Introduction

Inheritance Tax (IHT) is usually levied on the value of an individual’s estate net of liabilities. When determining the value of individual assets, secured debts are normally deducted from the value of the assets on which they are secured. However, in some cases debts may not be taken into account when determining net values of assets for IHT purposes, or debts may be set against the value of a different asset to the asset against which the loan is secured. This can result in more IHT being payable than would otherwise be the case. 

This particularly affects: 

• Liabilities which are incurred in order to finance investment in certain types of assets which are either ‘excluded property’ for IHT purposes, or which qualify for relief from IHT. This is relevant to individuals and trustees, and; 

• Liabilities which are not repaid following the death of an individual, subject to certain commercial exemptions.

More details are given about operation of the rules and the liabilities affected below.

Background

Broadly, IHT is charged on the net value of assets owned by an individual or by trustees. The value of assets is normally reduced for IHT purposes if a debt is secured against a particular asset, before IHT reliefs or exemptions are considered. 

Historically, this meant that, for example, a loan could be taken out and secured against an individual's home, which would reduce the value of the home for IHT purposes. The borrowed funds could then be invested in assets which qualify for 100% Business Property Relief (BPR). As the value of the home would be reduced by the debt for IHT purposes and the business assets would be fully relieved from IHT by BPR, this could mean that no IHT would be payable on the death of the individual (provided he or she survives for at least two years following the acquisition of BPR assets and depending on the net value of the property and any other assets in the estate).  

There is anti-avoidance legislation which prevents such 'double deductions'.  

Provisions also apply to prevent deduction of liabilities on death where a debt is not repaid following the death of an individual, unless there were commercial reasons for the debt remaining outstanding and there is no intention to obtain a tax advantage (this point is explained in more detail below).

Debts which relate to the financing of property eligible for IHT reliefs or excluded property

IHT reliefs

The anti-avoidance legislation may apply where debts are taken out which are used to finance the acquisition, maintenance or enhancement of property eligible for IHT relief in respect of business property (BPR, as above), agricultural property (Agricultural Property Relief - APR) or woodlands (woodlands relief). All three of these reliefs reduce the value of assets for IHT purposes, and can, depending on the amount of relief available, result in assets effectively being exempt from IHT.  

Where the anti-avoidance legislation applies, the liability is first taken into account against the value of property eligible for IHT relief, and, to the extent the liability exceeds the value of the relieved asset, against the value of the remainder of the estate.  

For example, suppose a mortgage of £1million is taken out and secured against the value of the family home, which is worth £1million. The borrowed amount is then invested in shares which qualify for BPR. After two years the individual dies. The shares qualify for 100% BPR. At this point, the shares are worth £2million and the £1million mortgage remains outstanding. £1million of the debt is first deducted from the £2million value of the BPR shares, so half of the BPR is effectively wasted. The value of the family home at the date of death is chargeable to IHT.  

If the shares were instead worth £800,000 on death, £800,000 of the loan would be deducted from the BPR asset (the shares) and the remaining £200,000 would be deducted from the value of the family home at the date of death, reducing the IHT due on the home. The BPR available would be completely wasted.  

Grandfathering applies in certain cases where loans were taken out before 6 April 2013 and the borrowed funds were used to finance property eligible for BPR, APR and/or woodlands relief.

Excluded property

Excluded property is, broadly, assets that are located outside the UK and owned by a non-UK domiciled individual, or such assets owned by trustees of a trust settled by a non-UK domiciled individual. Excluded property is outside the scope of IHT.

Assets consisting of interests in land are normally treated as located in the jurisdiction where the land is situated. Likewise, assets consisting of physical objects such as cars and paintings are located in the jurisdiction where they are physically present. There are special rules for determining the location of intangible assets such as shares and debts, and advice may need to be taken if these assets are held and the location affects the IHT position. Specific comments in respect of UK residential property owned by certain foreign companies or partnerships are included below. 

A non-UK domiciled individual is, broadly, an individual whose permanent home is not in the UK, though in some cases a non-UK domiciled individual may be deemed or can elect to be UK domiciled for IHT purposes. 

Debts which are used to finance the acquisition, maintenance or enhancement of excluded property cannot be deducted from the value of property which is subject to IHT. This could apply where, say, a non-UK domiciled individual takes out a mortgage secured against UK situated assets and the borrowed funds are deposited in an offshore bank account. Before the introduction of these anti-avoidance rules, the value of the UK assets would be reduced and the funds held in the offshore bank account would be exempt from IHT, provided the individual remained non-UK domiciled on death. 

These rules also apply where UK property becomes excluded property. For example, where a painting which is in the UK is purchased wholly or partly by way of debt finance, and is later taken offshore, thereby becoming excluded property. 

As for assets eligible for IHT reliefs, debts may be deductible from the value of the UK estate if the value of the debt exceeds the value of the excluded property. However, the value of the debt in excess of the value of the excluded property cannot be deducted to the extent the excess debt exists because: 

• There are arrangements of which the or a main purpose is to obtain a tax advantage. Tax advantage is a broad term which includes tax avoidance and deferring taxation. ‘Tax’ for this purpose includes income tax and capital gains tax, in addition to IHT, or; 

• To the extent the liability exceeds the value of the excluded property due to interest being rolled up. This provision will need to be considered carefully where more than one debt is secured against the same property, or; 

• There is a disposal (in whole or part) of the excluded property.

Grandfathering is not available for pre-6 April 2013 loans which were used to finance excluded property. 

The tax position is similar where loans are taken out and used to finance a foreign currency bank account held with a UK bank, which is outside the scope of IHT if the account is owned by an individual who is both non-UK resident and non-UK domiciled. 

Repayment of debts

Complicated rules apply where part of a loan taken out to purchase, maintain, or enhance excluded property or IHT relievable assets is repaid during lifetime. The rules are especially complex where the debt is deductible against both exempt (or effectively exempt) property and non-exempt property. 

Debt repayments in this situation must first be treated as reducing the debt deductible from non-exempt property (i.e. property chargeable to IHT), then the debt deductible from property qualifying for BPR, APR and/or woodlands relief, and finally from excluded property. The result is that any part of the debt which could be deducted from property which could be chargeable to IHT is repaid first, and so this would result in the highest IHT liability.

Deduction of liabilities on death

Liabilities are only deductible from an estate on death if they are either repaid by the estate following the death of the individual, or, if they are not repaid, if the following conditions are met: 

• The debt is not repaid for 'real commercial reasons'. This means that a debt is not repaid because a creditor acting on arm’s length terms does not or would not require the debt to be repaid, and; 

• The liability is not left outstanding as part of arrangements the main purpose, or one of the main purposes of which, is to secure a tax advantage (as explained in the excluded property section above), and; 

• No other IHT anti-avoidance provisions apply.

UK residential property

UK property held directly by a non-UK domiciled individual is not excluded property, and so is within the scope of IHT. Furthermore, subject to a de minimis limit, non-UK situated interests in ‘close companies’ or partnerships are deemed to be UK situated for IHT purposes, to the extent the close company or partnership derives value from UK residential property. In addition, broadly, the value of loans made by an individual that are used by the debtor to finance the acquisition, maintenance or enhancement of UK residential property are also within the scope of IHT. 

Similar rules apply to trusts settled by non-UK domiciled individuals. 

Determining the best way for non-UK domiciled individuals and trusts settled by such individuals to own UK residential property is a complicated area, particularly if an existing property is remortgaged. This area is not covered in detail in this note and advice is essential if you may be affected by these changes.