KPMG’s Justine Howard considers the extension to the IHT rules for UK residential property.
On 19 August 2016, the UK Government published another consultation document drip-feeding us a few more details about the proposed new rules that will fundamentally change the inheritance tax (IHT) treatment of UK residential property held via foreign companies.
At present, it is relatively easy for a non-UK domiciled individual (non-dom) to shelter UK residential property from IHT. As non-doms are only charged IHT on UK assets, if UK property is held through say an Isle of Man company (IOMCo), then the asset owned for IHT purposes is the shares in IOMCo and not the underlying UK property.
From 6 April 2017 this will no longer be the case. The value of the shares in the foreign company will be chargeable to IHT to the extent that their value is “derived (directly or indirectly) from UK residential property” (meaning a “dwelling”). The new rules apply only to UK residential property held via a foreign close company, ie a company controlled by five or fewer participators or by its directors.
In simple terms, if IOMCo holds a UK property worth £1m and other assets worth £2m, the value of the shares attributable to the UK property would be £1m and it is this amount that would be brought within the scope of IHT under the new rules after taking into account any allowable debt, eg a third party mortgage taken out by IOMCo to purchase the property.
What is not clear is whether a loan taken out to purchase the shares in IOMCo would also be deductible in these circumstances and, generally, how debts must be secured (if at all) in order for relief to be available. It is understood that loans between connected parties will be specifically disregarded but how this will work in practice also remains to be seen.
The definition of a dwelling for these purposes will be modelled closely on the Non-Resident CGT (NRCGT) definition which came into effect on 6 April 2015 and will therefore apply to dwellings under construction off-plan as well as existing properties. There will be no exemptions for properties occupied as a main residence, or for properties used in a rental business.
In addition, property that has been a dwelling at any time in the two years prior to the chargeable event in question will also be caught. This poses a problem for purchasers of foreign companies holding UK commercial property who may find themselves within the charge to IHT if the property was, say, converted from a dwelling within the two years prior to the purchase of the shares in the foreign company.
When the Government first announced the proposed IHT changes to UK residential property back in July 2015, they hinted that there may be some form of “de-enveloping” relief from other tax charges, such as Stamp Duty Land Tax (SDLT) and NRCGT, for those wishing to unwind structures falling within the new IHT charge. However, it seems clear now that this is not going to happen and so those who adopted a “wait and see” approach may want to start reviewing their position and considering any restructuring opportunities available to them.
The consultation document remains silent as to how the new rules will work in conjunction with the small number of Capital Taxes Treaties, eg those the UK has with India and Pakistan. These treaties specifically exempt any charge to IHT arising on death in certain circumstances, with the taxing rights retained by the country of domicile. We have not seen anything yet to suggest that these treaties will be renegotiated and can only hope this will be dealt with in the draft legislation expected at the end of this year.
HMRC have indicated that a Targeted Anti-Avoidance Rule (TAAR) may be introduced which, at first glance, seems unnecessary given the existence of other weapons HMRC have at their disposal such as the General Anti Abuse Rule (GAAR). However, the proposed TAAR does seem quite narrow in scope and refers primarily to arrangements put in place to convert residential property to “excluded” property.
One might then ask whether there is now any benefit to holding UK residential property in a foreign company and the answer is: it depends! Foreign companies may still benefit from lower rates of income tax on UK rental income whilst also avoiding the Annual Tax on Enveloped Dwellings (ATED) if the appropriate ATED relief is being claimed.
But it is probably safe to say that if the property is going to be personally occupied by the beneficial owner and/or his/her family, there may be some merit in holding the property directly, now there are no capital gains tax or inheritance tax benefits of holding the property in a foreign company. Whether an existing structure should be “de-enveloped” may depend on whether it can be done in such a way as to avoid immediate SDLT and CGT charges.
There is also still planning to be done going forward. For example, a residential property purchase can be funded with qualifying debt so as to reduce its net value for IHT purposes, insurance can be taken out to cover any potential IHT liability that may arise and the ownership of a property may be spread between family members in order benefit from several nil rate bands in the event of death.
Finally, it’s worth remembering that the new IHT rules only apply to UK residential property. Non-doms can still benefit from holding other non-UK assets and UK commercial property in a foreign company so perhaps all is not lost - yet!