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  • Katherine Bullock

Practical Magic – Estate Planning – Debts and IHT

Since debt is not usually the source of good news, it may be a pleasant surprise to discover that as a general rule, for Inheritance Tax (IHT) purposes the value of assets chargeable to tax may be reduced by outstanding liabilities. This is the case for lifetime transfers, transfer on death and where charges arise in trust. There are, however, a few things to keep in mind when considering your specific debt and sometimes determining whether a particular debt is deductible can be very difficult indeed.

"...determining whether a particular debt is deductible can be very difficult indeed..."

Before 17th July 2013, debts were regularly used to reduce IHT with varying levels of complexity and artificiality. For example, a person might borrow against an asset subject to IHT (such as their house) – thus reducing the value of that asset – and buy an asset with the borrowings that were not subject to IHT (such as AIM-listed shares). From 17th July 2013, anti-avoidance legislation was introduced that restricted the deduction of debt used to finance certain assets and on debts that were not repaid by the estate on death. These rules are complex and require careful consideration.

However, it is easy to overlook the other considerations that continue to apply whether or not these restrictions are relevant and which should not be skipped over in the rush to get to the anti-avoidance rules regarding loans to finance certain agricultural or business property, excluded property or certain foreign currency bank accounts.

To begin with, there are a number of basic requirements which might affect whether or not a debt is deductible, some obvious and some less so. For example, it is the person liable for the debt who is entitled to the deduction and the liability must either be imposed by law or incurred for consideration in money or money’s worth. So if the liability exceeds the consideration given – for example £5,000 owed for the purchase of a necklace worth £2,000, a deduction is only available up to the amount of the consideration, that is £2,000. Debts incurred voluntarily for no consideration (such as a promise to donate) are not deductible. The loan must be legally enforceable; there is no deduction for loans which the lender had no authority to make (or most gaming debts for that matter). Deductions cannot be made for loans which are repayable by somebody else. The value of the debt for the purposes of deduction is decided at the relevant time, usually the point of death, rather than at the theoretical time at which it would have otherwise been repaid.

At the other end of the scale, it is important not to overlook the GAAR. The General Anti-Abuse Rule ensures that abusive arrangements that might otherwise confer a tax advantage are disallowed – a catch-all to avoid egregious abuse of the system. The taxpayer can reasonably expect that the ‘double reasonableness’ requirement of the GAAR will avoid its application in most circumstances where a debt meets the conditions for deductibility. Nevertheless, the GAAR should not be overlooked where liabilities are created with an IHT saving in mind. For example: a trust takes out a loan against a property shortly before its ten-year anniversary IHT charge was due. The funds are paid out to the trust on the understanding that they will be returned. This debt then offsets the IHT charge. The trust then repays the debt shortly afterwards. With no reason for the loan other than to avoid the IHT charge, HMRC consider that the GAAR would activate. The other major instance in which the GAAR would activate would be a situation where the borrower seeks to borrow what is effectively his own money in order to obtain an IHT deduction. Whether the GAAR applies or not, the long reach of WT Ramsay v IRC [1981] STC 174 may still apply to negate the tax advantages of artificial arrangements, specifically artificial debts incurred as part of an overarching tax avoidance scheme. If in doubt, avoid any proposed debt with no commercial purpose other than being a step to reduce or eliminate IHT.

In addition, from 17th July 2013 a deduction is normally allowed only to the extent that a liability is discharged on or after death out of the estate of the deceased or excluded property that the deceased owned before death. Waiving the debt will not discharge it for these purposes. However, some debts that are not paid off on or immediately after the borrower’s death can still be deductible for IHT purposes. Broadly there must be a real commercial reason for the debt not being discharged on death, and one of the main purposes must not be the securing of a tax advantage. ‘Real commercial reason’ here means either that the liability is to a person dealing at arm’s length or, if it were to such a person, that person would not require the discharge of the debt. It is not clear from the legislation if this list is intended to be exhaustive or other commercial reasons might suffice. Whilst, therefore, a loan from a person dealing at arm’s length is sufficient to meet the real commercial reason test regardless of the terms of the loan or the reasons for any waiver, the tax advantage condition still needs to be met. The deduction of the ongoing debt to a continuing and viable business with lending or overdraft facilities or a house being transferred with an ongoing mortgage may therefore depend on who is the lender.

In short, whether ultimately the taxpayer borrows from family or bank, giving thought to the structure in advance should ensure that significant, and often assumed, IHT advantages in the future are realised.


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