The use of ‘nil rate band’ trusts for the legal avoidance of Inheritance Tax (IHT) is quite common, but a recent court case, which has attracted a great deal of attention, has pointed out a possible pitfall in such arrangements.
IHT nil rate band trusts are used to avoid IHT on a couple’s estate by passing an amount equivalent to the IHT nil rate band (£300,000 for the year 2007/2008) into a trust on the death of a spouse or civil partner, so that on the second death that sum is no longer part of the estate.
The case in point involved a transfer of a share in a property jointly owned by a husband and wife. When the wife died, her half share in their home was transferred into a trust, which transferred it back to the husband in exchange for his IOU.
The intended effect of the arrangement was that his estate would be reduced for IHT purposes by the extent of his debt due to the trust and that any further increase in the value of the property would be wholly exempt from Capital Gains Tax (CGT) because of the ‘principal private residence’ exemption. Had the trust retained ownership of a share in the house, the increase in the value of the trust’s share would be subject to CGT.
When the husband died, the sum due under his IOU (£153,222.99) was claimed as a deduction from his estate, but HM Revenue and Customs (HMRC) argued that the sum was not deductible. Their reasoning was based on a section of the Finance Act 1986 (S103) which provides that a liability is not deductible if the consideration for the debt consists of property which ‘derived from the deceased’. In this case, the wife had never worked so, in HMRC’s view, the whole of the value of the house was derived from the husband’s estate. The Special Commissioners of Tax upheld the decision.
However, this case need not cause undue alarm, since nowadays it is usual for both spouses or civil partners to work (at least at the beginning of the relationship) and in such circumstances HMRC’s argument would be difficult to sustain. Secondly, had the husband predeceased his wife, or the transfer been dealt with by the creation of a formal charge over the property, the problem would not have arisen. Thirdly, alternative arrangements can be made which circumvent the problem.