IHT Planning Exercise Fails Due to Covenants

In order for an asset to be removed from an estate for Inheritance Tax (IHT) purposes, the donor of the asset must retain no benefit from it after the legal title to it passes. Complex ‘reservation of benefit’ legislation exists to ensure that assets given away, which are called ‘potentially exempt transfers’ (PETs), are not treated as gifts prior to death where a benefit is retained by the donor.

A recent case dealt with a situation in which a woman gifted a leasehold property in Knightsbridge, which was entitled to be underlet by way of a licence, into a trust set up for the benefit of her sons. HM Revenue and Customs argued that between the time of the gift and her death the property was, to paraphrase the section which prevents such a transfer being a PET, ‘not enjoyed to the entire exclusion, or virtually to the entire exclusion, of the donor and of any benefit to her by contract or otherwise’.

The trust sublet the property (which had more than 85 years left on the lease) to a nominee company. Later, the landlord granted a longer lease to the woman, although this did not affect the legal position for IHT purposes.

When the woman died in 2008, the head lease was valued at £50,000, compared with a valuation as a freehold of more than £2 million. The rather complex arrangement was backed by a series of covenants between the parties… and this is how the scheme failed.

The problem was that the covenants, which existed to pass the costs of owning the property across to the occupants, created a liability on the occupants to meet financial claims that were the prior responsibility of the woman under her lease. Because the right to occupy the land was conditional on fulfilment of covenants in her favour, she had failed to ‘exclude herself from the enjoyment’ of the property, which therefore fell into her estate for IHT.

In the view of the judge, had the donee covenanted with the superior landlord to pay the relevant charges, the situation might have been different. Because the covenant allowed the woman to enforce it, she had retained a benefit in the property.

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