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Private client briefing for May 2013

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The Upper Tribunal has reversed a First-tier Tribunal ruling that a furnished holiday lettings property qualified for business property relief. The new US Medicare tax may result in an increased tax burden for UK-resident US taxpayers. The proposed changes to the treatment of liabilities for IHT purposes create uncertainties for executors and make tax planning difficult. Charities and community amateur sports clubs may need to adapt their procedures as a result of some changes which took effect in April.

Key developments this month are as follows.

Pawson: UT rules out BPR for holiday letting business

Last year, the First-tier Tribunal (FTT) in the case of Pawson’s Personal Representatives v HMRC [2012] UKFTT 51 found that a furnished holiday let (FHL) should not be considered an investment for IHT business property relief (BPR) purposes. However, the Upper Tribunal ([2013] UKUT 050 (TCC)) has now reversed that ruling, which had given some hope to holiday home owners that they would be able to claim relief from IHT for holiday homes run as businesses.

The property in question, located in Thorpeness in Suffolk, was let fully furnished as a holiday home, and was jointly owned by Nicolette Pawson (the deceased) and members of her family. The deceased held a 25% share in the property and it was accepted by the FTT that the property had been run as a business for more than two years before the deceased’s death.

The FTT also accepted that although the family’s use of the property for three weeks a year reduced the level of activity, it was not sufficient to prevent it from being run as a holiday let business. The FHL had been profitable for two of the three years before the deceased’s death, and was running profitably in the year of her death. The FTT concluded that the business was being run with a view to gain, satisfying IHTA 1984 s 103(1).

Since 2008, HMRC has generally sought to apply a stricter interpretation of the availability of BPR for FHLs for IHT purposes, stating that it would look more closely at the level and type of services provided to holiday makers, rather than who provided them.

The Upper Tribunal considered: ‘The relevant test is not the degree or level of activity, but rather the nature of the activities which are carried out.’

Overall, Mr Justice Henderson stated that in any normal property letting business, the provision of additional services or facilities of a non-investment nature will either be incidental to the business of holding the property as an investment or at least will not predominate to such an extent that the business ceases to be one of holding property as an investment. He, therefore, went on to conclude that the FTT should have found that ‘the business … did indeed remain one which was mainly that of holding the property as an investment. The services provided were all of a relatively standard nature, and they were all aimed at maximising the income which the family could obtain from the short-term holiday letting of the property’. The judge stated that it was a typical example of a property letting business.

Why it matters: This ruling will disappoint many FHL owners. Clients should review their FHLs with regard to whether the nature of the services provided results in the property being held not mainly as an investment. A possible appeal may be made; until then, this remains the current authority on FHLs.

US tax update

Following the last minute two-year extension in December 2010, the Bush era tax cuts were scheduled to expire on 31 December 2012. As a result, on 1 January 2013, US Congress passed the American Taxpayer Relief Act 2012 (ATRA), which has been subsequently signed into law by President Obama.

For the majority of UK-resident US taxpayers, the increase in the income tax rates to 39.6% and the reintroduction of the phase-out of itemised deductions and personal exemptions for taxpayers earning over a certain level will have little impact. The 2013/14 top rate of UK tax is still higher at 45%; therefore, the relief for foreign tax credit should mean that no further tax is payable to the IRS in respect of the individual’s UK earnings.

However, some US taxpayers may see an increase in their worldwide tax rate where they have significant unearned investment income, which is now subject to the new 3.8% Medicare tax. This change was introduced in 2010, rather than in ATRA; this new tax is payable from 1 January 2013 on interest income, dividends, rents, capital gains and other investment income.

There have been suggestions that US taxpayers who are subject to UK national insurance would be exempt from the new Medicare tax under the UK/US totalisation agreement. It has also been suggested that foreign tax credits may be used to offset the charge. However, indications from the IRS are that neither of these reliefs are available, resulting in a real increase in the tax burden of some US taxpayers wherever they are resident.

The new legislation has reduced the estate tax planning uncertainty by permanently setting the estate tax rate at 40% and the exemption amount at $5m, adjusted annually for inflation from 2011. It had been expected that the exemption amount would be reduced, so the continuation of the estate and gift tax exemption at the $5m level has been regarded as a welcome surprise.

Why it matters: With individuals now given more certainty in respect of estate and gift tax within the new legislation, they can consider making lifetime gifts to reduce future estate tax liabilities.

Treatment of liabilities for IHT purposes

We outlined the proposed changes to the treatment of liabilities for IHT purposes in our article published last month (‘The private client briefing for April’, Tax Journal, dated 19 April). However, a number of uncertainties arise from the draft legislation and explanatory notes, which may make any tax planning or a review of existing IHT exposure difficult.

Currently, personal representatives (PRs) of an estate must submit the IHT account and pay the IHT liability on a deceased’s estate before a grant of representation can be applied for. The PRs will often be unable to settle a liability outstanding at death without raising funds from the sale of other assets in the estate, which they cannot do without the grant of representation. Under the draft legislation, the liability may therefore not be deductible for IHT purposes at the point the IHT account is submitted;  as such, the PRs will need to pay IHT on the gross estate, presumably having to submit a corrective account and claim a refund at a later date once the liability has been discharged. This could cause issues if the value of the loan is significant.

The legislation places the burden of proof on the PRs to show that there is a ‘real commercial reason’ for the liability not being repaid. This would seem unfair on PRs who may not be aware of or understand the motivation behind a particular arrangement.

With regard to the restriction of liabilities to any excluded property or BPR, APR or woodland relief qualifying property which the borrowing was used to acquire, it is unclear from the wording of the draft legislation as to whether property must qualify as excluded property or relievable property from the date on which it was purchased for the relevant sections of the draft legislation to apply.

If the applicable date for excluded property is the date of acquisition then, should that property subsequently cease to be excluded property, the liability may still not be deductible, assuming the excluded property had not been disposed of. The taxpayer would therefore have an asset subject to IHT but without the benefit of deducting the liability attached to it. There is no guidance provided as to how liabilities should be split where the borrowing has been used to acquire property that is part qualifying and part non-qualifying, i.e. whether the liability would be pro-rated based on the acquisition values of the qualifying and non-qualifying elements or their values at the date of transfer; the proportions of these may be different, or there may in fact have been no qualifying element at the date of acquisition.

Why it matters: Concerns and comments from leading professional bodies have been submitted to HMRC in respect of the draft legislation and we await the outcome. In the meantime, the uncertainties make it difficult for clients to fully review their affairs and undertake any tax planning to mitigate their IHT exposure.

Charities online

From 22 April 2013, charities and community amateur sports clubs (CASCs) can sign up to make repayment claims electronically. HMRC states that the new service will make repayment claims faster and easier by filing online. The current R68(i) print and post repayment form will be replaced by three options for making claims:

  • online claim form via HMRC portal;
  • online claim via third party software; and
  • new paper repayment claim form ChR1.

The existing R68(i) will continue to be accepted until 30 September 2013. However, HMRC recommends that trustees use one of the three new options wherever possible.

Additionally, the gift aid small donations scheme (GASDS) came into effect from 6 April 2013, allowing eligible charities and CASCs to claim top-up payments from HMRC on small cash donations that they receive after 6 April 2013.

A charity or CASC can claim a top-up payment on up to £5,000 of small cash donations in a tax year, provided it:

  • is a charitable trust or a charitable company, recognised by HMRC as a charity for tax purposes, or a CASC;
  • makes claims under gift aid;
  • has existed for at least the last two complete tax years;
  • has made a successful gift aid claim in at least two out of the last four tax years; and
  • has not incurred a penalty on a gift aid or GASDS claim made in the current or previous tax year.

A claim under GASDS by the charity or CASC will be made using one of the three gift aid repayment claim options outlined above.
The charity must keep a record of the date the cash was collected and who collected it. Records will be required to substantiate any claim for top-up payments under the GASDS, including keeping records of the amounts collected, when and by whom. A record of any donations over £20 must also be made to ensure they are not included in a claim under GASDS.

Why it matters: Trustees should ensure that they are aware of the changes and take the necessary steps now to ensure that they are ready for the new procedures, including making sure that they have full donor details for inclusion on the repayment claims. Trustees intending to use HMRC online will need to sign up for HMRC online services. Larger charities may need to look into available software or ensure that their current software is compatible with the HMRC online system.