It's all gone to pot

01.01.06

It's all gone to pot

The Finance Act 2004 was passed on 22 July 2004 and with it came, arguably, one of the most radical changes to United Kingdom tax law for many years with changes centred around the introduction of what has become known as "pre owned assets tax" ("POT"). Alan Barr discusses the implications.

The provisions in the Act which introduce the new POT are some of the most complicated that the Treasury has ever sought to draft. To make matters even more challenging, these new provisions effectively serve to bolster the existing (and already complex) inheritance tax ("IHT") laws.

IHT is a tax which is payable on the assets which you own at the time of your death. Currently, IHT is levied at 40% on the amount by which your estate on death exceeds the IHT personal allowance (or "nil rate band"), currently 275,000 (subject to a number of exemptions and reliefs).

The simplest way of mitigating the effects of IHT is to ensure that the amount of your estate at the time of your death is less than the amount of the nil rate band. This will generally be achieved by gifting or disposing of assets during your lifetime. Where the total value of an asset (or assets) gifted by a person in any one year exceeds 3,000 then, and subject to a number of exemptions and reliefs, the donor will generally have to survive for seven years following the date of the gift for the gift to be effective for IHT planning purposes.

Beyond this, the donor is not permitted to reserve any kind of enjoyment or benefit in the asset gifted. If you want to give a valuable painting to your daughter to reduce the size of your estate, then it is generally the case that you will not be permitted to leave it hanging on your wall. The picture must be physically handed over to your daughter and removed from your house by her if the consequences of the IHT reservation of benefit rules are to be avoided.

For most people their house is their major asset and over the years a number of IHT planning schemes have been devised allowing a house owner to give their house to their children whilst retaining the right to continue to live in the house without falling foul of the IHT reservation of benefit rules.

Most of these schemes operated around a transformation of the bricks and mortar value of the house into a paper debt. This was normally achieved by the donor selling their house to a trust which had already been specifically created by the donor for this purpose. The donor was usually the primary beneficiary of the trust. However, instead of paying for the house in cash, the trustees would give the owner a paper "IOU" for the value of the house. The donor would then gift the IOU to their children, or to a separate trust for the benefit of the children.

The result of this was that the owner had managed, in theory, to gift the value of the house to their children whilst retaining the right to reside in the house.

This is where the new POT rears its ugly head. The Treasury was so concerned about the possible detrimental effects to its inheritance tax revenue stream that, amongst others, IOU based IHT planning schemes might have on IHT revenues that it was felt that remedial action was required. In very general terms, POT will now be payable where a person (the "Chargeable Person") falls foul of (1) a Disposal Condition, or (2) a Contribution Condition.

In the case of a house, the POT charge requires the Chargeable Person to be occupying a house which he or she has previously disposed of in order to fund his or her continuing occupation of that house this is the Disposal Condition. Alternatively the Chargeable Person must have provided the consideration for the acquisition of the house the Contribution Condition.

POT will, subject to a number of exceptions, be imposed in the form of an income tax charge calculated by reference to open market rental value. It became effective as from 6 April 2005 and, significantly, catches, retrospectively, disposals made after 17 March 1986.

The moral of all of this is that if you are contemplating making gifts or disposals for IHT planning purposes or if you have done so after 17 March 1986 you should take appropriate professional advice to ensure that you do not fall foul of either (1) the existing IHT reservation of benefit rules, or (2) the new POT.

For further information, please contact Alan Barr or Iain Sime.