Trusts and Tax

Inheritance Tax – Nil-rate-band discretionary trusts

The implications of Phizackerley for married couples

The ruling by the Special Commissioners in Personal Representatives of Phizackerley v HMRC [2007] SpC 591 has attracted many headlines and caused much concern to married couples who have made use of nil-rate-band discretionary trusts to maximise the use of the inheritance tax nil-rate-band and to minimise IHT on the deaths in turn of each spouse.

Headline writers have to attract attention.  "Brown hits trusts again" and talk of "a Revenue u-turn" rings political as well as financial bells, and ensures that the readers have something to choke on over breakfast. Whilst Phizackerley undoubtedly fits within the Chancellor's general intention to undermine IHT schemes, it needs sober reflection and careful advice rather than screaming headlines.

The ruling turns on the particular facts – the death of a non-working spouse before that of the spouse whose earnings paid for the property - and, whilst potentially relevant to thousands of families, does not undermine the effectiveness of a properly-drawn Will trust in most cases. It might have been appealed, not least on the grounds that it offends against modern principles of equality of contribution between working and non-working spouses, but the family chose not to appeal.

Before we look at the facts and the finding, what is the context? What is a nil-rate-band discretionary trust and what does it aim to achieve?

The tax and legal context

IHT is payable at 40% on the net value of assets owned by the deceased at the date of death to the extent that the assets exceed the nil-rate-band, currently £312,000. "Net" means the value after deducting debts or other charges to which the estate or any particular asset is subject. IHT is not payable on transfers between spouses, and each spouse has the benefit of his or her own nil-rate-band exemption – a small enough exemption having regard to property values and itself the subject of much criticism, but something we are stuck with.

The tax-planning objective is therefore to maximise the usage of both nil-rate bands and, where it can properly be done, to make full use of any charges which have the effect of reducing the net value.

For most families, the only relevant asset is the family home, which cannot physically be divided up on the first death. It can, however, be held by the couple as tenants in common (rather than as joint tenants) so that each half can be bequeathed separately – to the other spouse, to trustees, or to the next generation as seems appropriate. 

Leaving it to the surviving spouse simply bumps up the IHT liability on the second death. Shared ownership between the surviving spouse and the children or grand-children has tax as well as other more personal implications. It is common therefore to leave the deceased's half-share to trustees for the benefit of both the survivor and the children.

Whilst that maximises the dead spouse's IHT exemption, it also creates a potential Capital Gains Tax liability on the part of the trustees since they (unlike the human owners of the property) are liable to GCT on the eventual disposal of the house. It is common (and this was done in the Phizackerley case) for the survivor to treat the nil-band share as a debt owed to the trustees by the survivor.

That in turn has potential Stamp Duty Land Tax (SDLT) implications, avoided by the trustees creating a charge over their share of the property enforceable against the property rather than against the surviving spouse.

A final wrinkle – and one which proved relevant to the Special Commissioners' finding – is that under S103 of the Finance Act 1986 debts may not be deductible in computing the net value of the estate if there have been relevant gifts between husband and wife in their lifetime. S103 itself has defences and exemptions which turn on the individual facts and which must be navigated with care.

This much-simplified summary demonstrates that there is more to nil-rate discretionary trusts than simply providing that part of a property is left to a trust. It follows that the specific circumstances may give HM Customs & Excise room to argue that the intention has failed. Where did the Phizackerleys fall down?

The facts of the case

Mrs Phizackerley had not worked during her married life and Professor Phizackerley was the sole earner of the cash which had bought the house.  She died first and left her nil-rate sum to the trustees of her Will.  Her interest in the house went to her husband in exchange for his IOU for £150,000 given to the trustees.

When he died, his executors sought to deduct that debt from the net value of his estate. The matter came before the Special Commissioners because HM Customs & Excise said that S103 made the debt non-deductible.

The IHT implications for others

Anyone who has set up analogous arrangements must take note of this decision, and many will be adversely – and unavoidably – affected by it, particularly in those cases where the first death has already occurred and where the trustees and the surviving spouse are stuck with facts which parallel those recited here.

But this does not mean that nil rate band discretionary trusts are dead as a means of mitigating IHT.

Bear in mind the following:

The fact that Professor Phizackerley was the sole contributor to the purchase of the house was a fact which was agreed. It has long been accepted in divorce law, however, that the financial contribution of the only working spouse is by no means the only contribution to be taken into account.

The debt and related charge were created by the surviving spouse which is what brought S103 into play. Had the assets been originally acquired subject to the charge (or simply left to the trustees), it is unlikely that the S103 point would have been taken or would have succeeded.

There were subsidiary arguments as to whether the husband's provision of value to his wife were for her maintenance, in which case the transfer would not have been a transfer for value and would not have been caught by S103. The Phizackerleys lost this argument on their facts and, whilst the finding will certainly be persuasive in subsequent cases, will not be conclusive in all such cases.

Within limits, a Deed of Variation may be used retrospectively to organise the affairs of a deceased person, which may rescue arrangements which now seem at risk.

The finding was not appealed further; a different answer may have come out of a higher decision.
 

Conclusion

The Phizackerley case is certainly important and many will pay more tax as a result. The nil rate band discretionary trust will doubtless continue to be the subject of attack by the Revenue and, for our part, we prefer that potential difficulties are flushed out now and addressed in the drafting than that our clients (or their heirs) should find out too late that their arrangements are challenged on grounds not in contemplation at the drafting stage.

What is clear is that any arrangements which depend on similar facts should be reviewed, and quickly.

To discuss your own situation or to make an appointment, contact Felix Appelbe or Andrew Penfold on 020 7242 7000 or use the Contact Request Form.

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