By Lesley King, College of Law, London

Debt scheme and artificial debts

The recent decision of Personal Representatives of Phizackerley v HMRC [2007] SpC 591 is of great importance to practitioners using the debt/charge arrangement in wills.

Before dealing with the case, it may be useful to give a brief explanation of the debt/charge arrangement.

When preparing wills for married couples with children who want to minimise the burden of inheritance tax, the ideal is for the first spouse to die to make gifts up to the limit of the nil-rate band to the children, rather than passing everything to the surviving spouse. In this way, the couple can pass more assets to the children tax free. In tax year 2006/07, the inheritance tax saved is £114,000 and next year, when the nil-rate band increases to £300,000, the saving will be £120,000.

Unfortunately, most couples are insufficiently wealthy to be able to afford to leave substantial assets away from the surviving spouse. The standard will-drafting technique, therefore, is to create a nil-rate band discretionary trust, which includes the spouse and issue as beneficiaries. The intention is that the spouse will benefit from the trust assets.

When the first spouse dies, the personal representatives (PRs) have to transfer assets to the trust. Where the deceased spouse has sufficient cash and investments, life is simple. The PRs will transfer them to the trust, and the spouse can be given the income for as long as necessary.

In many cases, however, the first spouse to die simply does not have sufficient cash or investments to fund the discretionary trust. The deceased spouse's major asset may be a half-share in the matrimonial home. There is nothing to prevent some or all of the deceased's interest in the home being transferred to the trust (after severing the beneficial joint tenancy by post-death variation, if required), but many practitioners worry that there may be a significant capital gains tax liability for the trust when the house is sold after the surviving spouse dies.

To avoid possible capital gains tax problems, many practitioners use the debt/charge route. In essence, the will authorises the trustees to accept a debt from the surviving spouse equal to the nil-rate band. The spouse receives all the assets but has a debt which reduces the value of his/her death estate. Because the spouse owns the assets, there will be capital gains tax uplift on the value of the house when the spouse dies.

The debt could be a simple IOU but, to avoid stamp duty land tax (SDLT), it is usual for the PRs to place a charge over the assets transferred to the spouse for the amount of the debt. Revenue & Customs accepts that, provided the trustees have no right to enforce payment of the charge against the spouse personally, no SDLT is payable (see Manual SDLTM04045). Older arrangements were often made by a simple IOU from the spouse, and arrangements set up by post-death variation can still be made by IOU without SDLT consequences.

For a long time, practitioners have been concerned that, as a result of section 103 of the Finance Act 1986, debts may not be deductible where there have been lifetime gifts between spouses. Section 103 provides that a liability shall not be deductible to the extent that the consideration given for the debt consists of 'property derived from the deceased'. However, there is a defence under sub-section 4 if the disposition was not a transfer of value and was not part of associated operations.

Mr Phizackerley had been an Oxford don whose wife did not have a paid job during the marriage. The couple bought a house in joint names in 1992 when Mr Phizackerley retired. An agreed statement of facts said 'the funds must have been provided' by Mr Phizackerley.

Mrs Phizackerley died in 2000. She left a nil-rate band discretionary legacy and the residue to her husband. Her half-interest in the house was transferred to her husband in consideration for an IOU for £150,000. Mr Phizackerley died in 2002. His estate was valued at £529,000, less the debt. Revenue & Customs claimed that the debt was non-deductible under section 103.

John Avery Jones, the special commissioner, agreed. Mrs Phizackerley's half-interest in the house was property derived from her husband, who had provided either the cash with which to buy the half-share or the half-share itself. (The commissioner did not think it necessary to decide which.)

James Kessler QC argued that the disposition was not a transfer of value because it fell under section 11 of the Inheritance Tax Act 1984, which provides that 'a disposition is not a transfer of value if it is made by one party to a marriage in favour of the other party... and is for the maintenance of the other party'.

While agreeing that there are circumstances in which the transfer of an asset can be maintenance, the commissioner found that the reason married couples normally put their house into joint names is not for 'maintenance' but for security. He said: 'I do not consider that when a husband puts a house into joint names of himself and his wife during their marriage, it is within the ordinary meaning of maintenance. In spite of Mr Kessler's persuasive argument, I do not consider that the disposition is for maintenance in this case.'

Slightly oddly, section 18 of the 1984 Act (exemption for spouses and civil partners) is worded differently. It says 'a transfer of value is an exempt transfer'.

Although the decision is undeniably bad news for taxpayers, it is important to note that section 103 is only relevant where it is the surviving spouse who incurs the debt or creates the encumbrance.

In the more usual situation, where for SDLT reasons assets are transferred subject to a charge (or if residue is left to trustees to hold for the surviving spouse for life), section 103 should not normally be a problem.

It is also worth remembering that this was a fairly extreme case where the parties agreed that the full consideration for the property had come from the husband. In many marriages, both parties will have contributed to the joint funds.