This is an update to:

Drafting Trusts & Will Trusts 8^th edition (2006) and

Drafting Trusts& Will Trusts in Northern Ireland 2^nd edition (2007)

This update discusses two topics:

(1) transferable nil rate bands (text by Sheena Grattan & James Kessler QC)

(2) whether indexation of nil rate loans gives rise to taxable interest (by James Kessler QC)

Sheena Grattan is a member of the Bar of Northern Ireland and co-author of Drafting Trusts & Will Trusts in Northern Ireland, 2^nd edition 2007.

James Kessler QC is a member of the English Bar and of the Bar of Northern Ireland.

A new edition of the English DTWT will come out in autumn 2008, by James Kessler QC and Leon Sartin, barrister, of 5 Stone Buildings, Lincoln’s Inn.

The disclaimer of liability in the books also applies to this update. We hope nevertheless that you find it useful.

18 December 2007

TRANSFERABLE NIL RATE BANDS

“Nil rate band trusts complicate the drafting, increase the costs and delay the administration of estates, but the tax saving justifies the trouble. There is a simple reform which would make NRB trusts unnecessary: a transferable nil rate band. That is, if H by his will gives his entire estate to W (not using his nil rate band) W should on her death enjoy the unused nil rate band of H in addition to her own. This is in substance what the device of a NRB trust achieves. The only objection to this reform can be the loss of tax paid by the estates of those unaware of (or who choose not to take advantage of) existing possibilities for tax planning. IHT payable on the nil rate band of a testator who is married/a civil partner may fairly be described as a voluntary tax. It almost certainly benefits professional advisers more than HMRC; to ascertain by how much would be a worthwhile piece of research”.

Kessler and Grattan, Drafting Trusts and Will Trusts in Northern Ireland, 2^nd edition, 2007 at paragraph 29.11 (under the heading “Commentary: let’s abolish NRB discretionary trusts”). The same point has been made in the English edition since the 5^th edition in 2000.

In his Pre-Budget Report Alastair Darling announced that from 9^th October 2007 it will be possible for spouses and civil partners to transfer their NRB allowances so that any part of the NRB which was not used when the first spouse or civil partner died can be transferred to the individual’s surviving spouse or civil partner for use on their death.

The draft legislation, guidance, a FAQ and the new claim form can be found on HMRC’s website.   

Note also that the NRB will rise to £312,000 in April 2008 and eventually to £350,000 per person in April 2010.

THE BASICS

• From 9 October 2007 spouses and civil partners will be able to transfer their IHT NRB allowance so that any part of the NRB that was not used when the first spouse or civil partner died can be transferred to his or her surviving spouse.

• The amount that can be transferred will be based on the unused percentage of the NRB.

• A widow/widower and surviving civil partner who lost their spouse/partner before 9 October 2007 will also benefit – the transferable allowance will be available to all survivors of a marriage or civil partnership who die on or after 9 October 2007, no matter how long ago the first party died

• It is NOT, as was widely reported, a “doubling” of the NRB. The mistake is possibly due to inaccurate Treasury briefings: see “Date of first consideration of proposal to double inheritance tax threshold” accessible www.hm-treasury.gov.uk/about/information/foi_disclosures/2007/foi_iht_2007.cfm and recorded in STI 22 November 2007.

• It does not matter that the first spouse/civil partner to die did not have sufficient assets to utilize the entire nil-rate band. The unused part can still be transferred, whatever proportion of the NRB is unused on the first death is available for transfer to the survivor.

• Gifts and chargeable lifetime transfers eat into the NRB of the first to die in the usual way.

Example:

Wife dies December 2008 when NRB is £300,000. She leaves £150,000 to her son and the residue to her husband. Husband dies when the NRB is £400,000. The wife has only used 50 per cent of her NRB. On the husband’s death the NRB would be increased by 50 per cent, that is by £200,000 to £600,000.

Same facts save that wife left everything to her husband. As her full NRB can be transferred (ie 100 per cent), the NRB available on the husband’s death has increased by 100 per cent to £800,000

The initial consensus (at least in the non-legal press) was that the mechanism of applying the percentage of the NRB unused on the first death to the amount of the NRB in force on the second death penalizes those who have made the effort to utilize the NRB on the first death by way of discretionary trust or otherwise. But is it correct that those who have used the nil rate band on the first death or have done so in the past are at a disadvantage compared to those who did not and who rely on the new proposals? Taken at its simplest (without taking account of additional fees etc) this depends on the relative performance of the assets in the trust and the increase in the nil-rate band. Capital growth in the trust may outstrip the increase in the NRB over the survivor’s lifetime.

SOME PRACTICALITIES

• The claim to transfer the unused NRB available from the first death is made by the personal representatives (or the accountable person) of the second spouse to die.

• This will be done by completion of a claim form which is sent to HMRC with IHT 200.

• The personal representatives will have 24 months from the end of the month in which the death of the surviving spouse/civil partner occurred in order to make the claim (there is provision for late claims but this should not be relied on.)

• The personal representatives of the second to die will also need to provide certain documents to support their claim: the death certificate of the first spouse to die; the marriage certificate, a copy of the will; a copy of any deed of variation; a copy of the grant of probate.

• The personal representatives of the first to die should ordinarily calculate how much of the nil rate band is transferable and ensure that they pass on to the surviving spouse (or her solicitor) sufficient documents and information to permit the surviving spouse’s representatives to make a claim in due course.

• This will include: a copy of the HMRC return; a copy of the deceased’s will; a copy of any deeds of variation; a valuation of any assets which pass under the will or intestacy other than to the surviving spouse/civil partner; any evidence to support the availability of reliefs such as APR and BPR where the relievable assets pass to someone other than the surviving spouse/civil partner.

• Solicitors can expect to do much chasing of copy documents for their long widowed clients!

• Remember to heed HMRC’s warning about the importance of looking after one’s documents: “The information and documents about the claim could be very valuable… and it will be important to keep them safe.”

• Concerns about HMRC reopening valuations/eligibility for reliefs in relation to the first death on the occasion of the second death.

• Joint property (ie deceased has a joint tenancy with someone other than spouse) such that no grant required on first death – surviving spouse will have to keep careful records.

ADVISING CLIENTS ON GOING FORWARD

Scenario One: Both spouses/civil partners died before 9 October 2007

Unfortunate – no transferability.

The first spouse to die had to make use of his or her own nil rate band by way of a absolute gift or legacy to a discretionary trust. If this was not effected by the will there is still the facility to execute a deed of variation within 2 years of the first death. Remember that this can be done on the “double death” situation – so long as the instrument of variation is executed within 2 years of the death of the first spouse to die.

Scenario Two: Surviving spouse/civil partner is still alive; first spouse has died

The principles are the same whether the first spouse died before or after 9 October 2007. If the first spouse to die has left everything to the surviving spouse (and has not made lifetime gifts) the full nil rate band is intact.

Imagine that the first to die had a will incorporating a standard nil rate band discretionary trust? Many clients having read their Sunday papers will undoubtedly wish to “undo” the discretionary trust.

If you are still within the 2 year period (and remember the first 3 month trap) the trustees can make a section 144 IHTA appointment of the trust assets in favour of the surviving spouse/civil partner and this will be treated for IHT purposes as if the assets had simply been left to the surviving spouse or civil partner outright (confirmed – if confirmation is necessary - by HMRC guidance (para 15)).

This is not possible if the 2 years have expired (but a debt or charge scheme ought by then to be in place.)

Scenario Three:

Both spouses are dead. The husband died on 2 April 2006 (nil rate band was £275,000). The wife died on 12 October 2007. The husband’s will gave the NRB to a discretionary trust and the residue to his wife. The wife’s executors are alert to the fact that if husband had not used any of his NRB, her estate would benefit from £600,000 (rather than £575,000).

The appointment out within 2 year route has been closed since the wife has died before any distribution could be made to her from the NRB trust. Is it possible to vary the husband’s will to eliminate the NRBDT? Answer: unlikely that class of beneficiaries in a standard NRBDT would permit such. Is it possible to appoint out to adult beneficiaries who then make the variation under s. 142 IHTA 1984? In James Kessler’s view, the answer is, yes.

And Finally

Both parties are still alive and well and proud owners of Nil Rate Band Will Trusts, executed by them last year and both still in shock at the legal fees charged (£400 plus VAT for two wills). Should they (as they are advised in virtually every Sunday paper) make new wills? No: a codicil could be made to revoke the NRB gifts, but that can (as noted above) just as well be done after the death by a deed of appointment.

Has the PBR sounded the death knell for NRB discretionary will trusts?

• Undoubtedly NRBDTs will plummet in popularity.

• It has been argued that the NRBDT remains preferable because (1) the transferable NRB may be abolished in the future; (2) using a NRBDT on the first death allows time to consider matters fully when administering the first estate and encourages the survivor to seek legal and tax advice which she might not otherwise have done. However, this argument ignores the fact that the continued efficacy of say debt and charge schemes cannot be guaranteed with 100 per cent certainty.

• Our view is that clients will overwhelmingly opt for the simplicity and the much more modest legal and administrative cost of leaving their NRB intact on the first death and, where life expectancy warrants such, more use will be made of PETS by the survivor in place of gifts to non-exempt beneficiaries on the first death.

NRB trusts will still be useful in the following cases:

• Where the testator (following the death of a spouse) has two NRBs. He or she cannot acquire more than that, so for wills for remarried spouses it is generally necessary to use NRB trusts.

• Where it is desired to make provision for non married cohabitants or relatives (remember the elderly home-sharing Burden sisters). The new transferable nil rate bands do not apply in this case.

• NRBDTs may still be appropriate for those clients where the estate is such that assets – particularly those likely to achieve significant gains in value – can be transferred to the trustees. If one has to rely on index-linked charge or loan it will be more appropriate to rely on the transferable NRB.

• It will still be prudent to pass assets which qualify for BPR and APR to non-exempt beneficiaries on the first death: a NRBDT continues to provide a useful recipient for such gifts.

• NRBDTs (along with other types of trust) will still prove useful to clients whose asset protection requirements go beyond IHT: eg care fees; divorce; vulnerable beneficiaries.

Some miscellaneous points

• The £55,000 restriction where the surviving spouse is domiciled outside the UK still applies – In Northern Ireland, don’t overlook the County Louth spouse.

• Immediate Post Death Interests (ie life interest to surviving spouse remainder to children): the full unused allowance will be available on the second death – these will probably become even more popular for second and subsequent relationships.

Tax on payment of index linked nil rate sum

In the draft spouse undertaking in DTWT, the spouse undertakes to pay to the trustees an amount called the Index Linked Nil Rate Sum, which is, the nil rate sum increased by the retail price index (“RPI”). In the draft charge, the executors charge property (the testator’s interest in the land) with payment of the index linked nil rate sum.

This update deals with the question of whether the trustees are subject to tax on the indexation element when this amount is paid.

These comments only apply to the drafts in this book. It is possible that a drafter unfamiliar with the tax rules could create a debt on which interest accrues (income-taxable if interest paid); or a deeply discounted security (income-taxable on disposal): or a debt on a security (CGTable on disposal).

Income tax: Interest

HMRC have on occasion argued that the indexation element is interest and subject to income tax. This update discusses the issue in detail.

Someone who lends money faces various losses or risks of losses, for which he would normally require compensation or consideration, in return for making the loan:

(a) Loss of the benefit of use of the money while the loan is outstanding.

(b) The risk that the lender will not recover all the money owing due to insolvency of the borrower.

(c) The risk that the money which the lender does recover will not be worth as much as when it was lent due to inflation or other changes in the value of currency.

The following propositions are well established:

(1) Compensation for (a) (loss of use of money) is classified as interest and subject to income tax when received. Compensation for risks (b) and (c) (risk of failure to fully recover money lent) may either take the form of additional interest or it may be a capital receipt (“capital”). If it is capital it is not subject to income tax. The only difficulty is to tell which category a payment falls into: this depends on the contract and surrounding circumstances.

(2) So if

(a) the loan is at a reasonable commercial rate of interest, and

(b) the supplement is identified as compensation for the capital risk because of the risk of insolvency of the borrower

then the supplement is capital:

“A lends £100 to B at a reasonable commercial rate of interest and stipulated for payment of £120 at the maturity of the loan. In such a case it may well be that A requires payment of the £20 as compensation for the capital risk; or it may merely be deferred interest. If it be proved that the former was the case by evidence of what took place during the negotiations, it is difficult to see on what principle the £20 ought to be treated as income [ie, it is capital].”¹

This was in fact the case in Lomax v Peter Dixon, where the loan to a Finnish company in 1930 faced the risk that it would not be repaid in the event of a Russian invasion:

“The element of capital risk was quite obviously a serious one, and the parties were entitled to express it in the form of capital rather than in the form of interest if they bona fide so chose.”²

(3) The same applies if:

(a) the loan is at a reasonable commercial rate of interest, and

(b) the supplement is compensation for the capital risk of inflation (reduction in the value of money).

Lord Greene gives the example of repayment linked to gold prices:

“A good example of the difficulty is to be found in the contracts of loan which used to be made on a gold basis when the currency had left, or was expected to leave, the gold standard.³ In such contracts the amount to be repaid was fixed by reference to the price of gold ruling at the repayment date, and if the currency depreciated in terms of gold, there was a corresponding increase in the amount of sterling to be repaid at the maturity of the loan. It could scarcely be suggested that this excess ought to be treated as income when the whole object of the contract was to ensure that the lender should not suffer a capital loss due to the depreciation of the currency.”⁴

The same principle applies to RPI indexation:

“The Inland Revenue wish to clarify the tax position regarding corporate stock issued on an indexed basis and bearing a reasonable commercial rate of interest. … Although the precise tax treatment must have regard to the terms of any contract between the parties, in general if the indexation constitutes a capital uplift of the principal on redemption to take account of no more than the fall in real value because of inflation the lender, … will be liable only to CGT on the uplift… [ie the uplift is capital not interest].⁵

(3) If a commercial loan does not provide for interest, then any supplement paid on repayment of the loan is regarded as interest:

“But in many cases mere interpretation of the contract leads nowhere. If A lends B £100 on the terms that B will pay him £110 at the expiration of two years, interpretation of the contract tells us that B's obligation is to make this payment; it tells us nothing more. The contract does not explain the nature of the £10. Yet who could doubt that the £10 represented interest for the two years? The justification for reaching this conclusion may well be that, as the transaction is obviously a commercial one, the lender must be presumed to have acted on ordinary commercial lines and to have stipulated for interest on his money. In the case supposed, the £10, if regarded as interest, is obviously interest at a reasonable commercial rate, a circumstance which helps to stamp it as interest.”⁶

The same applies if a commercial loan is at a low rate of interest: the supplement may be regarded as further interest. A possible example is IRC v Thomas Nelson & Sons: interest on the loan was payable at 3% which was “a remarkably low rate for an unsecured loan of this kind”. The supplement was held to be interest.⁷

In the light of these clear cases, what is the position with the index linked sum? The key to the answer is to appreciate that the spouse undertaking or charge is not a commercial transaction. The spouse undertaking is a transaction between friendly, connected persons, the executors and the spouse. The charge is a unilateral transaction, though the executors have in mind the interests of two parties, the spouse and the trustees of the NRB trust. In each case the indexation element is less than market rate interest: the parties intend that the spouse should pay less than the commercial cost of borrowing. The object of indexation is not to obtain a profit: it is so as not to incur a loss due to inflation. It is the paradigm of a capital receipt.

If the agreement had included market rate interest and an indexation element, the indexation element would be capital. The fact that the interest is dropped because of the element of bounty or gratuitous intent does not turn what would otherwise be capital into income.

HMRC must rely on proposition (3): that if a commercial loan does not provide for interest, then the supplement paid on repayment of the loan is regarded as interest because “the lender must be presumed to have acted on ordinary commercial terms.” This reason does not apply here because the spouse undertaking or charge is not commercial.

It is true that Lord Greene says:

“Where no interest is payable as such, different considerations will, of course, apply. In such a case, … a "premium" will normally, if not always, be interest. But it is not necessary or desirable to do more than to point out the distinction between such cases and the case of a contract similar to that which we are considering.”⁸

Here is some comfort for HMRC. But Lord Greene is at all times considering commercial loans, and he rightly qualified this broad statement so it applies “normally” but not necessarily “always”.

For these reasons there is no income tax charge on payment of the index linked nil rate sum.

If this were held to be wrong, one could avoid the charge on interest from arising by waiving the debt, or the indexation element, after the death of the debtor. Interest is not taxable if it is waived before payment.⁹

Income tax: Deeply discounted securities

If the spouse undertaking or charge is a deeply discounted security, the profit is subject to IT under s. 427 ITTOIA 2005.

However, this only applies if the agreement constitutes a “security” within the meaning of these provisions. Clearly, not every debt is a security, there must be something more. “Security” is not defined and bears its normal commercial meaning. For the meaning of the phrase it is more appropriate to turn to commercial law than to tax cases.

Interests in Securities (Benjamin, 2000) states¹⁰:

Securities are a type of transferable financial asset. The meaning of the term ‘securities’ has varied over time.¹¹ Originally the term was used to denote security interests (such as mortgages and charges) supporting the payment of a debt or other obligation. In the early modern period, companies and government agencies began to raise capital from the public by issuing transferable debt obligations, the repayment of these debt obligations was secured on the assets of the issuer. By a process of elision, these secured debt obligations came to be known as ‘securities’.¹² Since late medieval times, commercial companies have raised funds by issuing participations or shares. In the Victorian era the transferability of these shares under the general principles of company law was put beyond doubt. As shares became more readily transferable, their functional likeness to debt securities became clearer, and both forms of investment became known as ‘securities’. More recently, the term ‘securities’ has been extended to include units in investment funds and other forms of readily transferable investment…. ¹³

Transferability is an essential characteristic of securities.¹⁴

Gore-Browne on Companies states¹⁵

The term ‘security’ has no precise legal meaning, but is traditionally used to describe ‘something which makes the enjoyment or enforcement of a right more secure or certain’.¹⁶ Consequently, the term ‘debt security’ traditionally describes an instrument, given by the debtor in addition to the original debt, and either containing an additional promise or constituting evidence of the debt, designed to make the creditor’s burden easier to discharge.¹⁷ One major example of such an instrument is obviously one which creates security, but the creation of security is not essential. It appears to be enough that the instrument acknowledges a liability in a form which makes its enforcement easier or more convenient. Thus promissory notes and certificates for unsecured loan stock are ‘securities’,¹⁸ and the term is now commonly used to describe virtually any form of financial instrument issued in connection with a loan.

The points which emerge are that it is irrelevant whether or not the debt is secured by a charge or mortgage. The spouse undertaking (not usually secured) is not a security even though unsecured; the charge is not a security even though secured. What matters is whether the asset is a transferable investment; it is not.

Further, a “deeply discounted security” is one where the amount payable on maturity is or might be an amount involving a deep gain. Since the spouse’s debt on the spouse undertaking is payable on demand, the debt matures immediately it is made.¹⁹ Hence the debt (even it is a security) is not a “deeply discounted security”.²⁰

Capital Gains Tax

Section 251(1) TCGA 1992 provides:

Where a person incurs a debt to another, whether in sterling or in some other currency, no chargeable gain shall accrue to that (that is the original) creditor or his personal representative or legatee on a disposal of the debt, except in the case of the debt on a security…

Thus no chargeable gain arises on a disposal of the debt. The spouse undertaking clearly gives rise to a debt; it is considered that the rights of the trustees under the charge are likewise within the relief of s. 251.

The relief does not apply if the debt is a “debt on a security”. The fact (inter alia) that the debtor is entitled to repay the debt at any time is inconsistent with the status of “debt on a security”: see Taylor Clark International v Lewis 71 TC 226.

Indexation by reference to property prices

The spouse undertaking or charge in this book is index-linked by reference to the retail price index. Sometimes an index of house prices is used instead. There are many such indexes published, eg those by Halifax and Nationwide.

Historically house price indexes have exceeded the RPI, which is in principle a good thing for NRB trusts, as it maximised the IHT deduction on the death of the spouse. But there is no reason to think that must continue to be the case.

As far as interest is concerned, it makes no difference whether the indexation is by reference to house prices or the RPI: in neither case is the index linked element to be categorised as interest.

Some practitioners prefer the house price index on the grounds that the debt or charge then qualifies as an excluded indexed security. The advantage is that an excluded indexed security is outside the definition of deeply discounted security so there is no IT charge on a disposal.²¹ But this is mistaken for two reasons. As explained above, the debt or charge is not a deeply discounted security (and so is not an excluded indexed security). Even if that were wrong, there is no great advantage in being an excluded indexed security, since such assets do not qualify for the CGT relief for debts.²² So the result is to move from the IT regime to the CGT regime, but the rates of CGT are in most cases not very significantly lower.

Conclusion

For these reasons there is in my view no tax on the payment of the index linked sum.

The amount of tax at stake in any one case is likely to be small but (to avoid cases settling by reason of the costs of defending what is right) I would be prepared to act on a pro bono basis if this were challenged.

James Kessler QC

15 Old Square

Lincoln’s Inn

WC2

21 October 2007