Alex Way, senior associate in the private client team at law firm Taylor Wessing, discusses the implications of proposed new IHT measures in the UK.

Alex Way, senior associate in the private client team at law firm Taylor Wessing, discusses the implications of proposed new IHT measures in the UK.

A fortnight ago UK finance minister George Osborne stood up and pledged to continue his fight against tax avoidance. As happens every year, only the measures that can be captured in a single sentence make it to the budget speech. Those that require some explanation are buried in the pages of briefing notes.

This year the papers included new measures to counter inheritance tax avoidance through the use of “contrived debts” and loans used to acquire assets which are not themselves subject to IHT. This includes debts incurred to buy assets that attract 100 per cent relief such as agricultural land, business interests (including AIM holdings) and, importantly, "excluded property" - the foreign assets of individuals with a foreign domicile. While the rules are not specific to property, a principle target will be to collect IHT on the family home.

The current rules are straightforward and logical. Only the net value of an estate is subject to IHT so, for example, only the equity in a home is taxable and an overdraft or other personal debts can be set against other assets. What has apparently upset the Treasury is the use of debt to shelter taxable property and shift the value into tax-free assets. Wealthier non-doms are only subject to IHT on their UK assets and so have been at the forefront of creativity in this area. Typically they can reduce the exposure on a London property by borrowing against it and moving the proceeds to a foreign account. The bank debt is deductible but the foreign bank account is immediately ignored – effectively minimising the IHT liability on death.

Similar techniques are also available to those domiciled in the UK, albeit at a slower pace. Rather than offshore accounts, the borrowed funds can be invested in agricultural land or a portfolio of AIM-listed shares – benefitting from 100 per cent relief after a two-year qualifying period.

Absent a U-turn, the new rules will take effect from the date of Royal Assent in July. Debts incurred in "acquiring, maintaining or enhancing" excluded property or property that benefits from 100 per cent relief will no longer be deductible with huge consequences for those who die in ignorance or are unable to restructure their affairs.

As well as the obvious targets, the new rules will also throw up a number of unexpected anomalies – often where the individual had no tax avoidance motive at all.

Unexpected anomalies

For example, an entrepreneur who borrows against his home to fund a business would currently benefit from a full deduction of the debt if he should unexpectedly meet his maker. The new rules work in the same manner where funds are lent to the business but borrowing to acquire equity would be ignored and the home would suffer IHT on its full value – ignoring the very real debt owed to the bank. Timing is also important: a non-dom individual who borrows to buy a London property would be able to deduct the debt but a cash buyer who later raises funds against the property for a foreign investment would not.

Whether by accident or design, the new rules will also catch a whole raft of restructuring triggered by the Treasury's simultaneous attack on the use of offshore companies to hold residential property. These companies were usually in place to avoid exposure to IHT and many individuals have chosen to wind up their structures and cover the risk with life insurance or expect to sell their London pied-à-terre long before they die. However, some have been looking at re-mortgaging and depositing the funds overseas. Others have been considering so-called "double-trust" structures in which the property was transferred to one trust but charged with a debt to another. Both now look likely to be caught, although alternatives are bubbling to the surface.

The new proposals also contain a second strand – the target of which is less clear. These rules limit the deduction of any debt to cases where the debt is actually repaid unless there are justifiable commercial reasons for it to remain outstanding. These provisions look more likely to hit the innocent than the hardened tax avoider and will hopefully undergo some drastic revisions in Committee. A peculiar unfairness of the probate process has always been that executors must pay the IHT before they have access to the estate assets – even where this may amount to several million pounds. Now, it seems, they must both pay the IHT and the deceased's debts before they can get their hands on the estate.

It is unlikely this will generate sufficient interest to amount to the next "pasty tax" (a controversial proposal to charge VAT on pastry snacks if served hot). Whether or not they undergo some amendment, these low-level changes look likely to introduce a number of new elephant traps for the unwary.