New rules on the deduction of liabilities for Inheritance Tax purposes

New Rules on the deduction of liabilities for Inheritance Tax (IHT) purposes

New rules which affect loans secured against the family home, designed to save IHT, were introduced by the Finance Act 2013 and came into force on 6th April 2013. The rules only apply to arrangements put in place from 6th April 2013 – i.e. they do not have retrospective effect, as originally planned by the government.

Position before the new rules

Before 6th April 2013, a commonly used tax planning technique was for a taxpayer to raise a mortgage against his main residence and to use the monies raised to purchase business property, qualifying for 100% business property relief –  i.e. on the death of the taxpayer, no inheritance tax (IHT) was payable on the business property, due to the relief.  In a taxable estate, on the death of the taxpayer, the mortgage used to buy the business property could be deducted from the value of the main residence, thus reducing the taxable estate and tax liability.  For example, if the taxpayer borrowed £400,000 against a residence worth £1m to buy business property, the value of the residence was reduced for IHT purposes to £600,000 resulting in a substantial tax saving.  The business asset would not attract an IHT liability due to the business property relief.

Position after the new rules

Under the new rules, the value of the mortgage is treated as reducing the value of the business property and not the property (in our example, the main residence) on which a mortgage was raised. It is therefore only the excess value on the business property (if any) which attracts relief. In the above case, the full value of the residence is taxable at 40%.

Care will be required when existing borrowings are restructured or replaced after 5th April 2013.

The Finance Act also includes new rules which state that in order for a liability to be deductible on death (reducing the taxable estate), the liability must be paid on or after death, out of the estate.

When a liability is not so discharged, it will only be deductible if there are genuine commercial reasons for not repaying the debt and the debt must not be left outstanding as part of arrangements for which the main purpose is to secure a tax advantage.

It is, at this stage, not clear how these restrictions will operate in practice, as invariably a liability will be paid after a Grant of Probate is obtained and after an IHT account is submitted to HMRC – i.e. a deduction reducing the IHT liability will be claimed before it is discharged.

It is, however, likely that HMRC will accept liabilities being deducted from taxable estates before they are paid.

However, if the liability is not in fact discharged at a later date from the estate, HMRC will want to be informed so that the tax can be recalculated.

It is of course not unusual for debts within a family to be left outstanding and, therefore, care will need to be taken when administering estates where liquid funds are not readily available to pay existing debts.