Inheritance tax anomalies affecting businesses and farms

In April the Office for Tax Simplification (OTS) published a paper examining the whole life cycle of a typical business and making recommendations for the simplification of the business tax system to encourage growth.

The paper contains many observations and in this article we look at two comments made with regard to the operation of business property relief and agricultural property relief and anomalies that may occur.

Loss of reliefs on gifts

One of the traps which lurks in the IHT legislation is a situation that can arise if an owner of business or agricultural property makes a lifetime gift of the property. When the gift is made, provided all the conditions necessary to claim business or agricultural property relief are complied with, there is no inheritance tax to pay; the gift is a potentially exempt transfer which falls out of the charge to inheritance tax if the person making it survives by seven years.

David, for example, wishes to reduce his day-to-day involvement in his technology company and to motivate his son Josh to take on more responsibility. To this end, David transfers some shares to Josh. When Josh and his wife separate a year later Josh is forced to sell some of the shares to a local businessman to fund a divorce financial settlement. David is killed in a car crash three months later. As Josh no longer owns the shares, or replacement property, and as David made gifts valued in excess of £325,000 in the seven years before his death, the potentially exempt transfer is charged to inheritance tax.

What protective action could David have taken?

Josh’s sale of the shares means that non-family members became involved in the company. This situation may have been avoided if David had ensured through the company’s Articles, or a shareholders’ agreement, that he had the right to buy any company shares put up for sale by another shareholder (so ensuring that the shares remained within the family).

As far as the loss of relief is concerned, if the gift of the shares had been made to a trust for Josh’s benefit the shares would then have received a level of protection against the divorce settlement. David could have been appointed as one of the trustees and would have retained control through the trustees over the assets given to Josh.

The OTS observes that the above situation can occur, and that the solution (the creation of a trust), is a relatively complicated one. They do not put forward any recommendations for reform, although the fact that they have flagged the point indicates that this is an aspect of the system they believe could be simplified.

Investment businesses

The OTS also highlights another problem which is relatively common for those wishing to claim business property relief. The relief can be curtailed when the business is considered to be wholly or mainly an investment business. This can cause problems for example for property based companies as, unless they are providing considerable additional services alongside the letting of the property, the business is likely to be classed as an investment business and business relief refused. Farms that have diversified their activities, and perhaps have a separate holiday let business, can lose their relief. As pointed out by the OTS, the fact that many of these operations are classed as trades for other tax purposes (such as income tax) causes confusion. The OTS also observes that this can result in “convoluted and artificial ownership structures” in an attempt to ensure that a trading business is not “tainted” by investment activities.

Given that the existing legislation has been interpreted by the courts in a long line of cases, it would seem that only legislative amendment can change this IHT treatment of certain businesses. In the meantime businesses will need to remain aware of the problem and hive off activities likely to be classed as investment activities as appropriate.