UK residential property owned by non-domiciliaries; unexpected announcement of IHT charges for lenders and borrowers
The Government announced in the Summer Budget 2015 that from April 2017 non-UK domiciled individuals will no longer be able to shelter their UK residential property from inheritance tax ("IHT") by holding the property in an offshore structure. This change was proposed as part of a package of further reforms to the taxation of non-UK domiciliaries. As part of its reforms the Government also proposed that loans made between people who are connected with each other should no longer be used to achieve a deduction from the value of UK residential property for IHT purposes.
In December 2016 the Government published its response to a further consultation on the reforms stating that "only minor amendments" had been introduced. The Government now intends to take a different approach to connected party loans which may give rise to very significant new IHT charges for lenders and borrowers. These will apply where loans are made for the purchase, maintenance or enhancement of UK residential property to non-domiciled individuals, trustees of settlements created by non-domiciled settlors, close companies or partnerships. As a result the scope for imposing IHT charges is now much wider than originally expected. The proposed new IHT charges are summarised as follows:
- Loans to acquire UK residential property – a charge on the lender
Loans made to a non-UK domiciled borrower to buy, maintain or enhance UK residential property will continue to be deductible by the borrower for IHT purposes but may now give rise to a charge to IHT for the lender if the lender is within the scope of IHT (i.e. where the lender is an individual, partnership or a company owned by a small number of participants). This charge potentially applies to all loans, even a loan by a lender unconnected to the borrower, including a commercial loan made by a Bank if the Bank is a close company (i.e. broadly speaking a company owned by a small group of individuals).
- Security provided for loans to acquire UK residential property – a charge on the borrower
Assets which a non-UK domiciled borrower makes available as security, collateral or guarantee for a loan to buy, maintain or enhance UK residential property, (which is sometimes known as "back to back lending" and which we refer to here as "Collateral Security") will be treated as property subject to IHT in the hands of the borrower. This will bring within the scope of IHT any foreign Collateral Security (UK assets are already within the scope of IHT). The implications of this are far reaching. Borrowers may have pledged significant foreign assets possibly with a value exceeding the value of the UK residential property which may all potentially become subject to an IHT charge at the rate of 40%.
For example, if X, a non-domiciled individual, purchases a UK residential property for £1m with the assistance of a £0.5m loan from Bank Y, and Bank Y requires that X makes his property in Doha (worth £2m) available as security for the loan, the full value of the property in Doha could be subject to IHT. If the loan is outstanding on X's death, X's executors can deduct the value of the loan outstanding from the total value of the UK residential property and the property in Doha. The remaining value will be subject to IHT. Therefore X's estate will potentially be liable for IHT on assets valued at £2.5m (being the Doha assets worth £2m plus the UK property worth £1m less the loan of £0.5m).
It is not known if the Government intended this outcome and it is possible that it may amend the draft legislation before 5 April 2017 to limit the scope of the charge, perhaps to the value of the UK residential property.
- Rights of participators in close companies and partnerships – charges on participators and partners
Rights and interests that a participator has in a foreign close company, or that a partner has in an offshore partnership, which are directly or indirectly attributable to a relevant loan (i.e. to a loan to buy, maintain or enhance UK residential property) or to the Collateral Security for such a loan will now come within the scope of IHT.
What you should do
Borrowers and lenders should review the terms of their loan agreements and consider solutions, particularly in case the Government does not amend the draft legislation before April 2017 to limit the scope for charging IHT on Collateral Security.
Solutions may include:
(a) ensuring that the loan is deductible for IHT purposes
(b) amending the loan agreement to limit the value of any foreign Collateral Security to the value of the borrower's UK residential property; or
(c) obtaining insurance to cover the IHT risk.
It is important to note that it is what the borrower does with the funds that is relevant, and not the intention of the lender when the loan is made. When loans are made lenders will need to make enquiries about what the borrower intends to use the funds for and to keep this under review, in order to identify any exposure to IHT under the new rules.
If you would like to discuss the implication of these proposed reforms please contact one of the following members of our private client team:
Penny Wotton at firstname.lastname@example.org
Amanda Gordon-Napier-Tompkinson at Amanda.email@example.com
Olga Tabenko at firstname.lastname@example.org