Inheritance tax and the deductibility of debts

15 Nov 2020

country house with gate

Anti-avoidance provisions can limit the deductions that can be made when calculating the chargeable value of an individual’s estate for inheritance tax (IHT) purposes.

The rules are designed to stop individuals creating debts in order to reduce their IHT liabilities. Their scope, however, means that they may also apply in situations where IHT mitigation was not a primary consideration.

This factsheet gives an overview of the background to the rules, and their implications in practice.

The rules in overview

IHT is charged on the net value of an individual’s estate, after deducting allowable debts and liabilities. Debts secured on an asset will normally reduce the value of that asset for IHT purposes. The anti-avoidance rules restrict the deductibility of debts in certain circumstances, and apply to deaths and chargeable transfers on or after 17 July 2013. They cover three main areas:

  • Liabilities used to acquire ‘excluded property’;
  • Liabilities used to acquire an asset qualifying for an IHT relief; and
  • Liabilities that are not repaid after death.

Liabilities used to acquire excluded property

Individuals who are not domiciled or deemed domiciled in the UK are not liable to IHT on ‘excluded property’. Excluded property means property situated outside the UK, held directly by a non-domiciled person. It also includes such property settled into trust by a non-domiciliary.

It is worth noting here that, from 6 April 2017, holdings in overseas companies and other entities will not be excluded property to the extent that they derive their value from UK residential property. Specific rules apply to the IHT treatment of such holdings, and any associated debts, which are not considered further here.

Prior to the introduction of the restrictions on the deductibility of debts, a person could fund the acquisition of excluded property by taking out a debt secured on an asset subject to IHT. For example, an individual with a house in the UK could borrow against that house in order to purchase another property overseas. The overseas property would rank as excluded property and hence not be subject to IHT (unless the individual became UK domiciled or deemed domiciled). At the same time, the value of the UK property for IHT purposes would be reduced by the amount of the debt. This could have a significant impact on the individual’s contingent IHT liabilities.

To prevent this, from 17 July 2013, no deduction has been allowed for a debt, to the extent that it is used (directly or indirectly) to acquire, enhance or maintain excluded property. This measure applies irrespective of when the liability was incurred, so affects any debts in place at 17 July 2013 as well as subsequent ones.

When applying the restriction, the debt is taken to first reduce the value of the overseas asset funded by the loan proceeds.

Any excess borrowing may be allowable against the value of the UK asset which has acted as collateral, but this is subject to a number of conditions. In particular, the borrowing must not have been put in place to secure a tax advantage, it must not have increased (for example by reason of the accrual of interest) and the excluded property must not have been disposed of, in whole or part, to bring its value below the level of borrowing.

The debt will be allowable for IHT purposes if the excluded property is sold for full consideration and the proceeds of sale are used to purchase property otherwise chargeable to IHT. However, where a non-domiciled individual borrowed to finance excluded property which was later disposed of by way of gift or a sale at undervalue, the debt will continue to be ignored in calculating his estate for IHT purposes.

Similarly, if the trustees of a trust settled by a non-domiciliary incur debts in order to purchase non-UK situated assets, such debts will not be deductible in calculating any IHT periodic charges arising under the special IHT rules for property held in trust.

Liabilities used to acquire assets already subject to IHT relief

Where liabilities are incurred to acquire, maintain or enhance property which attracts an IHT relief, such as Business Relief (BR) or Agricultural Property Relief (APR), the liability now attaches to that property first and not to the asset on which the debt is secured. This will reduce the value of the relievable property before it reduces that of any property subject to IHT. The restriction applies to new debts incurred on or after 6 April 2013. Borrowings taken out before this date are not affected, provided that the loan terms are not amended subsequently.

The new rules affect farmers and business owners who secure liabilities on non-business assets, for example their home. It is not uncommon for an individual to take out a mortgage loan in order to invest in an asset qualifying for BR or APR. Historically, the debt would have reduced the value of the home for IHT purposes, with the business asset qualifying for BR. Now, however, the liability first attaches to the business asset, with only the excess (if any) deductible against assets subject to an IHT charge.

Similarly, trustees of a trust settled by a non-domiciliary may in the past have secured borrowing against a UK asset in order to acquire business or other relievable property, and in the process reduced or eliminated their exposure to the IHT 10-yearly periodic charge. This is no longer possible.

Liabilities that are not repaid

Under the new rules, a liability will only be deductible from the estate of a deceased person if it is repaid on or after their death, regardless of when it was first incurred. If the liability remains outstanding, there must be a ’real commercial reason’ for non-repayment and it must not give rise to a tax advantage. For non-repayment to meet the commerciality requirement, the terms of the loan must reflect the ‘arm’s length’ principle.

When it comes to completing an IHT return, HM Revenue & Customs’ (HMRC’s) expectation is that a debt will be repaid and hence all of the deceased’s liabilities at death may be deducted, unless the personal representatives are certain that a particular liability will not be discharged. If a debt for which a deduction has been claimed is not in fact repaid, the personal representatives will need to file a corrective account.

Partial repayment of liabilities

If a loan is taken out to finance both chargeable assets and those eligible for a relief or regarded as excluded property, subsequent repayments will be allocated firstly to the chargeable component. For example, where an individual borrows £500,000 secured on his home, uses £250,000 of the proceeds to invest in a business qualifying for BR and the remaining £250,000 to acquire non-exempt property, a later repayment of half of the loan will result in the residual debt of £250,000 being treated as reducing the value of the business asset. This approach clearly favours HMRC.

Foreign currency accounts

Foreign currency bank accounts held in the UK by individuals who are both non-resident and non-domiciled are not subject to IHT. This being the case, the anti-avoidance rules could be sidestepped by borrowing against a UK property and depositing the loan proceeds in a foreign currency UK bank account. The debt would then be deductible against the value of the estate and the monies comprised in the foreign currency bank account disregarded for IHT purposes.

Finance Act 2014 closed this loophole, by denying a deduction for the debt where it is used to fund a foreign currency bank account which is not itself chargeable to IHT.

In summary

The anti-avoidance rules on the deduction of debt seek to prevent individuals using borrowing as a means of mitigating their IHT liabilities.

It is, therefore, necessary to consider the purpose of the borrowing, and hence the likely impact on an individual’s future IHT liabilities, when taking out a loan.

Any remaining loans taken out before 6 April 2013 to acquire property which qualifies for an IHT relief can be ignored, provided their terms remain unchanged. However, debts to acquire excluded property are not deductible, regardless of when first incurred.

In all cases, professional advice should be sought before entering into arrangements involving significant amounts of debt.

This factsheet is based on law and HMRC practice at 1 March 2019.

For more information regarding any of the issues raised here, please speak to your usual Saffery Champness partner or Robert Langston, National Tax Partner.