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This article was first published in the April 2009 edition of Accounting and Business magazine.
The credit crunch, global banking crisis and now recession have all had their effects on the property market, not all of them negative. The opportunity now exists to carry out inheritance tax (IHT) planning more tax efficiently than a year or two ago.
Consider the case of George, a 65-year-old widower in good health. He recognises that his estate will produce a substantial IHT liability on his eventual death and is keen to make lifetime gifts to his children.
His assets include an investment property that provides little net profit.
It cost £150,000 in 1998 and when he first considered transferring the property to his eldest daughter in 2007 it was worth £300,000. At that stage he was advised that the capital gains tax (CGT) payable on the transfer would be approximately £39,000 (£150,000 at an effective rate of 26% after taper relief) and there would be no cash proceeds to pay the tax.
The property is now valued at £200,000 and the potential CGT has fallen to £9,000 (£50,000 at the new flat rate of 18%), a significant reduction.
George also has a portfolio of quoted shares in the property sector that produce modest dividends each year. The base cost of the shares was £500,000. A year ago the shares were worth £1m, but the current valuation is very close to the original base cost. George could transfer the portfolio to his two younger children with little or no CGT to pay, with the likelihood of them receiving good capital growth over time.
This would mean that George has passed assets, which not too long ago were worth £1.3m, to the next generation for a modest CGT liability of £9,000.
George may be able to reduce that liability to nil if he can crystallise losses elsewhere totalling £50,000. He has shares in the banking sector that he wishes to retain in the long term, but they are showing sufficient losses to cover the gain on the investment property. George could sell the bank shares, but if he wishes to remain in the banking sector he should wait for at least 30 days before buying back shares in the same company.
This is to ensure he is not caught out by the bed and breakfast anti-avoidance rule in section 106A(5) of the Taxation of Chargeable Gains Act 1992. Alternatively, he can immediately buy shares in a different bank if he does not want to be out of the sector for that period of time.
George subscribed for shares costing £30,000 in a friend's new trading company a few years ago. A claim for income tax relief under the enterprise investment scheme legislation was not made. The company is now in difficulty and might not survive.
If the company goes into liquidation, this will bring about a £30,000 capital loss, which could be claimed against George's income under section 131 of the Income Tax Act 2007 - provided the company meets the various conditions set out in section 134 of the Act. In other words, the potential loss relief will be £12,000 (40% of 30,000) rather than £5,400 (18% of £30,000). It might be possible to backdate that loss claim to 2007-08 if it can be shown that the shares were of negligible value before 5 April 2009.
For IHT purposes, the gifts to the three children would potentially be exempt transfers (section 3A of the Inheritance Tax Act 1984). This means there would be no IHT to pay as long as George survived for seven years.
If George did die during that time the transfers would be added back to his estate, but at the 2009 values. If his death occurred more than three years later the taper relief, in accordance with section 131 of the Act, would result in the IHT liability being reduced.
Valuing quoted securities is straightforward, as the values for both CGT and IHT are based on Stock Exchange records. Valuing property is less straightforward.
The best advice is to obtain a formal valuation from an independent qualified valuer and follow the guidance set out in Statement of Practice SP 1/06 (issued following the case of Veltema v Langham 2004 STC 544) when completing the relevant tax return.
Gifts within normal expenditure
Section 21(1) of the Inheritance Tax Act 1984 allows a transfer of value made during a lifetime to be exempt from IHT provided it meets certain conditions:
- it was made as part of the normal expenditure of the transferor
- taking one year with another it was made out of income
- after allowing for all transfers of value forming part of the normal expenditure, the transferor was left with sufficient income to maintain their usual standard of living.
'Normal' is not defined, but HM Revenue & Customs (HMRC) has said publicly: 'There is no rule of thumb. We basically judge each case on its merits. We do look very closely at the standard of living of the transferor. The test of normality requires patterns of giving to be established.' HMRC monitors claims for exemption and form IHT 403 must be completed when sorting out the IHT position for a deceased estate.
The first gift in a series can qualify as normal, provided there is clear evidence that further gifts are intended. Income for the purposes of the exemption means net income after income tax. By definition, a one-off payment cannot be exempt, even if it was made out of income.
In a case of Bennett and Others v CIR (1995 STC 54), Judge Lightman said that a pattern of gifts is intended to remain in place for more than a nominal period and for a sufficient time, barring unforeseen circumstances.
He went on to say that the amount of the expenditure need not be fixed nor was it necessary for the individual recipient to be the same, but a pattern had to be established either by proving a prior commitment or by reference to a sequence of events.
Examples of normal expenditure include paying a regular premium on an insurance policy for the benefit of another person or making a monthly or other regular payment. This relief gives a complete exemption from IHT and can be very valuable.
The best example of how this might work is where the grandparents have a pension that is not affected by the economic downturn, with the result that their annual income exceeds their annual expenditure by around £35,000 a year.
However, their son Rupert and his wife Priscilla are finding things more difficult. This year there will be no bonus, their savings will produce pitiful amounts of interest and their investment property currently has no tenants. They now regret their decision to send their children Johnny and Daisy to private school.
The answer is simple. Rupert just needs to persuade his parents to take on the payment of the school fees, not just for one term, but also for the whole schooling period. Assuming that the fees for each child are £10,000 a year, this course of action would, over a period of seven years, remove £140,000 from the grandparents' estates that might otherwise attract IHT at 40% (£56,000).
I mentioned earlier the possibility of a negligible value claim on unquoted shares in a trading company, resulting in a loss that could be claimed for income tax purposes. Where you have quoted shares or shares in a non-trading company that are worthless, it isn't possible to claim an income tax loss, but it is possible to claim CGT relief. This claim can be backdated for up to two tax years under section 24(2) of the Taxation of Chargeable Gains Act 1992 if it is possible to show that the value was negligible at the earlier time.
Richard Mannion, national tax director, Smith & Williamson
(This briefing provides only a short overview and it is essential to seek professional advice. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this article. Details correct at time of writing.)