12 December 2019 - Article
The tax rules for UK residential properties have substantially changed over the last 6 years, reducing the appetite for investment in UK real estate by foreigners. One of the major changes, introduced in April 2017, dealt with the extension of the UK inheritance tax (‘IHT’) charges for foreign entities holding UK residential properties. Before, it was possible for foreign investors to escape IHT charges altogether by purchasing UK residential property through a non-UK holding vehicle (most frequently a foreign company) as, under the traditional IHT situs rules, such investors would be treated as owning non UK assets (i.e. the shares in the foreign companies). This meant that the shares in the companies could be gifted or transferred on death with no IHT implications.
The 2017 changes have resulted in a IHT charge arising when a foreign individual (whether non-resident and non-domiciled or UK res non dom and not yet deemed domiciled) dies owning shares in a foreign company holding UK residential property. Additional complexities occur in the context of foreign trusts holding companies whose value is primarily attributable to UK residential property. In this case the trust will not only become subject to the 6% ten yearly charges (and registration on the UK trust register) and an up to 6% charge on the company leaving the trust, but also to a 40% IHT charge on the death of the settlor (assuming the settlor can still benefit from the trust and is not expressly excluded).
A major consideration in this type of planning is the availability of Treaty relief, which is too often overlooked. The UK has signed a number of double tax treaties covering IHT (11 overall) and it may be possible to fall outside the scope of the extended IHT charge as a result of these treaties. The new 2017 IHT rules contain a double tax treaty override provision, according to which, despite the existence of a relevant double tax Treaty, a person can still be liable to IHT if no tax of a similar character to IHT is charged by the other Treaty country or tax is charged but the effective rate is nil per cent, otherwise than by virtue of relief or exemption. This means that the Indian, Pakistan and Swedish double tax treaties will not prevent an IHT charge from arising as no IHT equivalent or estate duty is levied in any of these countries. However the Italian, French, Swiss and US double tax treaties could, if reliance on them is properly placed, afford protection from the 2017 IHT charges on enveloped UK residential property.
How does this work in practice?
When dealing with the Treaty override provisions, consideration must be given in the first place as to whether a tax charge is levied (in principle) in the Treaty partner country and, if so, whether this may be reduced to an effective rate of zero as a result of an exemption or a relief (which could be similar to, in their spirit, but not necessarily the same as, the spouse or charity exemption or the business property relief for UK tax purposes). However, where an effective rate of zero is achieved because of a tax free allowance (or a foreign equivalent to the UK nil rate band), treaty relief will not be available.
Take for instance the case of an Italian resident individual who died holding shares in an foreign holding company which owned UK residential property, where the shares will be, in principle, chargeable to imposta di successione in Italy on the value in excess of the personal tax free allowances (franchigie). The headline tax rates in Italy vary between 4% and 8% and therefore Treaty relief should be available. However, if the shares pass to the spouse and children of the deceased, it may be possible to achieve a result whereby the transfer of the shares on death is entirely relieved from Italian imposta di successione (subject to certain further conditions being satisfied). In this case, no IHT will be chargeable either on the basis that, under the Italy/UK Treaty, Italy will have exclusive taxation rights on the shares and the effective tax is nil – on the basis that imposta di successione will have been charged at 4% apart from (or “but for”) the specific Italian family business ‘relief’ being successfully claimed.
Compare this to a situation where the value of the shares in the foreign company falls within the foreign equivalent to the nil-rate band. In this instance, the effective rate will be nil and Treaty protection should not be available. This could clearly be an issue in relation to the US/UK Treaty as, due to the US$ 11m tax free allowance, it is fairly frequent for estates to be within this generous US nil rate allowance. The downside of this is that the US/UK treaty will not protect the enveloped UK residential property from an IHT charge, where the chargeable value is not taxable in the US because it is within the US nil rate allowance.
This highlights the importance of having an appropriate Will in place – under a Will, the shares in the foreign company could, for example, be left to a spouse, so that no IHT would apply due to the spouse exemption. Other assets, which would not be subject to UK IHT, could then be directed towards the children, and there would still be no US estate tax if the total estate was within the US tax free allowance.
Treaty reliance is mostly relevant to individuals who may have a foot in more than one jurisdiction. When trust structures are involved, they will normally be resident in offshore jurisdictions which do not have a double tax Treaty with the UK. However, to the extent that the Trust may be resident in a Treaty jurisdiction (e.g. Italy or Switzerland) and that a tax equivalent to IHT may be charged in this country on the death of the settlor, then it should be possible to make use of the Treaty override provision. Not all is lost!