Ordinary houses, big IHT bills: Revenue gets tough

Inheritance tax reforms will make it harder to shield assets, says Simon Hildrey

Thousands of people will be denied the chance to minimise the inheritance tax (IHT) bill on their homes by the Inland Revenue's closure of a number of loopholes. To make matters worse, existing schemes could be affected as the Revenue wants to impose income tax retrospectively.

IHT is a growing problem for homeowners in the UK because it is charged at 40 per cent on estates in excess of £255,000. Given that the average house price in London is now £244,600, many beneficiaries have to pay the tax since a person owning a home of this value needs to have just £10,400 in savings for their estate to be caught in the IHT net.

IHT is lucrative for the Government: it is estimated that the amount collected by the Revenue has doubled over the past 10 years to £2.4bn. The number of people paying IHT has gone up by 55 per cent since 1998.

The Revenue's attempts to stop parents minimising the IHT their children will pay after their deaths are being introduced in several stages, starting in June 2003 with the closing of the loophole known as the Eversden scheme. This had allowed people to protect their homes and other assets from death duties while still enjoying the benefits of them.

And since last December, capital gains tax (CGT) holdover relief has no longer been available for gifts to so-called "settlor interested trusts". A settlor is the person who sets up a trust, and the trust is regarded as settlor interested if the settlor or his or her spouse benefits from assets held in it.

This change will hit a range of tax planning schemes relying on gifts to trusts under which settlors or their spouses can continue to enjoy the use of an asset such as a house. From now on, they will not be able to use holdover relief to avoid paying CGT when the home is taken out of their estate and put into a trust.

Settlors can avoid CGT if the property is their main home, since they are allowed to claim principal private residence relief (PPR). But the Revenue made another change from 10 December so that CGT cannot be avoided both when the house is placed in a trust and when it is subsequently sold. A settlor can either claim PPR to avoid CGT when the house is put into the trust, or pay the tax up front so that beneficiaries don't have to pay it later on.

The second stage of the Revenue's attack comes in its proposed income tax charge. The consultation period ended earlier this month.

Under current IHT anti-avoidance rules, which date from 1986 and concern what are known as "gifts with reservation", you cannot make a gift for IHT purposes unless you no longer benefit from what has been given away. If it is your home, you should either move out or pay a market rent to continue to occupy the property. In the case of rented property, you can no longer receive the income.

The Revenue proposes to block IHT schemes that get round the "gifts with reservation" rules by imposing an annual income tax on assets such as a house that you have put in trust, unless you are paying a market rent.

Robert Ham of the Society of Trust and Estate Practitioners says that the Revenue plans to levy income tax on the deemed benefit in kind of the home from April 2005. For example, if your house is worth £500,000 and has an annual rental value of £25,000, you will either have to pay the trust the full market rent or pay tax on the benefit - equal to £10,000 a year for a higher-rate taxpayer. In effect, although you are not renting out the property, you are being taxed on the income you would have received had you done so.

This proposal has been criticised by tax advisers because it is retrospective and will apply to existing IHT schemes.

"Thousands of homeowners have placed their properties in trust to pass their estate intact to their families," says Mr Ham.

The Revenue has suggested that settlors will be able to dismantle schemes to avoid paying retrospective income tax, but this presents problems. The home has been given to a trust and no longer belongs to the settlor. The trustees have a duty to act in the interests of beneficiaries, which is unlikely to involve handing the house back to the settlor.

Tax advisers argue these rule changes mean there is little if anything you can now do to reduce the IHT bill on your home. If you have IHT planning in place, Chris Shepard, senior trust manager at Smith & Williamson, the professional and financial services group, recommends you sit tight and wait for the outcome of the current consultation process on pre-owned assets.

Paul Knox, director of Ernst & Young Private Client Services, says the rule changes underline the need to be cautious about the use of your home in tax planning. "We generally take the view that the family home is the last thing you involve in tax planning. For most people, it's their most important asset, and there must be a doubt whether they should give it away to a trust."

Margaret Jago, specialist tax manager at Scottish Equitable, warns that the consultation paper on taxing pre-owned assets could have far-reaching effects. "This could catch schemes beyond home loans," she says. "The consultation paper talks about capital assets, but this could mean anything."

Indeed, trusts have already been attacked with an increase in the income and capital gains tax they will pay from 6 April 2004. This will be raised from 34 to 40 per cent and the corresponding dividend trust rate from 25 to 32.5 per cent, reducing the amount of income that can be distributed to beneficiaries.