Clause 174 - Treatment of liabilities for inheritance tax purposes

Finance Bill – in a Public Bill Committee am 3:00 pm ar 13 Mehefin 2013.

Danfonwch hysbysiad imi am ddadleuon fel hyn

Question proposed, That the clause stand part of the Bill.

Photo of Sir David Amess Sir David Amess Ceidwadwyr, Southend West

With this it will be convenient to discuss that schedule 34 be the Thirty-fourth schedule to the Bill.

Photo of Rory Stewart Rory Stewart Ceidwadwyr, Penrith and The Border

Given the late hour, I am not going to take too much of the Committee’s time. Clause 174 and schedule 34 are very important parts of the Bill. On behalf of my constituency and other rural areas of the country, I would like to focus on some of the issues around them.

Overall, the Budget is excellent. I am very excited by what the Government are doing on SMEs, on employers’ national insurance, on taking people out of tax, on investment relief, and on cheaper beer, thanks to my hon. Friend the Economic Secretary to the Treasury.

However, there are some serious issues, in particular in relation to new section 162A and 162B of the Inheritance Tax Act 1984. Essentially, the clause disincentivises people from borrowing on their houses and their estates to invest. That is a difficult problem to explain. To put it in the clearest possible terms, imagine two notional people—Kwasi and Brooks—though not, of course, the people of those names here. Imagine each of them had a house worth £2 million and both of them wished to make a £1.5 million investment in an enterprise, which is something we would like to encourage. They take two different approaches. Brooks decides to sell his £2 million house, buy a smaller house worth £500,000 and invest £1.5 million cash in the business; Kwasi, on the other hand, chooses to keep his house and instead borrow £1.5 million against its value to invest in the business.

What is the situation we now have? Their net wealth remains the same—£2 million; their investment remains the same—£1.5 million. Their equity remains the same—£500,000. However, in the event of death, Brooks’s descendents would not be liable for anything more than tax on £500,000, whereas Kwasi’s would be liable for tax on £2 million.

Why does this matter? It matters because across the country an enormous amount of the investment made by estates and by farms—the policy also applies to a lot of medium-sized farms in my constituency, and does not affect only the £2 million level, which was just an example—is made by borrowing against existing houses. That is one of the things that allows a vigorous rural economy. Unfortunately, the new policy could result in  a situation in which, understandably, estate owners and farmers choose either to retain their houses—farmers are very reluctant to sell their houses or farms, as Committee members can imagine—in which case they will not invest because of the tax liability that that imposes on their descendents, or to sell their assets to make the investment, which would cause other kinds of problems. That is why I am hoping that we can have further consultation and discussion on the policy.

As Conservatives, we are strongly committed to two principles. One is the encouragement of investment and entrepreneurial activity; the other, of course, within rural constituencies, is our belief that the deep structure of ownership of small farms and estates is part of the deep structure of our rural life. I therefore beg the Government to reconsider some of the details of the clause and schedule.

The policy was introduced for a very clear reason: the Treasury concluded that the current situation allowed people to avoid tax. I would argue that within the general anti-abuse rule we already have enough power to catch anyone engaged in aggressive tax avoidance.

I hope that the Government are willing to consider just two small things. One is the possibility of a delay. At the moment, the policy comes into play at Royal Assent, which creates a retroactive problem. Most large estates and farms in rural Britain will have borrowed against their properties—they have gone to an external source of financing but have put up their house or state against that external source—and anybody trapped in that situation at the moment will be forced to deleverage and get out of all those agreements. However, they are not being given much time to do so.

I also beg the Government to consider the possibility of a serious consultation. This is a policy that I think will not result in our ending the kind of abuse that the Government are focused on but will have a damaging impact on some of the most entrepreneurial and energetic people in rural areas, and on the great Conservative principle of balancing innovation with continued property ownership.

Photo of Catherine McKinnell Catherine McKinnell Shadow Minister (Treasury)

Save for the passionate belief in the main tenets of Conservative ideology as being focusing on investment and freedom of enterprise, I agree with most of what the hon. Member for Penrith and The Border has said. He gave a useful summary of a scenario which I was going to set out—although I was going to use Bill and Ben rather than Brooks and Kwasi—that shows the anomaly in the clause and schedule, which will impact differently upon people in comparable positions. It also highlights what is alarming or—in the words of the Chartered Institute of Taxation—disconcerting to some people. The tax information impact note clearly states:

“there has been no consultation on the measure…It is disconcerting that such complex provisions have been introduced without proper consultation—the result is flawed legislation. Given that they are retroactive”— as the hon. Gentleman eloquently explained—

“the excuse that this was necessary to prevent forestalling is hollow.”

I should be interested to hear the Minister’s response to the worries outlined by the hon. Gentleman and his explanation of why no consultation has taken place on  the measure. Do the Government intend to iron out some of the problems that have been highlighted, while ensuring that genuine tax avoidance is targeted by the measure, which we all support? Will the Minister explain why the general anti-abuse rule cannot be used to deal with the abuses under clause 174 and schedule 34, the abuses that it is aimed at preventing from happening, given that the inheritance tax falls within the scope of the general anti-abuse rules?

I turn now to a couple of issues that need clarification. The tax information impact note suggests that “only a few hundred” estates will be affected by the measure. That number is rather vague, so perhaps the Minister can be more specific about the figures. Is he aware of how many estates left on death have been used by the scheme? Historically, how much revenue has been lost to the Exchequer as a result of the loophole? Has such a process been marketed to people as an inheritance tax avoidance method? It is incumbent on Her Majesty’s Revenue and Customs to deal with such issues sensitively following a death, but can the hon. Gentleman outline what steps have been taken to challenge attempts to avoid tax in the event of death by such avoidance arrangements that could be exploited?

Photo of David Gauke David Gauke The Exchequer Secretary

As we have heard, clause 174 and schedule 34 reform the inheritance tax treatment of outstanding liabilities. They introduce new conditions and restrictions on when a liability can be deducted from the value of an estate. The Government are making such changes to improve the integrity and fairness of the inheritance tax system. In doing so, we will close down avoidance opportunities that are currently being exploited and remove the existing inconsistency in the treatment of loans secured against different assets.

By way of background, inheritance tax is charged on the value of a person’s estate at death and on the value of assets transferred into a trust. The current rules allow almost all outstanding liabilities at death to reduce the value of an estate, irrespective of how the borrowed moneys have been used or whether the loan is repaid following the death. In most cases, that does not matter because the liability will be a normal commercial debt and will be repaid after death. However, the current rules create opportunities for avoidance and can lead to situations in which decisions and arrangements are made purely for tax reasons. I am sure that members of the Committee agree that that is undesirable and should be addressed.

Contrived arrangements and avoidance schemes are on the market to exploit the current rules, the number of which is expected to increase as other avoidance routes are closed. For example, when the creditor is a family member, a family trust or has some other connection to the deceased, they may decide that the loan need not be repaid. In doing so, the value of the estate on which tax is charged is reduced by that liability, yet the amount of estate left for the beneficiaries is not decreased as the liability is not repaid. As such, the estate and beneficiaries suffer no loss, but the Exchequer does.

Such debts might be index-linked or carry an interest charge that is rolled up as part of the overall debt. Under current rules, the full amount of the debt plus interest must be allowed as a deduction against the  estate, but the creditor may waive the interest element to avoid paying income tax on the interest, so a larger proportion of the estate passes to the beneficiaries. Again, the Exchequer loses because of the mismatch.

Other avoidance arrangements exploit the fact that the current rules allow a deduction where a loan has been used to acquire property that qualifies for a relief, such as business assets, or property that is specifically excluded from inheritance tax, such as interests in overseas trust assets settled by a non-UK domiciled individual. The assets are not taxable, yet the rest of the taxable estate is reduced by the liability. This incentivises individuals to take out loans and purchase certain types of assets just to avoid inheritance tax.

There is also an inconsistency in how the current rules treat liabilities used to acquire assets that qualify for a relief but are secured against different types of assets. For example, where a loan is used to acquire certain business assets and is secured against the business, the liability is, as one might expect, deducted from the value of the business, with relief granted on the net value of the business. But if that same loan is instead secured against other taxable assets in the estate, the liability is deducted from the value of those taxable assets, not the business assets. The full gross value of the business assets therefore qualifies for relief and the loan used to buy the business assets reduces the value of the rest of the estate.

Such inconsistency creates an advantageous tax position and distorts decision making by encouraging individuals to secure business loans against their personal property where there may be no need to. The Government recognise that lenders often require some form of security before they are willing to lend, but we believe the tax system should neither encourage nor penalise the choice of one form of security over another.

Clause 174 and schedule 34 address opportunities for avoidance and inconsistency in three ways. First, deductions will be disallowed where the loan has been used to acquire excluded property—property that is excluded from the charge to inheritance tax. That will remove the attraction of avoidance schemes that involve using loans to purchase interests in excluded property trusts by UK-domiciled individuals. Secondly, where the loan has been used to acquire relievable property—property that qualifies for a relief—the loan will first be set against that property. The relief will therefore be allowed against the net value of the property. This will result in greater fairness in how loans used to acquire relievable property are treated for inheritance tax purposes. It will stop certain schemes where the liability reduces the value of the estate and relief is claimed in full, and will remove the tax incentive to take out loans against chargeable personal assets to finance investment in business or other relievable property.

Thirdly, the loan will generally only be allowable as a deduction if it has been repaid from assets in the estate. That will ensure that the tax treatment reflects the economic consequences of repaying the loan. In other words, the deduction will be allowable only where the amount of the estate available for distribution to the beneficiaries has been reduced, because the loan has actually been repaid. This change will also address the  current mismatch used by some avoidance schemes that allows a deduction for IHT purposes, but does not tax the corresponding rolled-up interest if the debt is left unpaid.

Photo of Rory Stewart Rory Stewart Ceidwadwyr, Penrith and The Border 3:15, 13 Mehefin 2013

The Minister is absolutely correct that there is no reason why the taxation system should particularly favour one form of borrowing over another or one form of security over another. Unfortunately, it is simply the case that the structure the rural economies in particular depends on investments from people who are—to use a clichéd phrase—land-rich and cash-poor. In other words, the main way in which estates—owners of woodland, small farmers, people who tend to have most of their wealth tied up in property—can actually borrow money at an advantageous tax position in order to invest is exactly through these types of schemes. Unfortunately, clearing up the loophole is likely to have a significant effect on people’s willingness to make that type of investment, because it will be difficult for them to secure—not in theory, but in practice—external financing with their own property as collateral.

Photo of David Gauke David Gauke The Exchequer Secretary

I am grateful to my hon. Friend, who is a doughty defender of the interests of his constituents in Penrith and The Border. To address that point, I turn to some of the feedback that we have had from interested parties. To avoid publicising the existence of such arrangements and to protect the Exchequer, there was no prior warning of, or formal consultation on, the proposed changes. As such, the Government expected that interested parties would come forward with suggestions for refining the legislation following the publication of the Bill in March. HMRC has received comments from representative bodies, practitioners and individuals, which have highlighted sections of the legislation that might helpfully be clarified. Stakeholders have also expressed concern that the new provisions will apply retrospectively where individuals secured business loans on their non-business property for commercial reasons rather than for avoidance purposes before the changes were announced, and that as a result such individuals would face a higher IHT bill if they died before the debt was repaid.

In response to the comments from interested parties, the Government are proposing several amendments to schedule 34. They were due to be tabled today, but because we have reached the debate on clause 174 earlier than anticipated, they will now be tabled on Report. The Government recognise that some lenders may require security in the form of personal assets before they are willing to lend, and that individuals may not be able to restructure the loan or unwind the arrangements for some time. An amendment will, therefore, be tabled to change the commencement date so that new rules dealing with liabilities incurred to acquire a relievable property will apply only to new loans taken out on or after 6 April 2013. That will mean that the new provisions will not affect someone who took out a business loan in the past secured against their other assets. Amendments will also be tabled to clarify the interpretation of the legislation to ensure it works as intended and to address some of the technical issues that were identified in feedback. I have no doubt that my hon. Friend the Member for Penrith and The Border will study those amendments closely, and I hope that they will, at least in part, satisfy his concerns.

The reason why no consultation took place was that we did not want to expose the avoidance schemes to greater publicity, because that might have encouraged the setting up of more such schemes. In terms of the impact on borrowing and business investment, the new provisions are intended not to prevent or deter individuals from starting their own business or investing in an existing one, but to close down avoidance opportunities and remove distortion in the tax system. The change will not prevent a business from securing a loan against non-business assets or disrupt business activity; it will only remove the current anomaly that can provide a tax advantage for structuring debt in one way over another. It is also worth pointing out that according to independent research published in SME Finance Monitor, the majority of business overdrafts and loans are unsecured, and where security is provided, it is typically in the form of a charge on business property such as commercial mortgages. That is supported by a recent review of IHT returns. Most estates that have such liabilities will, therefore, be unaffected by the changes.

On the question of whether to use the GAAR rather than legislating specifically, it is worth pointing out that the GAAR is designed not to replace anti-avoidance legislation but to supplement it. I disagree with the suggestion that the provisions are retrospective. The new provisions will only change the tax treatment in future and will not result in additional IHT charges before the commencement date. We recognise that people may need to unwind their arrangements and that that may be costly and time-consuming, which is why we plan to table the amendments regarding the commencement date. The yield is estimated to be approximately £70 million between 2013-14 and 2017-18, based on estimates of ongoing losses. There are numbers in the Red Book in terms of existing schemes and arrangements.

A question was asked about whether the schemes are being marketed. The answer is yes. We have recently seen an avoidance scheme that sought to exploit the current rules. I will not set out all the details here—particularly given the late hour—but that is not something that we want to encourage. As for how many estates will be affected, it is worth pointing out that, currently, only 4% of estates pay any inheritance tax at all; of those, only a few hundred are likely to have outstanding debts upon death that will be affected by these provisions. Most taxable estates will not be affected, but I cannot be any more specific than that.

In conclusion, the Government are committed to acting quickly and robustly to tackle tax avoidance. Clause 174 and schedule 34 will ensure that the new provisions reduce potential tax losses and reduce the role of inheritance tax in business financing decisions, while minimising the impact on legitimate arrangements. I hope that the clause and schedule may stand part of the Bill.

Question put and agreed to.

Clause 174 accordingly ordered to stand part of the Bill.

Schedule 34 agreed to.