TAXATION OF PRE-OWNED ASSETS

Background

If you give away assets during your lifetime the gift will in most cases be a Potentially Exempt Transfer and will become completely free of Inheritance Tax if you survive seven years after the gift. However, if you continue to derive any benefit from the asset which has been given away, for example by giving your house to your children but continuing to live in it rent-free, this will be a Gift with Reservation and will be ineffective for Inheritance Tax purposes until the benefit ceases.

Much tax planning in recent years involving the family home has centred around schemes which seek to avoid the Gift with Reservation provisions, whilst enabling the donor to continue to live in the house without paying rent. The Government included provisions in the Finance Act 2004 for the taxation of pre-owned assets to counter-act much of these schemes. In general terms, these provisions impose a Pre-Owned Asset Tax (POAT), which is an Income Tax charge on the donor where an asset has been given away at any time since 17th March 1986, but the donor continues to use it, in situations where the transaction is not treated as a gift with reservation. The relevant provisions are in Section 84 and Schedule 15 of the Finance Act 2004.

Details of the Charge to Pre-Owned Asset Tax

The details of POAT are complex and its full effect is still to some extent uncertain, despite the publication by the Inland Revenue of Technical Guidance Notes in March 2005, shortly before the introduction of the new tax on 6th April 2005. There are separate rules for the tax treatment of land (including buildings), chattels (e.g. furniture and paintings) and intangible property (e.g. an interest in a Trust and money in a bank account).

Land and Chattels

Where the donor occupies or uses any land or chattels (either alone or with other persons) and has previously disposed of that asset at any time after 17th March 1986, or has gifted the funds to enable someone else to acquire the asset after that date, the donor will be liable to POAT as an annual Income Tax charge with effect from 6th April 2005. In the case of land, the tax will be payable on the open market rental value. In the case of chattels, the tax will be payable on the notional interest on the value of the asset and the initial rate of notional interest is 5%

For example, in cases where POAT applies:-

1. if the annual rental value of a house subject to POAT is £10,000, a higher rate taxpayer would have an additional Income Tax bill of £4,000 per annum;
2. if a painting worth £120,000 is subject to POAT, the notional interest is £6,000 on which a higher rate taxpayer would pay Income Tax of £2,400 per annum.

Intangible Property

In the case of intangible property - such as stocks and securities, insurance policies and bank accounts - POAT is payable on the annual value which is again on the basis of a notional rate of interest, as in the case of chattels, currently 5%.

Gifts with Reservation

POAT does not apply to any transaction which is treated as a Gift with Reservation. The Act allows a taxpayer to elect to opt back into the Gift with Reservation provisions. Where such an election is made, the property goes back into the donor's estate for Inheritance Tax purposes, although the gift will still be effective for all other purposes.

Reliefs and Exemptions

The Act lists a number of "excluded transactions" and exemptions which do not create a liability to POAT. These include –

1. a transaction at arms' length;
2. a transfer to a spouse;
3. small gifts, of up to £3,000 per annum;
4. a gift of money made at least seven years before the date on which the donor began occupation of the land or obtained possession of the chattel;
5. transactions which are within the Gifts with Reservation provisions;
6. a gift of a part share of an interest in land which the donor and donee both occupy (e.g. a half share of a house) and where both parties share the living expenses in proportion to their shares of ownership;
7. a de minimis provision where the value of the benefit does not exceed £5,000 in the year of assessment;
8. where full consideration is paid for the donor's continued occupation or use of the property – this must be supported by relevant documentation, such as a Lease or other written arrangement.

Some Practical Implications

1. "Double Trust Schemes" involving transfer of houses were widely used in England and give rise to a POAT liability. Because of differences between English and Scots property law such transactions gave rise to Stamp Duty in Scotland and were seldom used.
2. If a parent makes a gift of money to his or her child which is used to buy a house and the parent moves in to that house within seven years of the gift, POAT applies.
3. A disposal of a part share in a house or other property gives rise to difficulty unless, following the disposal, the donor and donee both occupy the property, each paying their share of the household expenses. In cases where the donee does not actually occupy the property (e.g. notwithstanding an agreement which says he may occupy based on his proportion of ownership) POAT may apply. For example, if parents had transferred a one-quarter interest in their holiday house to each of their three children, retaining the other one-quarter themselves, and if they had entered into an agreement stating that each may occupy the house for a proportion of the year based on the proportion of each's ownership, this should not give rise to a tax problem if all actually use the house. If, on the other hand, two of the children are overseas and never use the house, there may be a liability on the parents to POAT;
4. In cases where a large proportion of a holiday house has been transferred, with the donor retaining a small proportion, it may be preferable for the taxpayer to make a gift of his or her remaining proportion but to enter into an agreement with his or her children to pay rent for a certain number of weeks in the year.
5. The de minimis provision is useful, particular in cases where a small proportion of a house has been transferred where the annual value is likely to be less than the £5,000.