It sounds as if the trust was never properly constituted. HMRC are very aware of this far from unusual occurrence. IHTM43016https://www.gov.uk/hmrc-internal-manuals/inheritance-tax-manual/ihtm43016
They do not say there what they will do, seeming to operate on a case by case basis. But it must have the effect of having utilised the IHT NRB of H. It is too late now to do a variation or a s144 appointment in favour of W. You do not refer to values but it is possible that the estate of H was less than the then NRB amount in which case there might be some measure of TNRB. TRNRB works differently. Because H died before 6 April 2017 a £100k amount is the fixed TRNRB: s8G IHTA. (Unless his estate exceeded £2m!)
In order that your clients should not dig an even bigger hole you should reconstitute the trust by treating the NRB amount as a loan to W which the trustees (hopefully all still alive or you will have a replacement issue) can extinguish by appointing the receivable to W’s children, so debtor and creditor are united. I am assuming they are eligible beneficiaries of the trust. Theoretically the question of interest arises but the parties to the necessary document can agree that none is payable. This compromise agreement will give W her own NRB plus her own RNRB. There will only be a transferable NRB if the NRB was not fully utilised at H’s death i.e. the then value of his estate, which would have included his half share of the house, was less than the NRB in 2008. This was £300k or £312k, depending on his actual date of death.
There should be no CGT on the appointment as the loan wis not a chargeable asset. (it might be argued that it was a right of action not a loan but it should have a market value cost at the date of H’s death as there will have been no prior disposal of it, so no gain when it is extinguished at that value: CG12060 https://www.gov.uk/hmrc-internal-manuals/capital-gains-manual/cg12060)
There is in principle an IHT RPT chargeable event but a full NRB will apply as long as H had no cumulation at his death. A return will be required unless the value on distribution is less than £260k.
I have to assume that H’s residue was left to W. So the loan/right of action would have been her liability and she can be regarded as having inherited the entire house subject to that liability, at least by the compromise agreement, to which she (now her PRs) and H’s trustees and her will beneficiaries should all be parties to bind them in legally.The agreement must frame the appointment as a repayment of the liability so that its deductibility in her estate should not fall foul of s175A.
A potential issue is an argument that the NRBT was in fact entitled to all or part of H’s share of the house and thus of course to its increase in value since 2008. Any gain on the disposal by the trustees will hopefully be entitled to full PPRR as she will have lived in the house throughout. A return would be necessary for the trustees to make a claim.This is an uncomfortable argument for IHT because it would follow that her estate did not include the trust property but it will have, one hopes, the benefit of a full NRB as trust property at distribution: this is precisely what NRB trusts on the first death were meant to secure before TNRB came in. I do not think this is a good argument as in fact the trust was never completely constituted and so is not entitled to any particular property provided that is not expressly stated.
The agreement requires careful drafting and the co-operation of all involved. As you have not dealt with this before, having it settled by junior Counsel before execution could be a good idea. The compromise agreement cannot override the original factual position and its historic tax consequences; nor the tax consequences which follow from its execution. While it might not be strictly required to deal with the related compliance obligations, unless questions are raised by HMRC, your clients might feel happier for the agreement and your analysis of its tax effects to be fully disclosed to each branch of HMRC as part of discharging those obligations, so that there can be no later accusations of having misled HMRC or risk of their challenging their effectiveness. HMRC are likely to be satisfied if the tax liabilities, if any, which they see as having arisen on their view of events, which might coincide with yours, are met. Your clients should be made aware of such liabilities on a worst view basis.
An alternative would be to defer the compromise agreement until you have first put the facts to HMRC and sought to agree your analysis of what has happened. The alterations of that agreed position can then be designed on a firmer base. But as these matters can drag on, some immediately binding agreement of all relevant parties to enter into a future compromise agreement might be desirable.
Jack Harper