Business property relief and IHT
24 Mar 2014
Do your business interests qualify for IHT business property relief, asks Peter Rayney
24 Mar 2014
Many owner managers seem to ignore the potential impact of inheritance tax (IHT) on their business interests. There are many reasons for this: a reluctance to contemplate or plan for their own mortality, it will be someone else’s problem, ‘it’s all exempt from tax anyway’, and so on.
Although the IHT regime provides a generous exemption for owner managers in the form of business property relief (BPR), it should not be taken for granted because the legislation contains a number of dangerous traps. If BPR is denied or restricted, an IHT charge of 40% on death will normally arise on the relevant value of the shareholding (unless, for example, the spouse/civil partner exemption or nil rate band is available to shelter the IHT liability).
This article concentrates on how BPR is given to owner managers on their shares in private companies (it does not consider the BPR rules applicable to personally owned property used by ‘their’ companies). All statutory references are to the Inheritance Tax Act 1984, unless stated otherwise.
100% BPR potentially applies to all unquoted shareholdings in qualifying ‘trading’ companies (see below). BPR is available to both working and passive shareholders, and it is not necessary for them to be a director or work full time in the company. There is no minimum shareholding requirement and hence holdings of all sizes can qualify. It is also possible for non-voting and preference shares to attract relief.
No formal claim is necessary to obtain the relief but an intention to deduct BPR from the value of qualifying shares, etc, must be signalled on the IHT account, showing the amount deducted.
Shares held in a ‘qualifying’ trading company should often be completely exempt from IHT, both on a chargeable lifetime transfer and on death. BPR is not given on a potentially exempt transfer (PET) but may be used to reduce the IHT payable on a failed PET provided certain conditions are satisfied (s113A).
BPR operates by reducing the value transferred – in this case to nil (s104(1)). It can also be restricted in various circumstances.
Two-year holding requirement
The relevant shareholding must be held for at least two years prior to the transfer/death to qualify for the relief (s106, s107). This two-year holding rule is clearly designed to prevent relief being obtained on pre-death bed acquisitions of shares. However, where the shares are acquired on the death of a spouse/civil partner (but not a lifetime transfer), the deceased’s period of ownership also counts towards the two-year minimum ownership period (s108(b)).
Where shares are acquired on a share capital reorganisation for capital gains tax (CGT) purposes, such as on a share exchange or bonus issue, the ‘new’ shares are treated as being acquired at the same time as the original shares. Provided the company has a commercial need for additional cash, this rule might provide a planning opportunity to secure BPR where it is unlikely that an existing shareholder would satisfy the ‘two-year’ ownership period.
There is no BPR if a binding contract for the sale of the shares has been entered into at the time of the transfer or death, (unless this is part of a company reconstruction or amalgamation
This was demonstrated in Executors of Dugan-Chapman v HMRC  SpC 666. Mrs Dugan-Chapman (a long-standing shareholder of Wilton Antiques Ltd) decided to participate in a rights issue, subscribing for 1m new shares very shortly before she died. However, in this case, the legal procedures for a rights issue had not been correctly followed since all the shareholders had to participate. BPR on the rights issue shares was therefore denied but the planning should have worked if it had been properly executed.
There is no BPR if a binding contract for the sale of the shares has been entered into at the time of the transfer or death, (unless this is part of a company reconstruction or amalgamation (s113)). Many private companies often require a deceased shareholder’s shares to be purchased by the remaining shareholders (or the company), which could therefore lead to a loss of BPR. However, provided the ability to acquire the deceased’s holding is governed by suitable cross-option arrangements, their BPR should not be affected (SP 12/80).
Qualifying trading companies
BPR-eligible companies are often referred to as qualifying trading companies, but the statutory definition is framed in a negative way (s105 (3)). The statute effectively provides that shareholdings in all companies are eligible for BPR unless the company’s business consists wholly or mainly of:
- dealing in shares and securities or land and buildings; or
- making or holding investments (subject to an important exception for qualifying holding companies – see below).
Thus, for example, BPR has generally been denied for property letting activities, even where the landlord provided some services (Martin and another (executors of Moore deceased) v CIR  STC (SCD) 5 and Burkinyoung v CIR  STC (SCD) 29). More recently, BPR was refused on a furnished holiday letting business (HMRC v Mrs N V Pawson’s Personal Representative  UKUT 050). The Upper Tribunal held that the few services provided by Mrs Pawson and others were ‘unlikely to be material’ and insufficient to prevent the business being mainly one of property investment. On the other hand, property development businesses are eligible for BPR as per DWC Piercy’s Executors v HMRC  SpC 687.
BPR is determined on an ‘all or nothing’ basis – the shareholding either qualifies in full (subject to the ‘excepted assets’ exclusion) or it does not. It is therefore possible for a company’s shares to fully qualify for 100% BPR provided it is not mainly carrying out an investment business, ie, it is mainly trading. Thus, a small or incidental investment activity run alongside a predominant trading one would effectively attract BPR through the value of the shareholding.
BPR is not given after a company is wound-up, unless this is part of a company reconstruction process and the company’s business is to continue after the restructuring (s105 (5)).
Wholly or mainly
The ‘wholly or mainly’ test for BPR is generally taken as meaning more than 50%. However, the courts have tended to adopt a reasonably flexible approach in their application of this test to particular businesses. Two of the most influential decisions are those in Brander (representative of James (deceased), Fourth Earl of Balfour)  STC 2666 and Farmer (executors of Farmer) v IRC  STC (SCD). Both cases demonstrate the judicial approach to the ‘wholly or mainly’ test where there is a mixture of trading and investment activity.
The Brander case involved a classic large landed estate in Scotland, which consisted of two occupied farms (run on a contract farming basis), three farms let on agricultural tenancies, 26 houses and cottages mainly let on short-term tenancies. There were also sporting rights and parks let on a seasonal basis. The two occupied farms (trading) represented about 35% of the estate, whereas the let farms and other investment activities made up the balance. HMRC’s argument was that the ‘landed estate’ should be denied BPR completely since it consisted ‘mainly of holding or making investments’.
In reaching its decision, the Upper Tribunal analysed various key factors (see summary above). The Tribunal then stressed that it was essential to look at the overall context of the business, with no one factor being conclusive. All the factors must be assessed ‘in the round’ over a period of time so as to form a view about the relative importance of the investment and the ‘non-investment’ activities to the business as a whole. On this basis, the Tribunal concluded that the estate’s business was mainly a ‘trading’ one with BPR being available in full.
BPR is reduced to the extent that the value of the shares reflects any ‘excepted assets’ held by the company (s112) – see example. Broadly, this anti-avoidance provision seeks to prevent ‘taxable’ personal assets being ‘sheltered’ from IHT by being held within a BPR-eligible company – this might include holiday villas and other ‘private’ assets that are held within the company for the owner-manager’s private use. The excepted assets restriction can also prevent BPR being given on ‘excess’ cash reserves being built up within a company.
An asset is treated as an ‘excepted asset’ if it was not used wholly or mainly for business purposes in the previous two years, unless it is required for future use in the business [IHTA 1984, s112(2)]. HMRC will generally seek to examine the accounts and other relevant documentation to establish whether the company’s assets were being used by the business at the time of death/chargeable transfer.
HMRC recently confirmed that, unless there is evidence showing that the cash is being held for an identifiable future purpose, it is likely to be treated as an excepted asset for BPR purposes
HMRC will often look at substantial cash balances to determine whether they are really required for future business use. There will, of course, be seasonal trades, that generate a large cash balance at particular times of the year. In such cases, it should be possible to show that the cash was required to meet significant expenditure on re-stocking, etc, after the date of death.
In the wake of the recent economic conditions, many companies have prudently retained increased cash balances to act as a buffer against any future downturn in their trade. Many would argue that these amounts should be considered as being legitimately held for business purposes. However, somewhat surprisingly, HMRC recently confirmed that, unless there is evidence showing that the cash is being held for an identifiable future purpose, it is likely to be treated as an excepted asset for BPR purposes. HMRC stated that holding a ‘surplus’ cash buffer to ‘weather economic difficulties is not sufficient reason’ to prevent the funds being treated as an excepted asset (see ICAEW tax faculty tax guide 1/14).
HMRC’s attitude to cash ‘buffers’ is bound to be challenged at some point. Clearly, retaining key evidence of directors’ decisions, etc, will be crucial in rebutting any HMRC challenge in this area.
Qualifying holding companies
Section 105 (4)(b) contains a special rule that enables shares in most holding companies to qualify for BPR. Broadly, a company whose business consists wholly or mainly in being a holding company qualifies for BPR provided at least one of its subsidiaries carries on a qualifying trade. (For these purposes, a holding company follows the definition in s1159 and Schedule 6, Companies Act 2006.)
It is possible for shares in a holding company to qualify for BPR, even if it holds shares in one or more ‘investment’ subsidiaries. However, when calculating the BPR, the value of any ‘investment’ subsidiary must be excluded from the value of the holding company’s shares – effectively reducing the relievable amount (s111) – see example.
Some groups have property-holding companies that let properties to their fellow group members. This should not cause any BPR difficulties since s111(b) provides that intra-group property letting is not treated as an ‘investment’ activity provided the properties are let for trading use. Similarly, although the legislation is silent on the treatment of intra-group loans, HMRC has confirmed that they can be regarded as ‘non-investment’ where the loans are used to finance qualifying trading activities and ‘the amounts are reasonable in the context of the group business as a whole’ (see correspondence between HMRC and CIOT in December 2010/January 2011).
EXAMPLES: graphic presentation of BPR 'excepted assets'and qualifiing holding companies BusinessPropertyRelief.pdf
Personal borrowings against shares
Following the Finance Act (FA) 2013 changes, owner managers can no longer obtain IHT relief on loans used to buy shares that have been secured on their home or perhaps investment properties. Before FA 2013, such arrangements would carry an IHT benefit because of the general rule that an encumbrance on a property reduces the value of that property for IHT purposes. Thus, when the owner manager died, the shares would attract BPR and typically the chargeable value of the home would be reduced by the mortgage. However, this potential benefit has now been countered by the FA 2013, which provides that (for liabilities incurred after 5 April 2013), any borrowing used to finance the purchase of BPR eligible shares (and other qualifying BPR assets) must be deducted against the value of those shares, etc, for BPR purposes.
This means that BPR would now only be given against the ‘net value’ of the shares after deducting the debt. If the loan exceeds the value of the shares, then the excess amount can be deducted against the value of the taxable estate in the normal way (provided certain conditions are satisfied).
HMRC clearance procedure
HMRC operates a non-statutory clearance system to confirm whether BPR would be available for a proposed transaction or chargeable IHT event, such as a planned transfer of shares to a discretionary trust. This facility is only available where there is a material uncertainty over the application of the BPR legislation. If the relevant matter concerns legislation that is older than the last four Finance Acts, it must relate to a commercially significant issue (see HMRC Brief 25/08). Furthermore, HMRC will not deal with clearance requests for hypothetical cases or where there is no potential IHT liability in point (for example, due to the availability of the nil rate band).
The non-statutory clearance regime enables some certainty to be obtained on the BPR status of shares, etc, before a relevant transaction is undertaken or chargeable event occurs. Clearance applications should be carefully drafted and include all relevant facts and statutory and case law authorities.
Brander case Summary: tribunal findings
1: Turnover and profitability of the various businesses
Tribunal finding: demonstrated that the management of the estate was mainly a trading activity
2: The activities of and time spent by employees and others
Tribunal finding: pointed to a predominance of trading activity
3: Size of land dedicated to each activity
Tribunal finding: almost equally split between investment and trading
4: Capital value of the land employed in each activity
Tribunal finding: ratio was 1.88 to 1 in favour of ‘investment’ use. However, since there was no prospect of selling the estate, this factor was given less importance