08 April 2023
Loans are commonly used to fund trusts and provide benefits to beneficiaries, but doing so can have UK income tax, capital gains tax (CGT), inheritance tax (IHT) and commercial implications. This article focusses on the IHT implications of loans and some hidden traps which can create unintended IHT charges for the unwary trustee.
Brief background on situs and loans
Trusts created by non-UK domiciled settlors are generally not subject to IHT to the extent that the trustees hold non-UK situs assets (known as ‘excluded property’).
Most loans are treated as UK situs (ie ‘relevant property’) if the debtor is resident in the UK (which can be difficult for trustees to keep track of). ‘Specialty’ debts created under deed are generally situated where the deed is held, but HMRC’s view is that a specialty debt is UK situs if secured on UK assets. Loans used to acquire an interest in UK residential property are also UK situs (more on that later). Where a trust holds a UK situs loan, IHT ten-year anniversary and exit charges, at up to 6% of the value of assets held or transferred on the relevant date, will apply.
Is the loan deductible from the debtor’s estate? Potential double IHT charges
A debt is generally deductible in calculating the value of the debtor’s estate on death, provided that:
- it is repaid after the debtor’s death;
- it was incurred for a consideration in money or money’s worth or was imposed by law; and
- the restrictions on liabilities used to finance excluded property, UK foreign currency bank accounts or property subject to business property relief (BPR), agricultural property relief (APR) or woodlands relief do not apply.
However, if the executors do not discharge the liability in full from the estate on death but still claim it as a deduction against the estate in calculating the IHT payable on the estate, interest and penalties may be payable.
The question of whether trustees should write off a loan on the borrower’s death is therefore complicated – and even more so if the trust is an offshore trust that has a ‘relevant income’ or ‘stockpiled gains’ pool, to which the write-off of the liability could be matched and taxed on the estate as a benefit provided from the trust. Writing off a loan may appear to be a good idea, but it can create four different potential tax charges – IHT payable by the estate, income tax or CGT payable by the estate on the benefit of the write-off by an offshore trust, and an IHT exit charge payable by the trust.
Loans and UK residential property
From 6 April 2017, the following loans are within the scope of IHT.
- loans made to finance, directly or indirectly, the acquisition, maintenance or enhancement, by an individual, partnership or trustees of a settlement, of a UK residential property interest; and
- loans made to finance, directly or indirectly, the acquisition, maintenance or enhancement, by an individual, partnership or trustees of a settlement, of an interest in a close company or partnership which holds or acquires a UK residential property interest.
If such a loan is repaid but the property is still held by the borrower, the repayment proceeds remain within the charge to IHT for two years after repayment.
Double IHT charges may be lurking if a company borrows and also owns assets other than UK residential property. This is because company debt is pro-rated across all its gross assets, even if it was used solely to acquire residential property interests.
For example: Trust 1 lends £1m to Trust 2 which on-lends it to an underlying company to acquire UK residential property for £1m. The company also holds other assets worth £2m, so it has gross assets of £3m and net assets of £2m. In this case the value exposed to IHT would be determined as follows.
Trust 1 has a relevant loan of £1m. This is subject to an IHT charge.
Trust 2 has gross assets of £3m (being the loan to the company and the value of the shares in the company), and net assets, after deducting the loan, of £2m. For IHT purposes only the value related to UK residential property is subject to IHT. But in calculating this figure the amount of debt deductible is restricted on a pro-rata basis over all the gross assets of the company, leaving only £333,333 (£1/£3m) deductible against the UK residential property, and £666,667 subject to IHT.
Note that if the UK property had been bought by a company only holding the £1m UK residential property, the full £1m loan would be deductible in Trust 2, leaving no IHT exposure in that trust and £1m subject to IHT in Trust 1.
Loans can create a tax headache for trustees, and loans related to UK residential property even more so. To avoid unnecessary tax charges, trustees should keep careful records of loans including the purpose of the loan and the tax residence status of recipients, and should consider segregating UK residential property from other assets where possible. If possible, trust assets should be reviewed at least three years before the trust’s ten-year anniversary and any proposed capital distributions, with a view to removing any loans from the IHT net for the purpose of calculating tax arising on those events.