Caught in the net

Pre-Owned Assets Tax (POT) was included in the Pre-Budget statement of December 2003 as part of a raft of tax avoidance measures. There followed an extended period of consultation with all the relevant professional bodies. The proposals found legislative form in section 84 of and schedule 15 to the Finance Act 2004; paragraph references are to that schedule.

Pre-Owned Assets Tax (POT) is an income tax charge which is effective from 6 April 2005 aimed at targeting perceived abuses of the gift with reservation (GWR) rules for IHT and being, in many instances, drafted by reference to those rules. However it is now realised that the POT rules have a much wider ambit than had initially been thought.

What does the charge cover?

There are three distinct POT charges, relating to land, chattels and intangible property.

Land. (paragraph 3) An individual can be liable where he occupies land which:

<>(a) he himself used to own; or(b) which was subsequently purchased from the proceeds of sale of land previously owned by him, and he has disposed of all or part of his interest (this is known as the “disposal condition”: see below); or

(c) which was acquired using funds provided by himself (this is known as the “contribution condition”).

Chattels. The structure of the charging provisions as they relate to chattels which are in the owner’s possession or of which he has the use, is the same as for land: paragraph 6. Chattels are defined in Scotland to mean any corporeal moveable property other than money: paragraph 1.

Intangibles. In relation to intangible property, the charge arises where the asset is comprised in a settlement and where there is an “interest” as defined by the Taxes Act 1988, section 660A (paragraph 8). This is expanded on below.

It is worth noting at this point that in relation to land and chattels (not intangibles), a former owner will escape POT if the asset was disposed of or the consideration was provided by way of an excluded transaction (paragraphs 3, 6).

Excluded transactions

The POT rules set out five general events which can constitute an excluded transaction in relation to the disposal of land and chattels, namely:

sales for full consideration;

outright transfers to spouses/former spouses;

settlements for spouses/former spouses;

gifts of cash more than seven years previously;

where certain GWR exemptions apply.

Paragraph 10 defines excluded transactions separately in relation to disposal conditions and the contribution condition.

The disposal condition

Defined in paragraphs 3(2) and 6(2), the disposal condition is made up of two alternative parts. The first part will be satisfied where, at any time after 17 March 1986, an individual has owned either an interest in the land he now occupies or the chattel he now uses or possesses, and has disposed of all or part of his interest in that asset.

The second part of the disposal condition applies where the land now occupied or chattel now possessed or used was not itself owned and disposed of by the individual but represents other property which was so owned and disposed of.

This part of the condition will be satisfied where at any time after 17 March 1986 an individual has owned an interest in other property, the proceeds of the disposal of which were applied by another person toward the acquisition of an interest in the land now occupied, or the acquisition of the chattel now possessed, and the individual has disposed of all, or part of, his interest in that replaced property.

The contribution condition

By paragraphs 3(3) and 6(3), the contribution condition is met where at any time after 17 March 1986 the individual has directly or indirectly provided any of the consideration given by another person for the acquisition of an interest in the relevant asset, or in any other property the proceeds of the disposal of which were applied by another person towards the acquisition of an interest in that asset.

The charge

Where a charge applies, income tax is charged on the amount calculated by reference to:

an assumed market rental of any interest in land; or

an assumed rate of interest in relation to the value of any chattels or intangibles.

There are transitional arrangements (paragraph 21) which allow the former owner to avoid the POT by electing for the asset subject to the charge to be treated as “property subject to a reservation” for IHT purposes; thus the asset in question will fall back into the estate of the former owner.

The charge in relation to intangible property

“Intangible property” is defined to mean “any property other than chattels or interests in land” (paragraph 1). This includes cash, shares (quoted or unquoted), life policies, insurance bonds and anything else that does not fall within the definition of “land” or “chattel”.

Broadly a charge will arise (paragraph 8) where:

(a) an individual has settled property (intangible or otherwise) at any time after 17 March 1986;

(b) the settled property is now intangible property which is or represents property which the individual settled or added to the settlement; and

(c) that individual has an interest in the income arising from the property under the terms of the settlement and in relation to which he is the settler (as defined by TA 1988, section 660A).

Section 660A defines what constitutes an “interest” in the income of a settlement for POT; however, it must be remembered that the definition has to be read as if the reference to the individual’s interest in income payable to his spouse were not included (paragraph 8(1)(b)).

Exclusions from the definition are contained in section 660A(4)-(9) and should any of these provisions apply, there will be no POT charge.

Income arising under the terms of the settlement

It is a requirement under the POT rules that: “the terms of the settlement, as they affect any property comprised in that settlement, are such that any income arising from the property” is treated by virtue of section 660A as that of the settler.

This specific wording was introduced to clarify the fact that a POT charge in relation to section 660A arises due to the fact that the individual has an interest as a result of the terms of the settlement and not for any other reason.

Settlements with different interests

Settlor-interested settlements that hold trust property partly in land and/or chattels and partly in intangibles will only face a POT charge in respect of the intangible assets (paragraphs 8(1)(c) and 9).

Reversionary interests

POT charge will arise where under the terms of the settlement, the settler has no beneficial right to the trust property during the “trust period” but the settled assets revert to him at the end of the “trust period”, and the property in the trust is not property subject to a reservation for GWR purposes.

Excluded property settlements

No POT can arise in relation to property held by the trustees of an “excluded property” settlement where the property was transferred by an individual who was neither domiciled nor deemed to be domiciled in the UK at the time of transfer (paragraph 12(3)).

An excluded property settlement is a settlement:

in which the property so comprised in the settlement is situated outside the UK; and

the settler was neither domiciled nor “deemed domiciled” in the UK at the time the settlement was established (Inheritance Tax Act 1984, section 48(3)).

Deeds of variations and disclaimers

An area that has raised some doubt but which now seems to be quite clear is the treatment of POT on post-death variations.

A disposition made by an individual in relation to an interest in the estate of the deceased is to be disregarded for the purposes of the POT rules if, by virtue of IHTA 1984, section 17, the disposition is not treated as a transfer of value by the individual for the purposes of IHT.

Section 17 lists four such dispositions:

(a) a variation or disclaimer under IHTA 1984, section 142(1);

a transfer to which IHTA 1984, section 143 applies;

an election by a surviving spouse under the Administration of Estates Act 1925, section 47A;

the renunciation of a claim to legitim within the period mentioned in IHTA 1984, section 147(6).

Undoubtedly, the most common of the above to be encountered will be variation under IHTA 1984, section 142(1) which states:

“where within the period of two years after a person’s death–

“(a) any of the dispositions (whether effected by will, under the law relating to intestacy or otherwise) of the property comprised in his estate immediately before his death are varied, or“(b) the benefit conferred by any of those dispositions is disclaimed, by an instrument in writing made by the persons or any of the persons who benefit or would benefit under the dispositions,”this Act shall apply as if the variation had been effected by the deceased or, as the case may be, the disclaimed benefit had never been conferred”.

Disclaimers under section 142(1) are included within the POT relief, but disclaimers of interests in settled property are not. IHTA 1984 section 93 provides that individuals making such disclaimers shall be treated as never having become entitled to the interest, and no parallel relief applies in relation to the POT rules.

What are the options?

Elect into GWR? It would seem the Inland Revenue would like to see everyone opt into GWR by making the irrevocable election under paragraph 21 before the deadline, 31 January 2007 to the effect that the assets in question should be treated as part of the donor’s estate.

Alternatively, the client would pay the charge, accepting that the effect of the formula will be to increase the proportion of the appropriate rental value as years go by.

Lastly, avoid the POT charge by ensuring that the client pays the appropriate “benefit” for his occupation or use of the asset.

To avoid the implications of schedule 15 entirely, the final possibility would be to bring to an end before 5 April 2005, the benefit which would otherwise fall within the new legislation.

John Macdonald, Tax Manager, Blair Cadell, Edinburgh