George Brown’s long reign as Chancellor was marked by a series of complicated and elaborate additions to the already large volume of tax legislation. Each individual item can be excused as an attempt either to counter tax avoidance or to make the system fairer, but the overall effect was to produce an unmanageable mass of new and unfamiliar rules.
In no case is this more obvious than in that of the 2004 legislation on Pre-Owned Assets. A fundamentally reasonable idea has become so complicated and obscure in practice that very few people on either side of the tax profession understand it and one suspects that it is often omitted from consideration and that very little tax is raised.
The basic idea is to counter a long-established piece of Inheritance Tax planning, in which the ageing owner of an asset gives things away to those to whom he was intending to leave them in his will, in the hope that he will live for another seven years, and that they will be outside his estate for tax purposes. The Revenue regard this as avoidance to be discouraged, which makes one wonder why the seven year rule was introduced in the first place!
In many cases, of course, the old person needs to retain the use of the asset, particularly if it is his home or the source of his income, and a long-established rule states that gifts such as this, known as those “with reservation of benefit”, never leave the giver’s estate, and this negated most of the arrangements. Over the years, however, ingenious advisers found ways round it, and, by 2004, many people were expecting amendments to the rule designed to make it more difficult for families to have their cakes and eat them in this way. The reliefs available against Capital Gains Tax on gifts had already meant that the scheme usually involved either businesses, private houses or cash, and there were predictions that the seven year period would be lengthened or even abolished altogether.
What actually transpired, however, was a complete surprise. Anyone retaining the use of an asset, such as a house, which he had once owned but had given away, would, in future, be liable to pay Income Tax on theoretical income based on the market value of the asset at the official rate of interest used by the Revenue. Thus a person living in a £300,000 house now owned by his son might find himself having to pay tax on extra income of 300,000 x 4%. Even at the basic rate, this would produce extra tax of £2,400 without any income out of which to pay it, but the striking thing is that it does not apply to anything caught by the reservation rule, which means that it rarely arises at all.
It was, however, startling to find that it was to apply to transfers made as long ago as 17th March 1986. It is an unusual tax charge in that the then government seem not to have wanted it to apply; if one had previously managed to avoid the reservation rule, one simply had to choose to be subject to it for the income tax charge to disappear altogether.
It did, however, counter an established scheme under which a parent might sell his house, free of CGT as his residence, give the money to his children and then live rent-free in a smaller house which they generously bought for him. Such arrangements were already unusual, but they now give rise to a tax liability which the parent might well be in no position to meet.
In the time since 2005, this strange provision has attracted little attention and there must be many people who ought to be paying it but are not doing so out of genuine ignorance. That is, however, no excuse, and anyone living in a house or using or benefiting from anything which he used to own but no longer does, would be well-advised to check the position before the Revenue notice and ask him for five years’ tax on income which he has not received!
It may be, of course, that the Income Tax payable in this way will be substantially less than the Inheritance Tax due if the house is treated as a part of the estate; if so; it might be fair for the children, who would otherwise suffer the IHT, to help their parents out with this unexpected Income Tax!
This article is not, and is not intended to be, a detailed account of the Pre-Owned Asset rules, which are of great complexity, but it is a warning to tax practitioners and clients not to forget about this elusive and widely forgotten trap. It is still there; whilst it does not find many victims; those whom it does catch will find the experience very expensive, all the more so as 2005 recedes into the past and the number of years increases.