Inheritance tax and reversionary leases

The question of reversionary leases and reservation of benefit for inheritance tax purposes has come before the courts again with a different result from a similar case reported in 2014. We summarise the decisions and consider the possible uses of reversionary lease schemes today.

What is a reversionary lease?

A reversionary lease is where the owner of a freehold or leasehold property grants a long lease or sub-lease of the property to their chosen recipient, but the lease does not come into effect until sometime in the future. As the donee does not take up occupation immediately, such schemes are known as reversionary leases. They were common before 1999 (when the law changed) and enabled the person making the gift of the lease to remain in occupation of the property (by virtue of their retained freehold reversion) without paying a rent, but to make a gift of a substantial proportion of the value of their property. Reversionary leases were therefore an efficient way of making a gift of a substantial part of the value of a property without falling foul of the inheritance tax (IHT) reservation of benefit rules.

So for example, prior to 1999, Charles could grant a long lease of Laburnum House to his daughter, Clare, with a provision that the lease would not come into effect until 20 years’ time, which Charles estimates will be outside his life expectancy. Charles can continue to occupy Laburnum House without there being any reservation of benefit for IHT purposes. The gift of the lease is a potentially exempt transfer and exempt from IHT if Charles survives by seven years; the value of the freehold reversion in Charles’s estate is significantly less than the unencumbered freehold, and will decline still further in value as the time before the lease comes into effect elapses.

What happened in the 2014 case (Buzzoni v HMRC)?

Mrs Kamhi held the head lease of a property in Knightsbridge. In 1997 Mrs Kamhi granted an underlease to nominees for the trustees of a trust for her two sons. The underlease was not due to vest in possession until 2007 and Mrs Kamhi died in 2008.

HMRC contended that the gift of the underlease by Mrs Kamhi was a gift with reservation of benefit (and therefore ineffective to save IHT), because the nominees had entered into covenants in Mrs Kamhi’s favour in the underlease which were similar to those imposed on her by the head lease.

The relevant law provides that a reservation of benefit arises on a gift if possession and enjoyment of the property is not assumed by the donee or “the property is not enjoyed to the entire exclusion, or virtually the entire exclusion, of the donor and of any benefit to him by contract or otherwise”.

The court concluded that if a benefit has been reserved from property given away but the donor’s benefit makes no difference, or virtually no difference, to the donees’ enjoyment of the property, it is not possible to say that the donees’ enjoyment is other than to the exclusion of any benefit to the donor. In this case, because the donees’ covenants were identical to those given by them in the licence to underlet direct to the head landlord, the covenants given to Mrs Kamhi did not affect the donees’ enjoyment of the property; they enjoyed it to the exclusion of Mrs Kamhi and thus there was no gift with reservation of benefit by her.

What happened in the most recent case (Hood v HMRC)?

This case also involved a leasehold property. In 1997 the owner of the lease, Lady Hood, granted a sub-lease to her three sons, with the sub-lease commencing in 2012. Lady Hood died in 2008. HMRC again argued that this was a gift with reservation of benefit as the sub-lease was not enjoyed to the entire exclusion of any benefit to Lady Hood because the sub-lessees covenanted in the sub-lease to observe certain covenants in the head-lease. Importantly, unlike Buzzoni, the sub-lessees were not party to the licence to sub-let obtained from the landlord and they gave no direct covenants to the head lessor. The executors of Lady Hood’s estate relied on Buzzoni in arguing against HMRC’s contentions.

The fact that there had been no prior entry into covenants by the sub-lessees in favour of the head-lessor was, however, crucial and enabled the case to be distinguished from Buzzoni, with the court concluding that the sub-lessees’ enjoyment of the property was not to the exclusion of any benefit to Lady Hood. The court also decided that the benefit retained was referable to Lady Hood’s gift of the sub-lease and not to her retained freehold interest, and that there was no element of double taxation involved. The value of the sub-lease therefore fell to be taxed as part of Lady Hood’s estate on the basis that it was a gift with reservation of benefit.

Why have reversionary lease schemes been used less often since 1999?

In 1999 the law changed so that such schemes fell within the reservation of benefit rules unless the donor had owned the property for seven years or more before entering into the lease. This was followed in 2005 by the introduction of the pre-owned assets tax (POAT). This imposes an annual charge to income tax on an individual who has given away certain property (including land and buildings) and who subsequently benefits from that property by, in the case of land and buildings, occupying it. Reversionary lease schemes are therefore still effective if the donor has owned the interest in the property for at least seven years before entering into the lease, but the income tax charge means that they are now much less common.

How could reversionary leases be used today?

The POAT does not apply to let property, as the owner does not occupy it, so an individual who owns let property for at least seven years could consider entering into a reversionary lease with a consequent IHT saving.

If an individual is non-resident for income tax purposes he or she would also not be caught by the POAT and so could continue to occupy a property over which he or she has granted a reversionary lease until the lease falls in without an income tax charge. UK situs property owned in a foreign company is no longer excluded property for non-UK domiciliaries, and so will fall within the IHT net; the reversionary lease scheme may prove helpful in these circumstances.

For more information, please call us on 0800 915 7732.