this point.

On the other hand, despite widespread objections, the Government has not only retained the targeted anti-avoidance provisions of the previous draft but also expanded them.

Loans and collateral

As noted above, the new category of non-excluded property now expressly includes “relevant loans”.  For these purposes, a relevant loan is one that has been used by a trust, partnership or individual to acquire, maintain or enhance UK residential property or any non-excluded property (i.e. a company or partnership that holds any such residential property).  This definition of relevant loans is far reaching. It means that the creditor (who will not necessarily be aware of their new status) will now hold non-excluded property and will therefore be exposed to inheritance tax.  The owner of the actual UK residential property itself (whether it is held outright or within some type of structure), on the other hand, will still be able to mitigate their exposure to inheritance tax.

A huge number of lending arrangements in connection with UK residential property will need to be reviewed before the new rules come into force on 6 April 2017. From that date onwards, there will be scope for inheritance tax for an individual if he or she dies holding a relevant loan, and for a trust if a decennial anniversary occurs whilst the trust holds a relevant loan (and, if the trust has a living settlor, perhaps also in the event of the settlor’s death).

Of even greater concern, the non-excluded property concept extends, in the new draft legislation, to “money or money’s worth held or otherwise made available as security, collateral or guarantee for a relevant loan”.  This means that where assets of any description have been made available as security, collateral or a guarantee for a loan that has been used to purchase or maintain a UK residential property (or a residential property holding structure), such assets will from 6 April 2017 be within the scope of inheritance tax.

The idea of bringing collateral for relevant loans into the inheritance tax net is, arguably, a fair one.  In the absence of a measure such as this, there would be continued scope for non-UK domiciliaries with significant foreign investment portfolios to mitigate/avoid inheritance tax by taking out a commercial loan to purchase a UK home with a 100% loan to value, so that (at least initially) there is no inheritance tax exposure with respect to the property.  The main problem with the proposal, or at least with the current drafting, is that the inheritance tax exposure on the collateral is not limited to the amount of the loan. 

It appears that if, for example, a non-UK domiciliary has pledged a £20m investment account to a bank as security for a £3m loan to purchase a £5m property, there will be inheritance tax exposure on the net value of the property (£2m) plus the entire value of the account (£20m). This is clearly overkill and could have disastrous, and very unfair, consequences for certain individuals.

What next?

Various structures and arrangements that have, up to now, provided inheritance tax protection for non-UK domiciliaries will shortly cease to have this effect.  Many corporate structures holding UK residential property are within the annual tax on enveloped dwellings (or ATED) regime that was introduced in 2013.  Shorn of their inheritance tax benefits, most of these structures will become functionless, and there will be a desire to dismantle them to avoid further ATED charges and indeed further administration costs.

The issue, though, is that these structures may be costly to unwind, as well as costly to retain.  The Government has reiterated that no relief will be available from the various taxes that may apply when structures are adjusted or unwound. These taxes may include CGT charges on latent gains and SDLT charges on debts.  Such liabilities may arise notwithstanding that the unwinding of the structure may not (and indeed, usually will not) create any liquidity to pay them.  To navigate around or minimise these tax liabilities requires expertise and careful implementation.

Care also needs to be taken to ensure that the property-ownership arrangements after the structure has been collapsed are as tax-efficient as possible.  All too often, little attention is paid to the long-standing “gift with reservation of benefit” rules.  The result can be an unexpected and deeply unwelcome 40% inheritance tax charge on the value of the property which, in many cases, could have been avoided or at least reduced with the benefit of good advice.

Individuals and fiduciaries affected by these sweeping and complicated changes should be seeking such advice now, if they have not yet done so.  Even though the Government still has various issues to work out, people will need to move quickly in order to be in a strong position by April 2017.

These articles were written by our International Private Client lawyers. For more information please get in touch with Dominic Lawrance on +44 (0)20 7427 6749 or via