Non-domiciled individuals and trusts owning UK residential property
With effect from 6 April 2017 an inheritance tax charge (IHT) will be imposed on UK residential property held through offshore structures. The relevant legislation is included in the Autumn Finance Bill which is expected to be enacted later this year. The legislation affects existing arrangements and not just new situations coming into existence as the new rules will apply to any taxable event which occurs after 5 April 2017.
The new rules will affect all non-UK domiciliaries and the trustees of trusts they have established who hold an interest in an offshore structure which derives its value from UK residential property. It will also catch loans used to acquire, maintain or improve UK residential property, collateral for such loans and those who made or provided collateral for such loans.
Which assets are caught?
While personally owned UK property has always been exposed to IHT the new legislation imposes an IHT charge on three further types of property:
- Interests (e.g. loans or shares) in closely held companies which directly or indirectly derive their value from UK residential property. An interest in a top company will caught even if the residential property is owned by a company lower down in the group.
- An interest in a partnership, the value of which is directly or indirectly attributable to UK residential property.
- The benefit of loans made to enable an individual, trustees or a partnership to acquire, maintain or improve a UK residential property or to invest in a close company or a partnership which uses the money to acquire, maintain or improve UK residential property. To avoid back-to-back lending arrangements, assets used as collateral for any such loan will also be subject to IHT under the new legislation. An interest in a close company or in a partnership which holds the benefit of the debt or the assets which are used as collateral are also caught.
A worrying aspect of the new legislation is the breadth of the rules relating to loans and collateral. In some circumstances this could lead to double taxation. For example, in the situation where a settlor interested offshore trust has made a loan to the settlor (X) to enable him to acquire UK residential property it is likely that the debt will not be deductible from the value of the property for IHT purposes as there are anti-avoidance provisions which deny a deduction for a loan which is made out of assets previously given away by the taxpayer. However, the benefit of the debt held by the trust will also be subject to IHT on X’s death as it will be regarded as forming part of his estate under the reservation of benefit rules since he is a beneficiary of the trust. The trustees will also be subject to ten year inheritance tax charges on the value of the debt.
Another aspect of the legislation is that where property which would otherwise be caught under the new legislation has been disposed of, or a loan which would be caught has been repaid, the proceeds of sale/repayment remain within the scope of IHT for two years. This means, for example, that if trustees own a company which holds a UK property and the shares of that company are sold less than two years before a ten year charge, there will still be a liability to inheritance tax at the date of the ten year charge, even though no UK residential property is owned at that time.
Where an interest in land held offshore contains a residential dwelling and land used for other purposes the value of the dwelling is included on a just and reasonable basis.
When will the new rules apply?
All the usual events on which IHT could be chargeable will be affected by the new rules. These include:
- The death of the individual who holds the property or who is a settlor and beneficiary of a trust which holds the property or who has a pre-2006 right to the income from a trust which holds the property.
- Lifetime gifts of any property which is subject to the new rules.
- Ten year charges and exit charges for trusts which hold such property.
The tax charge will apply to any IHT events which occur after 5 April 2017. However, if an individual has made a gift of property which is within the new rules before 6 April 2017 and dies after 5 April 2017 but within seven years of having made the gift, this will not give rise to a tax charge as the question as to whether the gift was of excluded property for IHT purposes is tested at the time the gift was made not at the date of death.
The valuation is applied to the property itself, i.e., the shareholding or partnership interest, and appropriate valuation techniques will need to be applied.
Where an offshore entity has borrowings, the debts will be deducted rateably from each of the assets owned by the company. Therefore, if a company has borrowed to acquire property other than UK residential property part of the debt will be deductible from the UK residential property in determining the value on which inheritance tax will be charged.
However, if a company has borrowed to acquire UK residential property but also owns other assets only part of the debt will be deductible from the UK residential property.
Will there be protection from a double tax treaty?
The UK has a limited number of IHT double tax treaties (11 in total). In some circumstances, exclusive taxing rights in relation to the sort of property caught by the new rules (for example, shares in a company) would be allocated to the other country under the terms of the relevant treaty.
The legislation includes provisions which override these treaties unless the other country charges inheritance tax or a similar tax and there is actually some tax to pay (however small) in that country. So, for example, if an individual is domiciled in India (where there is no inheritance tax), the treaty will not assist.
On the other hand, if the individual is domiciled in Geneva but paying tax under the forfait (Swiss Tax) system, there is a 6% charge to inheritance tax on assets passing to a spouse or descendants. It is therefore likely that, as a result of the treaty, there would be no UK IHT to pay.
There is a very widely drawn targeted anti-avoidance rule in the legislation which effectively ignores any arrangements intended to side step the new rules.
Who will be liable for the tax?
The individual or the trustees owning the property will be liable for the tax. Any IHT due will be charged on the underlying UK residential property.
What should you be doing?
You should review any offshore structure which owns UK residential property to see whether it will be caught by the new rules and, if so, when any IHT charges are likely to arise.
It will also be necessary to review whether you have any offshore structures which have made loans or provided security for loans which have been used in relation to UK residential property or whether you, as an individual, have made any such loans or provided any such collateral.
Where a property owning structure is caught by the new rules, it will no longer provide any IHT benefits. In cases where the annual tax on enveloped dwellings (ATED) is payable, there could be a strong case for dismantling the structure although this may incur a tax liability. There may be capital gains tax to pay on any increase in value since the property came within the ATED regime as well as possible UK capital gains tax on gains relating to earlier periods if the owner is UK resident. There could also be a stamp duty land tax liability unless careful structuring is undertaken if there are loans secured on the property.
Where properties are held through offshore structures which are not within the ATED regime, it is possible that there is no disadvantage in retaining the existing structure. There may, in fact, be some benefits as the rate of capital gains tax for offshore companies is currently lower than for individuals and funding the company with debt can reduce UK tax on the rental income.
Loans and collateral will need special attention given the scope for double tax charges.
In some situations it may be worth exploring whether connected party debt can be replaced with bank debt. Where a loan is secured on offshore assets either as well as or instead of the property itself, the feasibility of securing the loan on the property alone should be discussed with the lender or with alternative lenders.
A sale of the UK residential property itself is not caught by the two year rule and, therefore, if the proceeds are retained in the structure there will be no tax charge even if an inheritance tax event occurs within the following two years.
How can I protect myself against inheritance tax on UK residential property going forward?
The new legislation is widely drawn and, in the future, it will be difficult for non-domiciled individuals to avoid paying UK inheritance tax on UK residential property. There are, however, a number of relatively straightforward ways in which any tax liability can be mitigated:
- By making lifetime gifts to the next generation – but only if the parents do not live in the property or pay a market rent after the gift and survive seven years.
- For a married couple, using the spouse exemption on the first death, possibly coupled with a subsequent gift to the next generation with the benefit of the tax free uplift on death.
- Life insurance is a possibility. It should be relatively inexpensive in the early years but will become quite expensive once the owner gets older and so may not be a long-term solution. It is, however, a good solution for younger non-domiciliaries who may in due course leave the UK and then sell the property.
- A loan secured on the property used to purchase or improve the property. Any growth in value will still be subject to inheritance tax.