The structuring of business and farm interests essentially involves trying to ensure the maximum availability of Business Property Relief (BPR) and / or Agricultural Property Relief (APR). Two general points have historically applied here:
- When registering the death of an individual whose estate is likely to claim BPR or APR, the individual’s occupation should be stated on the Death Certificate as “Company Director” or “Farmer” (as appropriate), and never as “Retired” or “Semi-retired”.
- Loans would not be secured against assets which qualify for BPR or APR given that this would reduce their value and waste the relief. Loans would instead typically have been secured against other taxable assets, in order to reduce their value and the Inheritance Tax (IHT) payable.
Whilst the first of these two points is very important and still holds true, the second point has been affected by restrictions brought in by the tax office relating to the deduction of liabilities on an individual’s estate on death.
Restricted deductions of liabilities
On death, liabilities are generally deducted from the value of the individual’s gross estate before IHT is calculated on the net estate. Historically, these liabilities would have been deducted from the estate regardless of whether or not the liability was actually repaid from the estate; and these liabilities would have been deducted from the estate as a whole, unless the liability was secured against a particular asset in which case the liability would have been deducted from that particular asset.
It was therefore common practice to secure borrowings against taxable assets to ensure that the liability reduced the value of that taxable asset, rather than being secured against business or agricultural assets which may qualify for BPR or APR, and so be IHT free in any event.
However, there are now restrictions on when and to what extent liabilities may be deducted from an individual’s estate on death. The restrictions will apply depending on:
- what the borrowed money was used for; and
- whether the borrowed money is repaid from the individual’s estate on death.
The restrictions affect what were fairly standard arrangements – especially for business owners and farmers who would traditionally secure liabilities on their non-business or non-farming assets – including those that were implemented not for IHT planning purposes, but perhaps at the insistence of the lending bank. As a result, liabilities entered into some time ago may no longer have the expected tax effect and so may need to be reviewed.
For what was the borrowed money used?
If the liability was incurred on or after 6 April 2013 and the borrowed money was used directly or indirectly to finance (that is acquire, maintain or enhance) assets that qualify for BPR, APR or Woodland Relief (relievable assets), or excluded assets, then the liability will be taken to reduce the value of the relievable or excluded assets, even if the liability is secured on a taxable asset.
Excluded assets include non-UK assets for those individuals who are neither domiciled nor deemed domiciled in the UK. The general information set out here relates to UK domiciled individuals only, and so no further reference is made to excluded assets.
If the amount of the liability exceeds the value of the relievable assets, the excess can be deducted from the remainder of the estate in the usual way. If the liability is only partly attributable to financing relievable assets, the restriction on deduction of the liability only applies to that part that is attributable. The liability is apportioned using the values at the date of acquisition.
If an existing loan agreement is varied, the liability may be treated as having been incurred on the date the agreement was varied. If there is no written agreement recording the terms of the loan, the liability is treated as incurred on the date the money is paid to the borrower.
A liability can be deducted from the value of an individual’s estate on death if the borrowed funds were used to finance relievable assets and the individual gave away the relievable assets more than seven years before death. However, the liability cannot be taken into account to reduce the value transferred by a chargeable transfer, and then be taken into account again on the death of the individual.
Is the borrowed money to be repaid from the individual’s estate on death?
Where money was borrowed at any point in time, a deduction will only be allowed for the liability on the death of the individual if the liability is actually repaid out of the individual’s estate. A liability that is waived cannot therefore generally be deducted. Where a liability is partially repaid then only that part of the loan that has been repaid will be allowed as a deduction. The tax office may ask for evidence that the money has been repaid out of the estate.
The exception to this general principle is where there is a real commercial reason for the liability not to be repaid (such as a business being taken over by the beneficiaries and the bank is prepared to allow any lending facilities to continue); and one of the main purposes of not repaying any part of the liability is not to secure a tax advantage (whether for IHT, Capital Gains Tax (CGT) or income tax).
Aside from the points mentioned above, there is specific action that can be taken in the structuring of business and farm interests to ensure that BPR and APR is maximised:
Transfer assets from the individual to the business
BPR reduces the taxable value of qualifying assets by 100% or 50%. 100% relief is available for unquoted shareholdings and interests in a business (whether owned as a sole trade or in partnership), whilst only 50% relief is available for assets, such as land and buildings, owned by the individual but used by the partnership or company.
In order to ensure that assets, such as land and buildings, qualify for 100% relief rather than 50% relief, it is possible to transfer land and buildings from the name of the individual into the name of the partnership or company. However, transferring land and buildings from an individual to a partnership or company may give rise to a CGT liability and so consideration should be given to this before action is taken.
Double Option Agreements (also known as Cross Option Agreements)
There are various agreements that can be used when planning to pass on an interest in a business on the death of a shareholder or partner, but care needs to be taken because BPR and APR is denied if the asset on which the relief is sought was subject to a binding contract for sale at the time of death:
- Buy and sell agreement. The deceased owner’s estate must sell its interest in the business to the surviving business owners, and the surviving business owners must buy it. A pre-agreed method of valuation is used. These binding agreements should be avoided if IHT is a concern for any of the business owners.
- Automatic accrual method. The deceased owner’s interest in the business automatically passes to the surviving business owners. This method is usually used for partnerships only.
- Single option agreement. The single option agreement gives a business owner the option to sell their interest in the business to the remaining business owners if they fall terminally or critically ill. Not all businesses require critical illness cover, and not all individuals in the business are able to secure critical illness cover.
- Double option agreement. The deceased owner’s estate has the option to sell its interest in the business to the surviving business owners, and the surviving business owners have the option to buy the deceased owner’s interest in the business. If either party exercises their option, the other is obliged to comply. An option does not constitute a binding contract for sale and so any availability of BPR and APR is maintained.
The Double Option Agreement helps the surviving business owners keep control of the business if a partner or shareholder dies. Whilst the options do not have to be exercised, if either the deceased owner’s estate or the surviving business owners decide that they want to exercise their option then the agreement becomes binding regardless of what the other party may wish to do. Without a Double Option Agreement, a partner or shareholder’s beneficiaries could end up with a share of the business.
Taking out life insurance, in conjunction with a Double Option Agreement, helps ensure that a cash lump sum is available to buy the deceased owner’s interest in the business. Each business owner takes out a life policy on their own life, which is written in trust for the benefit of the surviving business owners. The deceased owner’s beneficiaries can receive cash for the interest in the business, and the business can remain wholly owned by the surviving owners.
The price to be paid for the deceased owner’s interest in the business can be determined as follows:
- A value can be specified in the Double Option Agreement. This value will apply unless and until a new value is specified. A professional valuation of the business should be carried out at the time of entering into the agreement, and at the time of any change to the specified value.
- In all other cases, a fair market value will have to be established by an appropriate valuer at the time the purchase is to take place. The valuer is appointed by agreement between the parties, and in the absence of agreement the Double Option Agreement would generally provide for an independent valuer to be appointed.
If the proceeds of any life policy are insufficient to pay the price for the deceased owner’s interest in the business, the Double Option Agreement can make provision for this by requiring that the shortfall be made up by the payment of equal instalments over an agreed period of time, either subject to interest or interest-free.
If the proceeds of the life policy exceed the value needed to purchase the deceased’s interest in the business, the Double Option Agreement would generally provide for any surplus to be retained by the surviving business owners without any obligation to the estate of the deceased owner.
A Double Option Agreement needs to take into account the specific circumstances and requirements of the business, and should not conflict with company law nor the terms of any existing documents (such as a partnership’s Partnership Deed or a company’s Articles of Association) or agreements between the business owners on what they want to happen when a co-owner dies.
Nothing in a Double Option Agreement prevents a business owner from disposing of their interest in the business during their lifetime, except that the Double Option Agreement would ordinarily state that a business owner cannot deal with their interest in the business in any way without the consent in writing of the remaining business owners.
Any new partner or shareholder who joins the business will need to enter a similar agreement. Any agreements between the existing business owners will not be affected.
Farm Business Tenancies (FBTs)
APR reduces the taxable value of qualifying assets by 100% or 50%. 100% relief is available for agricultural property where the individual had the right to vacant possession of the property immediately before death (that is, the individual both owned and occupied the property); where the individual had the right to vacant possession of the property within the next twelve months (for example, the individual owned the property which was occupied by someone else); where land was let on a grazing licence; where property was let on a Farm Business Tenancy (FBT) beginning on or after 1 September 1995; or where certain transitional provisions apply, on which expert advice is available. 50% relief is available in any other case, principally where property is let on a tenancy granted before 1 September 1995 and the transitional provisions do not apply.
An agricultural tenancy granted after 1 September 1995 will be (with some limited exceptions) an FBT so long as it fulfils the “business condition” and either the “agriculture condition” or the “notice condition”. The quality of the drafting and implementation of the FBT is paramount to ensure that these conditions are met. An FBT allows the let land to qualify for APR at 100%.
Pre-1 September 1995 tenancies may not give the individual the right to vacant possession of the land which therefore restricts the availability of APR to 50%. Whilst an old-style tenancy can be surrendered and an FBT granted in its place in order to help qualify for APR at 100% rather than 50%, this will have various consequences for, amongst other things, IHT, CGT and Stamp Duty Land Tax purposes. If consideration is being given to surrendering a tenancy early, both the tenant and the landlord should be separately advised. The general information set out here necessarily focuses on the IHT implications of surrendering an existing tenancy in favour of an FBT, and so no action should be taken without first considering all other factors.
For IHT purposes, a surrender of a tenancy for no consideration may constitute a “transfer of value” in the same way as if it were a gift. The value of the tenancy surrendered is likely to be approximately 50% of the difference between the vacant possession value and the tenanted value, which is known as “the vacant possession premium”. If the tenant dies within seven years of the surrender, APR will not be available on this value.
Further, in certain circumstances the granting of an FBT can result in the loss of APR on the farmhouse and farm cottages. In order to attract APR on the farmhouse, the farmhouse must be of a character appropriate to the land that surrounds it. One of the tests of “character appropriate” is that the occupiers of the farmhouse must be treated as farming (that is, occupying) the land. Letting the land associated with a farmhouse on an FBT is likely to result in the loss of APR on the farmhouse (assuming it is to be retained for occupation by the landowner and not included in the FBT) as the occupant of the house is no longer the occupier of the land.
Many farms have a number of let farm cottages included within the business. If part of the overall farming business, these let farm cottages can qualify for APR, but if an FBT is put in place on land which excludes the cottages then they cease to be part of the business. The move to an FBT can therefore result in the loss of APR on let farm cottages.
Due to the possible disadvantages associated with an FBT, an alternative way to hold agricultural property is under licence. A licence is usually granted for a short period of time and, unlike with an FBT, exclusive right of occupation is not given to the licensee but is instead retained by the landowner. A licence can therefore be more appropriate where the landowner needs to be in occupation of the land, whether that is for IHT purposes or, for example, to maintain the landowner’s entitlement to any grants, subsidies or quotas.
The usual use of a licence is to allow a licensee to graze his animals on the land (which is known as a “grazing agreement” or “grazing licence”). Grazing licences can be both verbal and written agreements. The rights and responsibilities under a grazing licence vary, but how a grazing licence is worded and operated in practice will determine who is the occupier of the land, which in turn will determine the availability of APR. It is therefore preferable to have a written agreement in place and, as with an FBT, the quality of the drafting and implementation of the licence is paramount to ensure that the necessary conditions are met.
There are a number of issues that will influence the landowner’s decision to use an FBT or a grazing licence, and so no action should be taken without first considering all factors. Generally speaking, however, an FBT is beneficial for areas of land that do not incorporate farmhouses and cottages; whilst a grazing licence is beneficial where the landowner needs to be in occupation of the land, such as in order to ensure that the farmhouse and any farm cottages qualify for APR. Whether an arrangement is a tenancy or a licence is a matter of law irrespective of what the parties actually call it and so the quality of the drafting of the agreement is paramount.
Farmland and lifetime gifts
If it is expected that agricultural property will qualify for APR on the death of the individual then the property can be retained since no IHT will arise on death and the beneficiaries would inherit at market value. However, if the individual is unlikely to be able to continue farming, with the potential loss of APR that this may bring, then a lifetime gift should be considered.
APR is available on the death of an individual if property which was given away within seven years of the date of death qualified for APR at the time of the gift, and the property:
- has been owned by the recipient of the gift throughout the period between the gift and the death of the individual, or the earlier death of the recipient of the gift, and (subject to special rules for replacement property) is not subject to a binding contract for sale; and
- is agricultural property immediately before the individual’s death, or the earlier death of the recipient of the gift, and has been occupied for agricultural purposes throughout the period between the gift and the death.
In short, if the individual dies within seven years of the date of the gift, APR will only be available on the gift if the recipient of the gift uses the land for agricultural purposes as at the date of death of the individual (that is, the asset given away must qualify for APR both at the date of the gift and at the date of death of the individual).
Where the original agricultural property was disposed of by the recipient of the gift prior to the individual’s death, APR is still available if the whole of the sale proceeds have been used to purchase replacement agricultural property, and both the sale and purchase were arm's length transactions taking place within three years of each other.
Another situation where a lifetime gift may be beneficial is where a change in the usage of the land is contemplated by the younger generation, such as developing the land for residential property. On such change of usage, the property will no longer attract APR and so a gift, before the change of usage, coupled with surviving for seven years will take the gift outside of the taxable estate. Any capital gains on the property may be held over as the asset given away will qualify as agricultural property as at the date of the gift.