Changes to debt deduction rules were announced in the recent Budget and are effective from 17 July, when the Finance Act received Royal Assent.

Previously the position was that inheritance tax (IHT) was chargeable on the net value of the estate (total assets less any debts). The new legislation carves out exceptions to this general principle and disallows the deduction of liabilities in whole or part where money is borrowed and:

  • is used to finance (directly or indirectly) the acquisition, maintenance or enhancement of assets qualifying for IHT relief (business or agricultural assets or woodlands);
  • the position is as above but the assets are excluded from IHT; or
  • is not repaid by the estate of the deceased.

With regard to the first point, the deduction is only disallowed if the liability was incurred on or after 6 April 2013.

So, let us say that Mr Graves borrows £200,000 today to expand his business and the bank takes a charge over his home, which is worth £500,000. Under the old rules, on Mr Graves' death, IHT would have been due on the net value of his home (£300,000) and the whole of the value of his business should have been IHT-exempt. Under the new rules, the £200,000 loan would not be deductible and IHT would be payable on the gross (£500,000) value of the house, representing an additional IHT liability of £80,000 (40% of £200,000). This common commercial situation is caught, notwithstanding the absence of any 'tax avoidance' motivation.

As regards the second scenario, assets are excluded from IHT where the individual is non- UK domiciled (and not deemed UK-domiciled for IHT purposes) and the asset(s) is situated outside the UK. Let us say that Mr Graves is non-UK domiciled and, instead of investing £200,000 in his business, he invests in overseas property. Again the loan will not be deductible for IHT purposes and this will be the case even if the liability was incurred before 6 April 2013.

The third element can catch a variety of situations (some which are "contrived" and some which are not).

Despite some recent clarifications, there is still uncertainty with regard to how the legislation might apply in certain circumstances. Further, the policy message is contradictory and at odds with the Government's general encouragement of small businesses. Similarly, the rules attack certain 'innocent' situations whilst completely missing the target in other cases.

The message for all taxpayers is that IHT is something that needs to be given careful thought over the long term and individuals with any form of debt which they are hoping will be offset against their gross assets for IHT purposes should have their situation professionally reviewed.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.