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HMRC internal manual

Inheritance Tax Manual

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HM Revenue & Customs
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Liabilities: restricted deductions: non-repayment of liabilities deducted against the estate on death

There may be good reasons why a liability should not discharged and will be taken over by the beneficiaries of the estate. This may be the case where a business is being taken over by the beneficiaries and the bank is prepared to allow any lending and overdraft facilities to continue. IHTA84/S175A(2) provides that where the whole or any part of a liability is not repaid, it may still be taken into account in reducing the value of the estate to the extent that;

  • there is a real commercial reason for the liability not to be repaid, IHTA84/S175A(2)(a),
  • the main purpose, or one of the main purposes of leaving the liability or part of it undischarged is not to secure a tax advantage, IHTA84/S175A(2)(b), and
  • the liability is not disallowed under any other provisions of the Act, IHTA84/S175A(2)(c).

Where the taxpayer can demonstrate that all three conditions are met, the liability may be allowed as a deduction against the estate, even though it is not being repaid. It is important to note here that whilst the liability may be part of wider arrangements that are aimed at securing a tax advantage, for example, a home loan or double trust scheme, you should only consider whether it is the non-repayment of the liability gives rise to a tax advantage.

IHTA84/S175A(3) sets out that there is a real commercial reason for a liability not being discharged where;

  • it is shown that the creditor is at arm’s length, or,
  • if the liability would have been due to a person at arm’s length, that person would not require the liability to be discharged.

IHTA84/S175A(5) defines ‘tax advantage’ for the purposes of IHTA84/S175A(2)(b) as;

  • a relief or increased relief from tax,
  • a repayment or an increased repayment of tax,
  • the avoidance, reduction or delay of a charge to tax or an assessment to tax, or
  • the avoidance of a possible assessment to tax or determination in respect of tax.

The definition of a tax advantage is extended to include Income Tax and Capital Gains Tax as well as Inheritance Tax by IHTA84/S175A(6).

Example 1

Harvey dies leaving a nil-rate band (NRB) discretionary trust under his Will with the residue of the estate passing to his wife, Wendy. The trustees of the NRB trust exercise their powers and pass the whole of the Harvey’s estate to Wendy in return for her agreeing to repay an amount equal to the NRB (£325,000). Interest is charged on the debt at 3% per annum, compounded annually.

On Wendy’s death four years later, interest has increased the liability from £325,000 to £365,790. The liability is not disallowed by any other part of the IHTA, so it can be taken into account to the extent that it is actually repaid out of the estate in money or money’s worth under IHTA84/S175A(1)(a).

Provided the whole £365,790 is repaid out of Wendy’s estate, the full sum can be deducted from her estate. The interest received by the NRB trustees will be income of the trust and should be declared for Income Tax purposes.

If, instead, only £325,000 is discharged from Wendy’s estate, that sum can still be deducted from her estate under IHTA84/S175A(1)(a). But there is unlikely to be any commercial purpose to the interest not being repaid as, had the creditor been at arm’s length, they would have wanted the interest repaid as well. As a result, the £40,790 of the liability that is not repaid from the estate is not allowed as a deduction against the estate - but equally, the trustees will have no Income Tax liability.

Even if it could be shown that the liability incurred by the wife to the NRB trustees was incurred in an arm’s length transaction, the provisions of IHTA84/S175A(2)(b) must be considered.

The part of the liability not discharged may not be taken into account if the main purpose, or one of the main purposes, for not repaying the liability was to secure a tax advantage. If the trustees have waived the interest, it would result in the trust receiving less income than it otherwise would. This in turn would lead to a reduced Income Tax liability. A reduction of a charge to Income Tax falls within the definition of a tax advantage in IHTA84/S175A(45), so £40,790 of the liability that is not repaid from the estate is not allowed as a deduction against the estate.

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Example 2

David’s estate includes a house valued at £800,000. There is a commercial mortgage of £200,000 from a family trust charged against the property. David leaves his house to his son, Roger. The trustees are content that the house can be transferred to Roger provided that Roger takes over the mortgage and continues to make the repayments.

Although the liability has not been repaid, the arrangements are commercial and there is no tax advantage arising from Roger taking over the mortgage, so the liability may be allowed as a deduction against the estate.

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Example 3

Adrian makes of loan of £25,000 to his father to help with living expenses, which is secured on his parent’s house. A normal rate of interest is charged, but they agree to allow the interest to be added to capital sum owing. The liability is not to be repaid until after the death of both parents, so when Adrian’s father dies, two years later the loan is not repaid.

Since the loan was not due to be repaid until the death of the survivor, an arm’s length creditor would not have any cause to seek repayment, so the liability may be allowed as a deduction against the estate.

On the mother’s subsequent death, the liability must be repaid from the estate before it can be allowed as a deduction against the estate. If the accrued interest was not repaid, no deduction should be allowed for that sum.

The position may be different if the loan agreement contains a ‘break’ clause that allows for early repayment. If a favourable rate of interest, or no interest, was charged and the repayment could be demanded after the first death, an arm’s length creditor might reasonably be expected to call in the loan to gain a better return from the money. In these circumstances, if the loan is not repaid on the first death, the terms of IHTA84/S175A(2)(a) are unlikely to be met and the liability should be disallowed unless it is repaid, although this may be of limited impact if most of the estate passes to the surviving spouse.