Reservation-free Loan?

IAN MASTON, solicitor warns that the home loan scheme might not be without problems.

A potential technical problem with the so-called inheritance tax 'home loan plan' if structured too simplistically, was highlighted by the replies to the query 'Home loan scheme' in Readers' Forum, Taxation, 2 August 2001 at pages 456 to 457. The editorial note which followed sounded a general note of caution about such planning which this article echoes by highlighting the possibility of a more fundamental problem with the scheme.

Intention of the planning

The basic arrangements are fairly straightforward. On day 1, the donor, Mr X sells his property for full market value to an interest in possession trust (trust 1) of which he is a life tenant in exchange for a loan note. At this stage, the value of Mr X's estate has not diminished because his estate now includes the benefit of the loan note worth the value of the property and his interest in trust 1 is of nil value (value of property less burden of loan note). (It should be noted that there are technical issues beyond the scope of this article which might suggest that it is not quite as simple as this but, for the purposes of the article, let us assume that it is. See Elizabeth Wilson's article in The Personal Tax Planning Review, Volume 8, 2001 Issue 2 at page 10 for more details.) Mr X continues to live in the property as the life tenant of trust 1.

On day 2, Mr X makes a gift of the loan note to another interest in possession or accumulation and maintenance trust (trust 2) of which he is not a beneficiary. This is a potentially exempt transfer which, if survived by seven years, will fall out of account for inheritance tax purposes. Most importantly, it is argued that because Mr X retains no benefit in trust 2, there is no gift with reservation of benefit problem.

An important technical issue concerns the precise terms of the loan note. If the loan note provides for the debt to be repayable on demand, the failure of the trustees of trust 2 to demand immediate payment is a 'benefit' to Mr X by way of an 'associated operation'. Instead, to avoid this conclusion, the loan note must be drafted so that the debt is not repayable until after Mr X's death. Even if this is done, however, there might be a more fundamental 'associated operations' problem with the planning. It is the interaction of the gift with reservation of benefit provisions in Finance Act 1986, and the 'associated operations' rules set out in section 268, Inheritance Tax Act 1984 which give rise to a concern.

Associated operations

Section 268, Inheritance Tax Act 1984 states inter alia:

'(1) "associated operations" means … any two or more operations of any kind, being –

In the home loan plan which, importantly, is being marketed as a scheme, the sale of the property to trust 1 is, clearly, effected 'with a view to enabling' the gift of the loan note to trust 2 and therefore, according to section 268, the sale to trust 1 and gift to trust 2 are associated operations.

Turning then to the gift with reservation of benefit provisions in Finance Act 1986, in relation to the gift of the loan note to trust 2, the gifted property (the loan note) will be 'property subject to a reservation' if, inter alia:

'… the property is not enjoyed to the entire exclusion, or virtually to the entire exclusion, of the donor and of any benefit to him by contract or otherwise.' (section 102(1)(b)).

At first, it would appear that Mr X does not benefit from the loan note: he is not a beneficiary or potential beneficiary of trust 2 and we will assume the loan note has been drafted to be repayable after Mr X's death. But what about the earlier associated operation: the sale to trust 1? Paragraph 6 of Schedule 20 to the Finance Act 1986 states:

'6(1) In determining whether any property which is disposed of by way of gift is enjoyed to the entire, or virtually to the entire, exclusion, of the donor and of any benefit to him by contract or otherwise –

Thus, as it has already been concluded that the sale to trust 1 is associated with the gift to trust 2, the benefit (of occupation) which the donor has obtained as life tenant of trust 1 should be treated, according to paragraph (1)(c), as a benefit to him 'by contract or otherwise' in relation to the gift to trust 2. If this is the case, the loan note would be property subject to a reservation and its value included in Mr X's estate.

Counter-arguments

Does the taxpayer have any persuasive counter-arguments which might defend the scheme from such an attack? Three possible arguments can be identified but none of them seems to offer a watertight defence.

Counter-argument 1: As the benefit is already taxable in the donor's estate (under section 49(1), Inheritance Tax Act 1984), it cannot be used to 'taint' the gift to trust 2.

This argument seems to be suggested by section 102(3), Finance Act 1986 which states:

'If, immediately before the death of the donor, there is any property which, in relation to him, is property subject to a reservation then, to the extent that the property would not, apart from this section, form part of the donor's estate immediately before his death, that property shall be treated for the purposes of the 1984 Act as property to which he was beneficially entitled immediately before his death.'

Thus, if the property gifted is already taxable as part of the donor's estate, it cannot be subject to the normal reservation of benefit rules. Here, however, it is the loan note which is gifted to trust 2 and the loan note itself does not otherwise form part of the donor's estate. The fact that the 'benefit' (i.e. the donor's interest in possession in trust 1) might already be taxable in the donor's estate is not relevant to section 102(3).

There would appear to be no other statutory provision or case law implying that the reservation of benefit rules do not apply where the benefit to the donor is already taxable in his estate.

Counter-argument 2: The benefit is not obtained by virtue of the associated operation because the benefit is the right to live in the property which the donor has always had.

While it may appear that the donor has received no additional benefit from the associated operation, this is to ignore the fact that the donor's right to occupy the property as freeholder and as the beneficiary under the terms of trust 1 are legally two completely different rights and, therefore, there must be a persuasive argument for saying that at the time trust 2 is established, the benefit (being the right of occupation of the property under the terms of trust 1) has been obtained by virtue of the creation of trust 1.

Interestingly, however, the authors of McCutcheon on Inheritance Tax, third edition appear to be attracted to a similar argument in a different context. They state at page 184:

'One question that remains is what is the effect, if any, paragraph 6(1)(c) has in circumstances where a donor begins by carving out a right from property which he proposes to give away, following which he gives away the property, subject to that right. The carving out of the right will presumably be an operation associated with the later gift, but can it be said that the right is a "benefit" to the donor? The authors find it difficult to see how a person can confer a benefit on himself.'

Presumably the authors had in mind carve-out arrangements similar to those in Lady Ingram's Executors v Commissioners of Inland Revenue [1999] STC 37, and it is indeed interesting to note that the Revenue appears (from the case reports) not to have raised the paragraph 6(1)(c) point at any stage during the progress of that case to the House of Lords. The home loan plan does not, however, involve a 'carve-out' as that phrase is ordinarily understood and whereas it might be difficult to argue that one has obtained a benefit from property properly carved out of one's own property, in the home loan plan the benefit obtained comes from a separate, third party, source (trust 1). It is not therefore strictly the case that the donor has conferred a benefit on himself, at least no more so than to the extent that the donors of most gifts with reservation of benefit have conferred benefits on themselves.

Counter-argument 3: There is no gift with reservation problem notwithstanding paragraph 6(1)(c) because the benefit does not trench on the gifted property.

This argument, in its general form, can be found in Robert Venables' Inheritance Tax Planning, third edition (at B 2.3.6). It states, broadly, that a 'benefit by contract or otherwise' within section 102(1)(b), Finance Act 1986 means an enforceable benefit which trenches on the gifted property and that any benefits which are not enforceable and which do so trench will not fall within section 102(1)(b). Further, the argument continues, even where section 6(1)(c) applies to deem the benefit from an associated operation to be 'a benefit to the donor by contract or otherwise' that section will have no effect unless the benefit is also enforceable and trenches on the donee's gift.

Applying this logic to the home loan plan, one comes to a position where it is conceded that paragraph 6(1)(c) applies, but where one argues that because the benefit of occupation (under trust 1) does not trench upon the gifted loan note (in trust 2), no reservation of benefit issue arises.

This is certainly an interesting argument; however, in its general form it appears to be supported by few other commentators. See, for example, Foster's Inheritance Tax at C4.15 and McCutcheon on Inheritance Tax at 6-53 and 6-54; and Dymond, likewise, states:

5.421 'Under paragraph 6(1)(c) of Schedule 20 to the Finance Act 1986, a benefit which the donor obtained by virtue of any associated operations … must be treated as a benefit by contract or otherwise. This is considered to apply whether the benefit was enforceable or not. [and]

5.422 'Although the side-note to section 102, Finance Act 1986 reads 'Gifts with Reservation', it is not a condition of liability under section 102(1)(b) that the benefit shall have been reserved out of the gifted property.'

The overwhelming problem with this argument is that it is counter-intuitive. If the argument is correct, paragraph 6(1)(c) appears to miss its mark and it becomes difficult to envisage any circumstances where it would create gift with reservation of benefit problems which were not already there. A court taking a robust view might not accept a statutory interpretation which makes paragraph 6(1)(c) otiose.

Litigious future

Whether any of the three counter-arguments is correct is likely, ultimately, to be determined by future litigation. However, those advising on the home loan plan should be aware that the scheme relies for its effectiveness on a limited and counter-intuitive interpretation of paragraph 6(1)(c) which may not be shared by a court.

Ian Maston is a senior tax consultant in the estate planning department at WJB Chiltern in Regent Street. He can be contacted by e-mail at mastoni@wjbchiltern.com.

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