Grossing up on failed PET

A colleague of mine is dealing with an estate with the following circumstances:

  • Less than 7 years before his death the deceased entered into an agreement with his son to pay him a cash sum in lieu of any inheritance and the payment was made. The amount was more than the nil rate band, so IHT is now payable.
  • The deceased expressly agreed to indemnify the son for any tax arising from the payment, so his estate is liable for the tax now due.
  • The deceased’s estate passes wholly to his widow and is therefore exempt.

I have been going round in circles trying to establish whether the amount of the gift should be grossed up by reference to the tax now payable. There are various confusing and conflicting comments in the HMRC IHT manual, but I believe I have come to the conclusion that no grossing up applies. This is on the basis that there was no tax paid at the time of the gift, so the loss to the deceased’s estate at the time of the gift was simply the amount of the gift, and the payment of the tax now by the estate is simply meeting a liability.

Can anybody please reassure me as to whether this is correct?

Diana Smart
Gordons LLP

The answers to problems of this kind are dealt with in IHTM 14502 onwards but they could most certainly be made easier to follow.

The cash gift was presumably a PET and so has become a failed PET. The unvarnished simple (or “insurance policy style”) analysis is No, you don’t gross up the tax.

The legal analysis, for those interested in such things, is that the transferor is not legally liable to pay the tax on it; only his PRs are: s199 (2) IHTA.

Grossing up only applies to transfers chargeable when made because the transferor is liable for the tax and so his estate is reduced not only by the cash gift itself but by the imposition on him of that liability: s199 (1) with ss3(1) and 5(4). Although he is only one person among many liable for it, any one of the persons made liable is liable for the whole amount : s205.

A lifetime binding agreement that the transferor will pay the tax is therefore in substance only a confirmation of the strict legal position if what is meant by that is that his PRs will pay it out of his estate. I have not seen the wording and if it was drafted by lay persons it could conceivably say anything. Even if not specifically confirmatory in that precise manner I would hope it would support that interpretation as the optimum. The mind boggles at what else it might have been seeking to achieve. You cannot take anything, including the liability, with you!

The Manual gets there at 14541 and 14593 but the latter contains a misleading statement: “Generally, grossing only applies to immediately chargeable transfers. It does not apply to failed potentially exempt transfers (PETs) (IHTM04057) unless the transferor is obliged to pay the tax”. The law in s199(2) does not oblige him to so so. This is clearly stated in IHTM 30041. The words in bold surely cannot refer to some lifetime agreement to the relevant effect.

What if the transferor makes a lifetime agreement to do so? As the tax charge does not crystallise until he dies, and if the agreement does not merely confirm the legal position as to the liability being that of his PRs, it would surely be fanciful to argue (notwithstanding, one hopes, the actual wording of the agreement) that he was purporting to alter that legal position by creating some separate species of personal contractual liability, which could also only be discharged by his PRs, and so grossing up applies----an own goal!

Section 199 (2) was differently worded before FA 1986 so the transferor was indeed a liable person before then but there were no PETS at that time so it then applied only to chargeable transfers. The Manual was published however after the change in the law.

It seems that the words “unless” onwards in IHTM 14593 are positively misleading i.e. wrong. We must rejoice that Manuals are not binding. Homer (the poet but possibly Simpson) has nodded.

Jack Harper

It is I think clear that there can be no grossing-up of the original transfer even when the PET subsequently becomes chargeable. The transferor has no liability for any IHT arising should the PET become chargeable.

However, as the transferor had contractually agreed that his executors discharge any IHT due then if such tax payment is made it would seem to constitute a tax free gift which itself may need to be grossed-up.

Malcolm Finney

“it would seem to constitute a tax free gift which itself may need to be grossed-up”.

I am not clear what the consequences are in law or for inheritance tax of a living transferor agreeing to pay a tax liability that is not due until he dies (and is contingent initially as he may survive 7 years) and which, apart from his agreement, is imposed by law not on him but on his estate under s199 (1)(a) with (2) or on the donee under (1)(b).

Legally, can he extinguish the statutory liability and substitute his own by his agreement and if not does his estate end up with two liabilities? After his death any liability of his not paid in his lifetime can only be discharged by his PRs out of his estate. My view is he cannot vary the statute by an agreement inter vivos and the potential outcome of double liability is absurd. I can make an argument for it, the one being contractual and the other statutory, but it can only be discharged once and by the PRs or the donee. And the contractual liability, if separate, would not be deductible for IHT!

The agreement might well be interpreted as being like a guarantee or indemnity which on its being given only reduces the giver’s estate contingently; and not at all, or vestigially, if the debtor is prospectively good for the money. Actual payment of the debt might be a gift if the arrangement did not come within s10(1) but not if made after death; and would only be deductible as a liability in the estate if the agreement was made for consideration of real value.

The debt is not owed by the donor but to the Crown under statute by the donor’s PRs or by the donee . If the PRs could not pay, the Crown has a statutory right of recovery against the donee; what enforceable value does the agreement have to the donee since it is with the donor? If the PRs pay, the agreement is a dead letter. As stated below, their actual ultimate liability to pay is to some extent a function of HMRC’s right to collect from the donee.

Assuming the agreement has some form of legal validity is it a transfer of value? It seems clearly outside s10. What is the value transferred? Is it a PET: does it increase the estate of the other party to the agreement? If not, what will go on the IHT 100a?The value transferred is fixed at the date of the disposition whether it is a PET or not. Unless at that date there is a prospect of non-payment by anyone within s199 the value transferred is apparently nil.

This all sounds rather like one of A P Herbert’s misleading cases, perhaps Haddock v HMRC.

I suspect a judge would strive to scrutinise the agreement so as to avoid its being a separate gift, if at all possible.

Despite that the agreement, if legally binding, might nonetheless have a salutary legal consequence in some circumstances. Section 204 (8) limits the PRs’ liability under s199 (2) where the transferee can be made liable under s 199 (1)(b). If they do not pay and he does, he might have a right to recover from them under the agreement (a right not given to him by the statute because technically under s205 he would be paying his own liability). IHTM 30043 indicates that HMRC in practice interpret these provisions as allowing (if not requiring) them to pursue the transferee first (and they do), only resorting to the PRs if he does not pay in full. The PRs can be made to pay up regardless if the debt remains unpaid 12 months after the end of the month in which death occurs. Their limitation of liability is only to all the assets in the estate and these will not include the gifted cash nor do they have a statutory right of recovery against the donee because of s205.

So the donee who is made to pay up might have an enforceable right under the agreement to recover from the PRs but their payment would not appear to be itself deductible for tax as a liability unless the agreement was made for value and to the extent value was received (IHTM 28382). It apparently was not and so legal enforceability of the agreement might also be in doubt unless consideration within the law of contract (including £1 or a chocolate wrapper) was given or a deed was used.

The donee could alternatively be given a specific gift in the will of an amount equal to the tax on the gift but that could be grossed up under s38 and an extra share of residue might be better.

Where the gift is not a PET an enforceable agreement by the donor to pay the tax does cause grossing up.

Ideally one would have sight of the agreement and know about the background but an agreement under hand is perhaps the most commonly encountered.

Jack Harper

Where a PET becomes chargeable it is the transferee who has the primary liability with the PRs of the transferor becoming liable if IHT is not paid 12 months later.

I don’t see a problem in the transferor agreeing with the transferee that should the PET fail, his (ie transferor’s) estate will discharge the liability by way of a legacy (which may or may not need itself to be grossed up). If the transferor was concerned the transferee would not use the legacy to pay the IHT this could easily be dealt with in the will.

I’m not sure if this deals with Jack’s issues he raises or ducks them.

Malcolm Finney

Thank you Jack and Malcolm for your very interesting and helpful analyses.

In case it makes any difference, I confirm that the original agreement was by way of a deed, and there is no legacy to the son to meet the tax liability. The wording of the deed is very clear to the effect that the son should suffer no tax liability in relation to the payment and contains an indemnity by the father on behalf of himself and his estate in respect of any claims arising from it.

Diana Smart

Thanks Diana.

The deed is good news. The son should be able to recover from the estate any amount he is made to pay by HMRC exercising their collection powers, subject to its solvency. The estate’s liability is not deductible for IHT.

I do not disagree ultimately with Malcolm. Section 199 (1) with (2) does not explicitly set out any order of priority for the four types of person liable to pay. You have to work that out from s204 (8) and see IHTM 30043. This is because the main objective of this set of provisions is to give HMRC the widest possible range of targets, especially the back up of s205 which rather undermines any simple concept of priority. The drafting nevertheless leaves something to be desired and suffers from having been bypassed by the Rewrite project.

A person who is made to pay under s205 has no right of recovery against another. This can be the PRs where the transferee has had the cash. A transferor of a failed PET who either does want the transferee to bear the tax or does not cannot be absolutely certain of that outcome by leaving it to the statute. In the first case he must make the gift conditional at the time of gift and in the second he must confer a right at that time legally enforceable against the PRs.

The statute is only concerned with HMRC getting their hands on the tax regardless of whose pocket it comes from. Depending on the size of his estate and the assets in it if he has not done the needful at the time he may be able to make an adjustment in his Will by reducing the entitlement of a lifetime transferee who was meant to pay but doesn’t or conferring it on one who was not meant to pay but does. As lifetime gifts are often made by those who regard a specialist adviser as an optional luxury some peoples’ tacit expectations may be thwarted.

Jack Harper

On death of the transferor within 7 years of making the PET the indemnification kicks in and the PRs are required to either refund the IHT paid by the transferee or discharge it on his behalf.

Either way, the estate of the transferor has a liability in respect of the quantum of IHT arising on the PET.

However, as the indemnity hasn’t been incurred for consideration in money or money’s worth it will not be deductible.

Malcolm Finney

Hadn’t seen Jack’s latest post before posting the above.

But think we are basically in agreement .

Malcolm Finney

If this is in a deed of indemnity is it an allowable debt, as it is not a legacy

Simon Northcott

To be deductible a liability must either be imposed by law or incurred for a consideration in money or money’s worth : s5 (5) IHTA

An indemnity may be legally enforceable e.g. made by deed but not deductible for IHT if provided gratuitously. Partial consideration can be recognised. The aim is to allow a deduction for a liability under a commercially based indemnity but not for those arising in the context of a gift, as in this thread.

HMRC’s take on it is in IHTM 28381-3 and 28353.

It would perhaps be surprising if a transferor could indemnify the transferee against the IHT payable on a gift and for it not only to be paid out of his estate but also to be deductible in charging IHT on that estate.

Jack Harper

To answer myself, I am guessing not as there was no consideration, so hmrc will say it is not deductible

Simon Northcott