Since the introduction of inheritance tax (IHT) in 1986, the area of gifts with reservation has proved fertile ground for disputes with HM Revenue & Customs (HMRC).
Inheritance tax differs from its predecessor taxes on the transfer of wealth by offering the opportunity to make lifetime gifts of substantial assets free of tax. The potentially exempt transfer (PET) regime encourages early estate planning because gifts made more than seven years before death will escape the charge to inheritance tax. The sticking point, of course, is that taxpayers do not want, or cannot afford, to give away significant portions of their wealth.
Often a client’s initial approach to inheritance tax planning will be to put a significant asset, usually his home, ‘in the name of’ a child or other beneficiary under the misapprehension that it will remove the asset from assessment to IHT on his death. The gifts with reservation anti-avoidance rules render such action ineffective for saving IHT.
What is a gift with reservation?
A gift with reservation (GWR) arises when an individual ostensibly makes a gift of his property to another person but retains for himself some or all of the benefit of owning the property. The legislation, which is to be found in Section 102 of the Finance Act (FA) 1986 (http://abytx.co/1egwnkt), applies to gifts on or after 18 March 1986, where either:
- possession and enjoyment of the property is not bona fide assumed by the donee at or before the beginning of the relevant period; or
- at any time in the relevant period the property is not enjoyed to the entire exclusion, or virtually to the entire exclusion, of the donor and of any benefit to him by contract or otherwise.
It makes no difference whether the donor’s enjoyment of the property or related benefit is enforceable under contract, by specific agreement, or merely incidental.
The ‘relevant period’ in the definition is the period of seven years before the death of the donor, or, if the donor dies within seven years of making the gift, it is the period between the date of the gift and the date of death.
Note that the significance of the relevant period is that it represents the period before death during which enjoyment of the gifted property and the donor’s exclusion from it is to be considered. It does not refer to a time limit after which the gift itself falls out of the account. There is no time limit for the GWR provisions to apply. A donor may make a gift 20 years or more before his death but if he still enjoys the benefit of the property during the seven years before his death, it will be a gift with reservation.
Examples of a GWR include:
- the transfer of legal ownership of a house in which the donor resides
- a rented property where the donor continues to receive the rental income
- a caravan or boat which the donor uses regularly for his holidays
- a picture displayed in the donor’s home
- the transfer of shares in a company where the donor retains an option to buy back the shares
Tax consequences of a gift with reservation
Tax on the death of the donor
The GWR provisions give rise to a charge to IHT on the death of a donor if he has made a gift of property which fits the definition of a GWR described above. Essentially, the gifted property is taxed, at the market value at date of death, as part of his estate as if he still owned it. If a donor has given up a previously retained benefit, the release of the reservation is treated as a Potentially Exempt Transfer (PET) at the date of the release.
Consequently, if the donor gives up the benefit at any time during the seven years before he dies, the value of the property at the date of the release will be brought into charge on the occasion of his death, as it is deemed a PET. A release of a benefit earlier than seven years before death will not be taxable as it occurs before the ‘relevant period’. Where the deemed PET becomes chargeable, it does not benefit from the annual exemptions.
Tax on the initial gift
An initial gift, which turns out to be a gift with reservation, is also a transfer of value at the time it is made just like any other gift. It may be:
- a Potentially Exempt Transfer (PET) (HMRC IHTM04057 onwards http://abytx.co/1fe6R2f), or
- a Chargeable Lifetime Transfer (CLT) (HMRC IHTM04051 onwards http://abytx.co/I3vr8o).
If it is a PET, there is no tax charge when it is made. However, the gift will be brought into charge if the donor dies within seven years of making the gift. If he has retained a benefit in the gift, it will also be taxed as part of his estate on death.
If it is a CLT in excess of the available nil rate band, it will be subject to the Lifetime Charge when it is made. It may also be subject to the additional charge on death if the donor dies within seven years of making the gift.
Double charges relief
As explained above, property subject to a reservation is potentially liable to a double charge to IHT if the initial gift occurs in the seven years before the death of the donor. Both the initial gift and the reserved benefit become taxable. The IHT (Double Charges Relief) Regulations provide that only one charge to tax will apply, and that will be the charge that yields the higher amount of tax. Two alternative calculations of the total tax arising on death are carried out:
- the property subject to a reservation (or release of reservation) is included in the death estate, but the initial gift is ignored. The value used is the market value at the date of death or release.
- the initial gift (PET or CLT) is included in the calculation of the charge on death, but the property subject to a reservation is excluded from the death estate. The value used is the market value at the date of gift.
Rising property values and the availability of taper relief will tend to make the first calculation yield the higher amount of tax, but other elements can skew the expected result, particularly where the deceased has made other gifts. Except in the most obvious of cases, it will be necessary to consider the detail of each potential charge.
The HMRC guidance concerning double charges relief can be found at IHTM14691 onwards (http://abytx.co/1isKbuU).
Other tax considerations
It is important to bear in mind that although the GWR provisions treat the gifted property as included in the estate of the donor, this is purely an anti-avoidance fiction for the purposes of charging inheritance tax. Legal and beneficial ownership of the gifted property is transferred to the donee. As a result:
- if the donee were to die before the donor, the property would be included in the donee’s estate for IHT purposes
- when the property is sold the donee is liable for capital gains tax. Therefore, on the death of the donor who has reserved a benefit, the gifted property is subject to inheritance tax as part of the donor’s estate and
- when sold, capital gains tax on the gain which has arisen over the period of the donee’s ownership. There is no ‘tax free uplift’ on death under Section 62 Taxation of Chargeable Gains Act (TCGA) 1992 (http://abytx.co/1jkyVhR) because the owner has not died.
There are a number of useful exceptions to the general rule providing practical benefit to families.
Spouses and civil partners
In keeping with the IHT exemption for gifts between spouses and civil partners, such gifts enjoy an exemption from the GWR provisions. Without it, couples would not be able to take full advantage of the general spouse exemption since, in practice, they share their assets.
De minimis provisions
The legislation moderates the strict application of the rules by use of the phrase ‘virtually the entire exclusion of the donor’. According to HMRC interpretation, the GWR regime does not apply to gifts where the benefit to the donor is insignificant in relation to the gifted property. HMRC guidance outlines a number of scenarios in which a limited benefit to the donor does not trigger the gift with reservation provisions, which can be found at IHTM14333 (http://abytx.co/IfdEtY). The acceptable benefit they envisage is indeed limited: for example, if a donor makes a gift of his house and then stays there as a guest of the donee for more than one month a year, he will fall foul of the GWR rules.
A gift of land or chattels is not a GWR if the donor pays full consideration in money or money’s worth for his occupation or enjoyment. If a parent gives his home to his children and continues to live there, he can avoid the GWR provisions if he pays them a market rate for occupation. The IHT value of his estate will be reduced by the value of the home, and in addition the rent he pays will continue to reduce his estate (or prevent it from increasing in value). This strategy will only be a viable option if the donor has sufficient resources to pay the rent and the rent is kept under review to maintain it at the market rate.
The recipients of the gift will be liable to income tax on the rent.
Gift of a share in land
The owner of land may make a gift of a share of it, so that it becomes jointly owned. Whether the property is owned as joint tenants or tenants in common, each owner shares an entitlement to the whole of the property. This is referred to as an undivided share. A gift of an undivided share in land, which is occupied by the donor is, on first principles, a gift with reservation. If a mother gives a share in her house to he daughter, the value of the whole property will be included in her estate on death under the GWR provisions.
However, a gift of an undivided share is not a GWR when the donor and the donee share occupation of the land, and the donor does not receive any benefit at the expense of the donee, other than a negligible one. This exception covers the situation where family members, or an unmarried couple live together. The owner of the property may give a share of it to the co-habitant. The share given may be more than half. In order to establish that the donor is not receiving a benefit at the expense of the donee, it is important that he pays at least his share of the household maintenance expenses.
Changed circumstances following a gift of land
A donor may make a gift of land in which he reserves no benefit and has no intention of occupying it in the future, but due to unforeseen circumstances, he does in fact derive a future benefit from it. Typically, such a situation will arise when a parent gives away the family home to a child to move into a smaller house or flat or to sheltered accommodation. Because of ill-health, he finds that he cannot live alone and he moves back to the family home to be looked after by his child. The legislation provides a very specific exception for these circumstances.
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