The UK’s HM Revenue and Customs (“HMRC”) has recently changed its view about the location of specialty debts for inheritance tax (“IHT”) purposes. A specialty debt is simply an agreement to repay a loan which is set out in a document which satisfies the (relatively straightforward) formalities to be a deed.1
Under HMRC’s previous practice, specialty debts were treated as located in the country or state where the deed containing the specialty debt was located. On 23 January 2013, however, HMRC announced that it regarded this as probably incorrect and that specialty debts should instead be treated for IHT purposes as located in the jurisdiction where the borrower lives or is resident.
This change of view is mainly relevant for non-domiciled individuals because of the rule for IHT that UK assets owned by a non-domiciliary are subject to IHT, whereas non-UK situated assets fall outside the scope of UK IHT.
HMRC’s previous view was based on case-law and although artificial it had been accepted practice for many years. Although HMRC say that their new view is based on advice that they have received, they have not indicated the nature of this advice. It is possible that their new view is wrong in law and that they will revert to the previous long established practice. However, it might take some time for the position to be established one way or the other.
Which debts are affected by HMRC’s change of view?
The normal rule for loans which are not specialty debts is that they are situated for IHT in the state where the debtor (borrower) resides. But until HMRC’s recent announcement the accepted position was that if the loan repayment obligation was set out in a specialty deed kept outside the UK, then the benefit of the loan was a non-UK situated asset. It was thus outside the scope of IHT if owned by a non-domiciliary. Likewise if a non-UK situated specialty debt was held in a trust set up by a non-UK domiciliary, it was outside the UK IHT net.
There was some doubt about the position where the specialty debt was secured on UK land, but probably the correct (and safest view) was that this was UK situated. Therefore HMRC’s change of view in practice only affects speciality debts that are not secured on UK land.
Who is affected by HMRC’s change of view?
If HMRC maintain their new view and it proves to be correct, then non-UK situated specialty debts repayable by a UK borrower and held by a non-UK domiciliary would be within the scope of UK IHT. This would mean that on the death of such an individual the value of the specialty debt would be within his/her estate for IHT and so subject to IHT.
Similarly there would be IHT implications if such an individual were to make a gift of such a specialty debt. If it were a gift to another individual there would be a potentially exempt transfer on which in principle IHT would be payable if the donor were to die within seven years after making the gift. A gift to a trust in principle would be immediately chargeable to IHT.
If such gifts have been made in the past the question arises whether HMRC would try to claim IHT retrospectively. The issue would then be whether taxpayers should be entitled to rely on HMRC’s previous guidance about the situs of specialty debts. If HMRC maintain their revised view, this would probably have to be established by a case brought before the UK courts.
There would also be tax implications for trustees holding specialty debts repayable by a UK borrower. For example, in the case of a discretionary trust the specialty debt might now be viewed by HMRC as within the scope of the special ten yearly charges and exit charges applicable to such trusts. If such charges would have arisen in the past on the basis of HMRC’s current view, there would now be the risk of HMRC trying to revisit these.
Note, however, that HMRC cannot go back for more than four or possibly six years in revisiting old charges (except in cases of deliberate wrongdoing by the taxpayer).
What action should be taken by those who are affected by HRMC’s change of view about the situs of specialty debts?
For individuals or trustees currently holding one or more specialty debts repayable by UK borrowers the question will be whether they need to take any steps in view of possible future IHT charges. For example, it should be possible by transferring the specialty debt to a non-UK company, to take it outside the UK IHT net. However, there could be other tax implications of doing this and care would be needed.
Are any other taxes (beside IHT) affected by HMRC’s change of view?
HMRC’s change of view is only relevant to IHT.
There is a separate rule about the situs of debts for capital gains tax. Here the position is that the debt is situated in the UK only if the creditor is UK resident.
For income tax the question is where the source of the interest on such debt is located. If it is in the UK then basic rate income tax must be deducted from the interest payments. Previously HMRC had rejected the argument that this requirement did not apply to interest payable on specialty debts held outside the UK. This is to be confirmed in legislation contained in the Finance Bill 2013 which will provide that the source of interest on a specialty debt is to be decided without reference to the situs of the specialty itself.
Conclusion
The correct IHT position regarding the situs of specialty debts has been thrown into confusion by HMRC’s recent change of view. In many cases it might be best for individuals and trustees who are potentially affected simply to wait and see how the issue is finally resolved. However, a final resolution could take some time to emerge. At worst, the position might have to be settled for the future by legislation.
Non-UK domiciliaries or their trustees who hold specialty debts might therefore need to review their IHT position. In some cases they will need to consider whether to take action to protect such specialty debts from possible future IHT charges, for example, by transferring the affected specialty debts to a non-UK company, bearing in mind that such steps might themselves have UK tax implications and, depending on the circumstances, tax implications in other jurisdictions.
In cases where HMRC’s change of view affects the IHT treatment of past gifts or other transfers, or tax in relation to discretionary trusts, it will probably be best to wait and see how the situation is finally resolved. In any event, in most cases (and in the absence of wrongdoing) HMRC should be able to take into account potentially taxable gifts or other transfers only in the past four to six tax years.
Footnotes
1 The requirements for a document to be a deed are usually straightforward; for example, the document must contain a statement that it is a deed and certain formalities must be followed when it is signed.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
