London buildings Georgian style

Inheritance Tax on UK Residential Property held indirectly

Tom Elliott
London buildings Georgian style
A fundamental principle of the UK inheritance tax (IHT) regime is that assets situated in the UK are within the scope of the tax, even for individuals who are not domiciled in the UK.

However, for non-domiciled individuals (non-doms) this historically only applied where those assets were held directly by the individual and therefore it was possible for non-doms to remove UK real estate from the charge to IHT through the use of a Special Purpose Vehicle — most commonly a company incorporated in an offshore jurisdiction. In such cases, an individual would hold shares in the offshore company and the foreign situs of the shareholding would protect the value of the underlying UK asset from UK IHT.

Draft legislation proposes that the position will change with retroactive effect from 6 April 2017, when UK residential property will be chargeable to IHT. This will apply irrespective of how the interest in that property is owned, for example, if held through a partnership or a close company. However where an individual holds an interest of less than 5% of the value of the company or partnership, this will be disregarded and the interest will remain outside of IHT. This change is focused purely on UK residential property.

Any property that is solely for commercial use is unaffected.

This extension of the scope of IHT could have been effected by simply disregarding the structure in which the property is held and charging the value of the underlying property to IHT. However, the way this change operates is to tax the value of the individual’s interest in the company or partnership that directly relates to the UK residential property.

This will require those who have an interest in UK residential property to obtain not only a valuation of the property to ascertain their potential IHT exposure, but also a valuation of their shares or their interest in the holding structure. The valuation of their shares will need to consider many factors such as any possible tax liabilities for the company and the risk of acquiring shares in a company. As a result, it is likely that the value of the shares will be subject to a discount, resulting in a reduction in the amount subject to IHT.

In determining the value chargeable to IHT, it is proposed that a deduction for relevant borrowings will be allowed under existing IHT rules. Therefore, we expect that mortgages taken on to fund a residential property acquisition will reduce the value to be taken into account for IHT.

In addition, the proposed legislation also brings into the scope of IHT the concept of ‘relevant loans’ and guarantees in respect of ‘relevant loans’. A ‘relevant loan’ is a loan secured on a residential property which has been provided by a person (corporate or natural) who is connected with the borrowing company. Where a ‘relevant loan’ exists, the value of the loan is treated as a UK residential property interest; therefore it is included in the new provisions and will be chargeable to IHT.

Worryingly, where there has been a guarantee in respect of relevant loans (such as an offshore portfolio held as collateral), there are circumstances where the value subject to this guarantee could also fall into the IHT net.

As a result, we would advise that connected lending and personal guarantees should be reviewed to determine whether or not they fall under the ‘relevant loan’ provisions and whether consideration should be given to repaying debt, where possible, or refinancing.

Those who have made loans to a connected party should now also give consideration as to whether they have, with effect from 6 April 2017, an exposure to IHT and whether they can undertake any mitigation of this potential liability.

A further consequence of these new rules is that excluded property Trusts that were not previously subject to the exit and 10 year charge regime may now find themselves within that regime and the consequent reporting it entails, if they hold UK residential property or relevant loans.

Furthermore, those who own properties within structures might want to consider if those structures now serve a purpose and whether they could be dismantled. It should be borne in mind that there will sometimes be good reasons to keep the structure and there may also be a possible tax cost of extraction.

If you require further assistance regarding this subject please contact your usual Crowe partner, who would be pleased to assist in undertaking relevant valuations, calculating the tax costs of dismantling a structure, determining potential IHT exposure, and considering options to mitigate that exposure.

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Tom Elliott
Tom Elliott
Partner, Head of London Private Clients