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Deductibility of loans

New anti-avoidance provisions were announced in the Budget which introduce certain conditions that must be met in order for a liability to be deductible from the value of a person's estate for inheritance tax (IHT) purposes.

There is a general consensus in the tax planning world that for non-UK domiciled individuals and wealthy UK domiciled individuals, it should be possible to plan so that no inheritance tax is paid on death.

However, in recent years there has been a concerted attack by the UK tax authorities on IHT planning including the introduction of pre-owned assets tax, the change to the rules concerning the taxation of trusts and the recent introduction of the tax on high value properties owned through companies.

The new provisions set out below are targeted against key areas of IHT planning which were long considered to be safe. They will affect owners of business and agricultural property and non-UK domiciliaries alike. The result is that individuals or trustees using debt as a way of IHT planning will need to review arrangements which have been put in place.

Discharge of liabilities after death

New provisions will come into force in relation to the deductibility of debts that are undischarged at the date of death from the overall value of an individual's estate.

The following rules apply from 6 April 2013:

  • Debts that would be allowed as a deduction from the value of an estate can only be used to reduce that value if they are repaid after death from estate funds.
  • Debts that are not going to be repaid from estate funds after death can only be used to reduce the value of the estate if there is a commercial reason for not repaying the liability, and the debt is not left unpaid as part of an arrangement to gain a tax advantage. By way of example, a commercial mortgage secured over a house should not therefore be caught under these rules and should still be deductible.

Liabilities used to finance Business or Agricultural Property

Under the new law, there will be a limit as to the extent to which debt used to finance the acquisition, maintenance or enhancement of relevant business or agricultural property can be used to reduce the IHT value of an individual's estate, or the value of property in a trust.

The restriction works by reducing the value of business or agricultural property that has been financed by debt, before working out the value of that property which will be subject to a reduction under the relevant relief.

The practical result of this is that the debt cannot reduce the IHT charge on the asset any further than it would in any case have been reduced by the relevant relief. Any liability over the value of the asset qualifying for relief will be allowable as a deduction against the estate, subject to the new rules above on unpaid debts. Liabilities incurred before 6 April 2013 are not caught.

This is intended to catch new arrangements whereby, for example, borrowing is secured on non-qualifying assets such as an investment portfolio, and is used to purchase shares in a company qualifying for business property relief.

Liabilities used to finance excluded property

The new rules also provide that it will no longer be possible to obtain a deduction for borrowing where the borrowing has been incurred to acquire so-called 'excluded property', i.e. property which is excluded from UK inheritance tax.

By way of example, a non-UK domiciled taxpayer purchases a property in London outright and then secures borrowing against the property. He then invests the borrowed funds in French bonds. The individual then dies. As the taxpayer is non-UK domiciled, the bonds are excluded property and therefore not subject to UK inheritance tax on his death. Currently, the borrowing could also be deducted from the value of the property, thereby reducing it for UK inheritance tax purposes. However, under the new rules, the borrowing would not be deductible and the full value of the property would therefore be subject to UK inheritance tax.

These rules could have wide-reaching implications. In the past so-called 'double trust' structures were set up to generate a deduction for trusts holding UK situs assets. These structures will certainly need to be reviewed in light of the new rules.

Furthermore, one consequence of the new property rules introduced in the 2013 Budget has been to cause properties owned in trust-company structures to be transferred from the company and put into the direct ownership of the trustees. As the trustees then hold a UK situs asset directly, they are subject to ten-yearly charges on the value of that property. Normally, consideration would be given to introducing borrowing into the structure prior to the ten-year anniversary to reduce the value of the property for the purposes of the inheritance tax charge. Great care would now need to be taken to ensure that such planning does not fall foul of the new rules and this will mean that direct ownership of UK property by offshore trustees will potentially become less attractive.

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at August 2013. Specific advice should be sought for specific cases; we cannot be held responsible for any action (or decision not to take action) made in reliance upon the content of this publication.

TLT LLP is a limited liability partnership registered in England & Wales number OC 308658 whose registered office is at One Redcliff Street, Bristol BS1 6TP England. A list of members (all of whom are solicitors or lawyers) can be inspected by visiting the People section of this website. TLT LLP is authorised and regulated by the Solicitors Regulation Authority under number 406297.

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