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PETER ERANE examines three aspects of house debt schemes.
MOST READERS WILL be familiar with the so-called 'house debt schemes'. They are designed to remove the value of a residence from an individual's estate for inheritance tax purposes. There are a variety of different schemes, but all share the same basic idea:
(1) An individual, H creates a trust in which he has an interest in possession.
PETER ERANE examines three aspects of house debt schemes.
MOST READERS WILL be familiar with the so-called 'house debt schemes'. They are designed to remove the value of a residence from an individual's estate for inheritance tax purposes. There are a variety of different schemes, but all share the same basic idea:
(1) An individual, H creates a trust in which he has an interest in possession.
(2) H sells his house to the trust ('the house trust'). The trustees do not pay the purchase price in cash, but instead promise to pay a sum of money ('the debt').
(3) H gives the debt to his children or to a separate trust for his children.
Simon McKie has provided the only detailed published analysis of the scheme in an article in the last issue of Private Client Business (2002 Issue No 6). He wisely comments 'this article examines the characteristics of a generic version of the scheme. It does not comment on any specific version marketed by any individual organisation and nothing in the article should be taken as reflecting upon the technical efficacy of any such specific strategy'. I echo the sentiment and make the same disclaimer.
On the death of H it is argued:
(1) The house is in the estate of H, but its value is (more or less) cancelled by a deduction for the debt owed by the trustees.
(2) The gifts with reservation rules do not apply to the sale to the trust.
(3) The gifts with reservation rules do not apply on the gift of the debt to the children.
Aspects of this scheme have also been discussed before in Taxation: see Taxation, 8 November 2001 at page 136. I will discuss three more aspects.
Deduction for the trustees debt
It is essential that there is a deduction for the debt owed by the trustees of the house trust. What is the statutory authority for that deduction? Section 5(3), Inheritance Tax Act 1984 authorises deductions for debts of individuals, but this does not help since the debt is not the liability of the individual. There is no other section directly in point, which has led some practitioners to say that there is no deduction available at all: see McCutcheon on Inheritance Tax, 3rd edition, paragraph 13-54B. But that would be surprising and unjust, and there is reasonable basis for making the deduction. Section 49(1), Inheritance Tax Act 1984 provides:
A person beneficially entitled to an interest in possession in settled property is treated as beneficially entitled to the property in which the interest subsists.
What is the property in which the interest of the life tenant subsists? The answer is that 'the property in which the interest subsists' is the settled property subject to the trustee's lien. Where a trustee has incurred a liability as trustee, and has not committed a breach of trust, he may of course reimburse himself out of the trust fund. The trustee has a lien over the trust fund which takes priority over any interest of a beneficiary. This is the reason that, as fairness requires, the debt is taken into account in valuing the property. The reasoning is adopted in De Feyne v Commissioners of Inland Revenue [1916] 2 Ir R 456.
Reservation of benefit on the sale
Now, the gifts with reservation of benefit rule only applies to a disposal by way of gift: see section 102A, Finance Act 1986. It may be assumed that this section does not apply on the sale to the house trust, as this is a sale for full value. Is it a sale for full value? That depends on the terms of the debt.
If the terms of the debt are to pay a sum equal to the current market value of the house, payment to be made on the death of H, then clearly the value of the debt is far below the value of the house.
If the terms of the debt are to pay a sum equal to the current market value of the house, and compound interest, payment to be made on the death of H, then the value of the debt may equal the value of the house. But still it depends. In some cases, the liability under the debt is capped to the value of the trust fund. In such cases, the value of the debt is plainly below the value of the house. In other cases, the debtor may be a company with no substantial assets to pay other than the trust fund. Once again, this devalues the debt. In cases where (1) the debt is not capped and (2) the debtor is good for the debt, the debt should have a value equal to the house. Most marketed house debt schemes do not operate in that manner, and one can see why. The original trustee of the house would have to take on a liability which no professional trustee would contemplate, for which an individual should receive independent advice before entering into the arrangement, and which the individual if independently advised would not lightly accept.
Does it matter if the sale is at an undervalue? Yes, it does. A sale at an undervalue is a disposal by way of gift: see Dymond's Capital Taxes at paragraph 5.460. (The contrary is faintly arguable, but I will not pursue that here.) If there is a disposal by way of gift, then on the death of H, section 102(3) applies:
(3) 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.
Do the italicised words help? It might be thought that the house is in the estate of H, under the house trust. But that is not so, because of the liability: see above. What is in the estate of H is the house subject to the lien. (If that is wrong, there is no deduction for the debt.)
Where the sale is at an undervalue, it would strictly follow that the entire property (without any deduction for the debt) falls back in the estate of H. Accordingly, the scheme fails. A sympathetic court may say that where the property is disposed of at an undervalue, there is only a gift of the undervalue and only the undervalue falls back in the estate of H. Whether a court would be sympathetic to a taxpayer litigating the house debt scheme, I leave to the reader to decide.
Reservation of benefit on the gift
What about the gift of the debt? One risk here (for disposals made after 8 March 1999) is section 102A, Finance Act 1986. The Revenue would argue that the debt is an interest in land. It is well established that a debt charged on land is an interest in land. The owner of the debt here has an interest in the land, if (as is probably the case) he has a direct right in equity to be repaid out of the land: see Underhill, Law Relating to Trusts & Trustees, 15th edition, pages 801-2. If that is right, then the debt will form part of the estate of H on his death.
Conclusion
No one would say that the success of any house debt scheme is certain. Since Grimm v Newman it is more important than ever that clients who enter into artificial tax-avoidance schemes are warned of the risks that they may face. This article has identified two such risks, and suggests that the house debt schemes are not all 'as safe as houses'.
