Measures introduced last year limit the deductions which can be made in certain circumstances when calculating the chargeable value of an individual’s estate for inheritance tax (IHT) purposes.
The new rules are designed to stop individuals creating debts in order to reduce their IHT liabilities.
IHT is charged on the net value of an individual’s estate after deducting allowable debts and liabilities. The new rules restrict the deductibility of debts in three main areas:
- Liabilities used to acquire ’excluded property’;
- Liabilities used to acquire an asset qualifying for an IHT relief; and
- Liabilities that are not repaid after death.
1. Liabilities used to acquire excluded property
Individuals who are not domiciled in the UK (other than those who have been UK resident for at least 17 of the last 20 tax years) are not liable to IHT on ‘excluded property’. Excluded property means property situated outside the UK, held directly by a non-domiciled person. It also includes such property settled into trust by a non-domiciliary.
Previously, for example a non-domiciled person could fund the acquisition of an overseas property by taking out a debt secured on an asset subject to UK IHT. The overseas property would rank as excluded property and not be subject to IHT. At the same time, the value of the UK asset for IHT purposes would be reduced by the amount of the debt.
From 17 July 2013, no deduction will be allowed for a debt, to the extent that it is used (directly or indirectly) to acquire, enhance or maintain excluded property. This measure will affect current debt arrangements as well as new ones.
Under the new rules, the debt will first reduce the value of the overseas asset funded by the loan proceeds. Any excess borrowing may be allowable against the value of the UK asset which has acted as collateral but this is subject to a number of conditions.
The debt will be allowable for IHT purposes if the excluded property is sold for full consideration and the proceeds of sale are used to purchase property otherwise chargeable to IHT.
2. Liabilities used to acquire assets already subject to IHT relief
Where liabilities are incurred to acquire, maintain or enhance property which attracts an IHT relief, such as Business Property Relief (BPR) or Agricultural Property Relief (APR), the liability now attaches to that property first and not the asset on which the debt is secured. This will reduce the value of the relievable property before it reduces that of any property subject to IHT. The restriction applies to new debts incurred on or after 6 April 2013. Borrowings taken out before this date are not affected, provided that the loan terms are not amended subsequently.
3. Liabilities that are not repaid
Under the new rules, a liability will only be deductible from the estate of a deceased person if it is repaid on or after their death, regardless of when it was first incurred. If the liability remains outstanding, there must be a ‘real commercial reason’ for non-repayment and it must not give rise to a tax advantage. Debts which are waived or forgiven after death will not be allowable.
The new debt rules seek to prevent individuals using borrowing as a means of mitigating their IHT liabilities.
Loans taken out before 6 April 2013 to acquire property which qualifies for an IHT relief can be ignored, provided their terms remain unchanged. However, debts to acquire excluded property will not be deductible, regardless of when first incurred.
For all new loans, it will be necessary to consider the purpose of the borrowing and hence the likely impact on an individual’s future IHT liabilities.