THE MEANING OF RESERVATION OF A BENEFIT

If a taxpayer makes a gift but ‘reserves a benefit’ to himself from the gift, the asset given is still considered to form part of his estate as long as he benefits or is entitled to benefit from it. A person is considered to reserve a benefit from an asset if he continues to have the use of it or to benefit from it in any way after it has been given, without making monetary payment for the use or benefit at a full commercial rate.

Moreover, a gift is not considered to have been completely made until the donee takes possession of the subject matter of the gift. By way of example, if someone tells his friend that he gives the friend a picture or antique table and the picture or table is not taken away and remains in the donor’s house, as long as the picture continues to hang on the donor’s house wall or the table is not taken away, then the donor is considered to reserve a benefit from the gifts, both because the donor continues to have the use of them and because the donee has not taken possession of them to the virtual exclusion of the donor. If a person is considered to reserve a benefit because possession or enjoyment of the subject of the gift is not assumed by the donee at least seven years before the death of the donor, or if at any time within that period the property given is ‘not enjoyed to the entire exclusion or virtually to the entire exclusion of the donor,’ the subject matter of the gift given will form part of the donor’s estate.

In effect the donor is considered to reserve a benefit if he keeps back any significant benefit from the property given away (unless he pays a commercial rent or hire charge for the benefit) and he will gain no tax benefit in respect of the gift because it will be counted as still owned by him and part of the value of his estate. If the benefit ceases at a date after the gift was first made, it ceases to be a gift with a reservation from the date the benefit is lost and, of course, a transaction in which a donor taxpayer paid a commercial rent or hiring charge for the benefit for a time and then stopped will become a gift with a reservation from the time the payments ceased.

The Revenue takes a strict view of what constitutes reservation of a benefit and has said that it considers there is a reservation of a benefit in any case where the benefit is ‘significant’ in relation to the value of the property given. By way of example the Revenue has stated that in the case of a gift of a house it does not consider that:

• visits to a house for domestic reasons, for example baby-sitting by the donor for the donee’s children, or
• staying in the house in the absence of the donee, for not more than two weeks each year, or
• staying in the property with the donee for less than one month each year, or
• staying temporarily while the donor convalesces after medical treatment, or while the donor looks after a donee convalescing after medical treatment or while the donor’s own home is being redecorated,

would cause the value of the gift to be included in the donor’s estate, but staying in the house most weekends or if a property which had been given is used by both the donor and the donee as a holiday or second home on an occassional basis would.

A taxpayer cannot have his cake and eat it. To be a tax-effective gift what is given must go almost in its entirety and no real benefit can be retained, even by a behind-the-scenes arrangement.

It is wise to avoid making a reservation from a gift because not only is the subject of the gift considered to remain in the estate of the giver but it is also considered to be in the estate of the recipient for inheritance tax purposes.

THE PRE-OWNED ASSETS INCOME TAX CHARGE

Various complicated schemes (usually based upon the use of trusts) have been marketed to avoid the inheritance tax liability resulting from the gifts with a reservation of an interest rules. As with any artificial arrangements which are solely for the purpose of saving of tax, a taxpayer should think carefully before entering into them because they have a habit of rebounding upon him. In his budget of March 2004 the Chancellor of the Exchequer outlined proposals for a ‘free standing income tax charge’ based on ‘pre-owned assets’ to counteract such schemes and ‘the benefit people get from having free or low cost enjoyment of assets they formerly owned or provided funds to purchase’. If a scheme succeeds in avoiding the liability for inheritance tax that results from the reservation of a benefit rules, liability to income tax is likely to be incurred under the pre-owned assets charge.

The nature of the charge

The pre-owned assets tax charge is similar to the income tax charge made upon employees for benefits in kind supplied by their employers and quantifies in cash the annual benefit enjoyed. A financial sum is attributed to the benefit and that sum is added to the taxpayer’s income for calculating his income tax, but if the cash value of the benefit is less than £5,000 it is disregarded.

The proposals were enacted into law by Schedule 15 of the Finance Act 2004 and apply from 6 April 2005 and to all gifts made after 17 March 1986.

What incurs the charge

The charge applies to both tangible and intangible assets. It also applies to any funds or contributions to the funds used to acquire the assets from which the donor benefits and whether the funds or contributions are directly or indirectly provided. It applies therefore to assets which have been given, to assets which have been acquired by cash which has been given and to any assets which have been acquired by the use of money raised by using assets which have been given, e.g. by selling or mortgaging them.

In the case of those who are or are deemed to be domiciled in United Kingdom, the charge applies to their assets anywhere in the world and in the case of others only to their assets in the United Kingdom.

Calculating the charge

The amount of the income tax charge is a sum equivalent to the annual rental value of the asset in the case of land or buildings and in the case of other assets to a rate of interest on a notional loan of a sum equal to the market value of the asset, and in each case less any payment made under a legally binding agreement for the use of the asset. After the deduction of the amount paid for the benefit, the sum so ascertained is added to the taxpayer’s taxable income and taxed at his top rate of tax. The first £5,000 per annum is ignored but once the £5,000 exemption is exceeded, the exemption is totally lost.

The market value is that which exists at the date the benefit starts and must be revised periodically. The current rate of interest is set out in the Charge to income tax by Reference to Enjoyment of Property previously owned Regulations 2005 (Statutory Instrument Number 724).

Exceptions from the charge

The income tax charge does not apply if:

• the asset ceased to be owned before 18 March 1986
• the formerly owned asset is currently owned by the taxpayer’s civil partner or spouse (their domiciles are irrelevant for this exception)
• the asset was transferred to a spouse, former spouse, civil partner or former civil partner by court order
• the entire asset was sold for its cash value in a transaction on arm’s length terms whether or not the parties were connected persons
• the owner of the asset was formerly the owner of the asset only by virtue of a will or intestacy which has subsequently been varied by agreement between the parties, i.e. by a Deed of Family Arrangement, as explained in Chapter 8
• the asset is land or buildings which have been given and the donor and the person to whom it is given share the occupation of the land and either the donor pays all the running costs and capital expenses relating to the occupation of the property or an amount at least proportionate to his share of the ownership and use of the property so that he cannot be said to be retaining any benefit from the arrangement
• the gift does not take the asset out of the donor’s taxable estate for inheritance tax purposes, e.g. a gift to a company in which the donor owns all the shares or the asset still counts as an asset of the donor for inheritance tax purposes under the gift with a reservation rules
• any benefit is no more than incidental, including cases where an out-and-out gift to a family member comes to benefit the giver as a result of a change in their circumstances, for example, a case where a parent gives a house to a child and several years later, because of ill health, needs to move into the house to live with the child so that the child can care for the parent
• the gift is an outright gift of money used to acquire land or another asset made seven years or more before the earliest date upon which the donor either occupied the land or had the use of the asset
• the original gift was for the maintenance of the donor’s family or within the small gifts exemption (£250 per donee) or within the inheritance tax annual gifts allowance (£3,000 in total) as set out on pages 13 and 14
• the donor is not resident in the United Kingdom
• the asset which gives rise to the benefit is situated abroad and the donor does not have his domicile in the United Kingdom
• the asset is a non-UK asset which the taxpayer ceased to own before he became domiciled in the United Kingdom
• the aggregate benefits do not exceed £5,000 in one year.

Former owners are not regarded as enjoying a taxable benefit if they retain an interest which is consistent with their ongoing enjoyment of the property. For example, the charge will not arise if an elderly parent formerly owning the whole of their home passes a 50% interest to a child who lives with the parent. It could well apply if the parent gave a 90% interest to the child and might also apply if the child did not live with the parent.

JUMPING OUT OF THE PRE-OWNED ASSETS TAX PAN INTO THE INHERITANCE TAX FIRE

If the taxpayer so elects before 31 January after the end of the first tax year in which the pre-owned asset rules apply to him (the relevant filing date), he can choose to have the property concerned treated as part of his estate for inheritance tax purposes as a gift with reservation of an interest rather than have the benefit taxed as income. In those circumstances, the property would be eligible for the normal inheritance tax reliefs and exemptions available; for example, to quick succession relief, business and agricultural property reliefs and to relief for heritage assets. As to these reliefs, please see the next chapter. The election, which can be withdrawn before the relevant filing date while the chargeable person is alive, is made to the Capital Taxes Office on its specified form.

Whether it will be advantageous for a taxpayer to opt into inheritance tax by reason of the transaction being a gift with a reservation of a benefit instead of paying the pre-owned asset income tax charge will depend upon how long he has to live, the amount of the income tax charge and the rate at which his income is taxed. If the taxpayer does consider opting out of the pre-owned asset regime and to be taxed on the basis of the gift with a reservation, it might be worthwhile comparing the cost of the premiums for a life policy to cover the cost of the anticipated inheritance tax with the amount of the income tax which it is anticipated will be charged. If a policy is to be taken out, the insurance company should be requested to write the policy in trust for those who will bear the inheritance tax liability so that the policy monies will not themselves be taxed as forming part of the deceased’s estate and will be available to pay the inheritance tax payable before a grant of representation is granted.

If a taxpayer gives an asset away and pays a full commercial rent or hiring fee to use it, although doing so will save inheritance tax, it will not usually be an otherwise tax-efficient transaction because as far as income tax is concerned, the taxpayer will be paying the rent or hiring fee out of taxed income and the recipient of the gift will have to pay income tax on the rent. Moreover, if the taxpayer’s principal private residence is the subject of the transaction, the capital gains tax exemption for a principal private residence will be lost when the donee comes to dispose of the property, unless during the period of the donor’s benefit the donee also uses it as his principal private residence.

Whenever a gift is made the capital gains tax and income tax implications as well as the inheritance tax implications of the transaction must always be considered. If the taxpayer is liable to the pre-owned asset charge he should declare the benefit in the ‘any other income’ section of his income tax return.