The Finance Act 2013 has introduced new rules regarding the deduction of debts from Inheritance Tax (IHT), which all business property owners and advisers should be aware of.
IHT is normally charged on the net value of a deceased person’s estate. This is after deducting debts outstanding at the date of death, taking into account any relevant IHT reliefs and exemptions, and the nil rate band (currently £325,000) if available.
One of the most pertinent changes is the new rule dealing with debts incurred to finance properties which qualify for IHT relief. Agricultural property relief (‘APR’), woodlands relief and business property relief (BPR) collectively known as ‘relievable property’ attract 100% tax relief in certain circumstances. The government has made these changes seeking to block a ‘double deduction’ for IHT purposes.
Take for example Mr Bieber who dies in December 2013. His estate consists of his home worth £725,000 and a loan of £400,000 which he took out three years ago against his home to buy Alternative Investment Market (AIM) shares worth £600,000. These shares qualify for 100% BPR for IHT purposes so his total estate (£1,325,000) minus the exempted shares makes his net estate worth £725,000. Mr Bieber’s IHT status before the changes would be that he has no IHT to pay once the £400,000 loan and nil rate band of £325,000 are deducted from his estate.
The effect of the new rules (applying in relation to liabilities incurred on or after 6 April 2013) would be that Mr Bieber’s AIM share portfolio worth £600,000 would be reduced by the home loan liability of £400,000. The remaining £200,000 would still be eligible for BPR at 100% and Bieber’s remaining estate of £725,000 would be reduced by his nil rate band of £325,000, leaving £400,000 chargeable to IHT at 40%, i.e. £160,000 to pay.
Another example. Bill and Ben go into business together. They both need to put £1.5m into the business and they both have a house worth £2m each. Bill sells his £2m house; invests £1.5m in the business and buys a smaller house for £500,000. Ben borrows £1.5m against his house and invests that in the business.
Both Bill and Ben have £1.5m of business assets and £500,000 of net equity in their houses. Under the old rules, their net estates on death would have reflected this. However, under Schedule 34 of The Finance Act 2013, Bill’s taxable estate (on death after 2 years) will be £500,000, whereas Ben’s will be £2m. Both Bill and Ben have the same net wealth of £2m; the same investment in business assets – £1.5m; and the same net equity in their house – £500,000.
The reason for this is that Ben’s ‘double deduction’ is illusory. He is getting one deduction for his business property and another for the fact that the equity in the house is reduced by the borrowing. His borrowing represents a real liability that may have been incurred to finance his investment in business property, but would still exist if the business property lost all value. Bill equally has one deduction for his business property reducing the taxable value of that property to zero, and the means by which he financed his investment in business property (the sale of his £2m house and purchase of one for £500,000) reduced the value of his non-business assets.
The scenario may be extended further. A year after setting up the business, Bill decides that he does not like his smaller house, so he sells it and borrows £1.5m to move back into a house costing £2m at which point he is arguably in a position identical to Ben. Both have 1.5m invested in the business, both live in a £2m house, and both have a loan of 1.5m secured on their house. Yet under the new rules, if death occurs 2 years after financing the business, Bill will have a net taxable estate of only £500,000, but Ben will have a net taxable estate of £2m!
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