Can I avoid inheritance tax through a loan?

I gifted a property to my children and the seven years have now passed and so the house is outside inheritance tax (IHT). The house was sold this year and the necessary capital gains tax paid, but I am now moving and my children have lent me £600,000 towards the purchase of my new home using the sale proceeds of the gifted house.

I have been advised that if I pay HM Revenue & Customs an annual sum to show the loan is income, this should then keep the money out of my estate for IHT purposes. Do I need any further legal documentation to protect the children from potential tax on my demise or will a promissory note for £600,000 payable from my estate on my death be sufficient for HMRC together with my annual tax returns showing the loan as income?

Simon Mitchell, head of the wills, estate & tax planning division at Thomson Snell & Passmore says this is the sort of question that crops up in tax exams, as it potentially involves three sets of anti-avoidance provisions. As a result, the answer isn’t simple, so it’s important that you seek professional advice on your own detailed circumstances. The following is a brief guide to the provisions that may be relevant but loan documentation alone won’t address the potential issues.

The first question is whether the original gift of the property to your children was a “gift with reservation of benefit” (a “Grob”). This applies if you used the property after the gift, without paying a market rent for that use.

If you lived there, continued to receive rent or spend holidays there, you would potentially need to wait seven years from the date of that benefit ceasing before the value of the property falls out of your estate for IHT purposes.

Even if there was no Grob originally, if at any time after the gift you receive a benefit from the gifted assets, the value of those assets will fall back into your estate for IHT purposes. There are “tracing” rules that can apply the Grob rules to the proceeds of sale or exchange of the original asset, although the receipt of cash often (but not always) prevents those rules from applying.

If you escape the Grob provisions, you look next at the pre-owned assets (POAT) rules. If they apply, the legislation imposes an annual income tax charge on the donor and I think it is these rules you have in mind.

The POAT rules are very wide. They apply where the Grob rules don’t, and can apply where a taxpayer has (directly or indirectly) contributed to the purchase of land by another person. If your children used the sale proceeds to buy another property, which you occupy, that could be caught by the POAT rules, but on the face of it, a loan from your children shouldn’t be caught.

The final provisions relate to the deductibility of debts for IHT purposes. In general, liabilities are deducted from assets to calculate the value of an estate for IHT on death, but if a debt is owed to somebody who has received property from the deceased in the past, then that debt cannot be deducted from the estate on death.

This means that once the loan has been made, your estate will be treated as including that £600,000 and IHT will be due on it unless you can demonstrate that you fall within a very limited exception (and a promissory note won’t affect that).

If you want to reorganise things now to repay the debt (such as by borrowing from someone else), the repayment to your children will be treated as a potentially exempt transfer (that is, you will need to survive for seven years after repayment for the £600,000 not to be included in your estate and subject to IHT).

This first appeared in the FT.