RPI/Indexation - when can it be called in?

Trusts Discussion
1

Hi all,

I have a client who has asked me a very interest query, and despite a lot of time researching I have been unable to locate an answer.

Parent 1 died leaving a NRBT which was constituted to an IOU subject to indexation. I know that any indexation called in will be subject to income tax and the client has been advised as such. There is power to waive the indexation in the Will Trust.

Parent 2 is still alive and in a care home. Family home is to be sold to fund care but also to repay the IOU. Clients want to administer trust to other beneficiaries and not Parent 2 so to reduce Parent 2’s pot for assessment of care.

The question which arises is - does the indexation have to be called in at the same time as the debt is repaid? Or can the Trustees decide to call in the debt and then exercise their powers to call in the indexation at a later date (with the relevant calculation being from the date of Parent 1’s death to the date the loan was called in and not the date the indexation itself is paid)? Technically the Trustees have not waived their right to claim the indexation and so arguably it is still a debt owing to the trust until the waiver is undertaken? They want to make sure there is enough in Parent 2’s pot to pay care costs, but equally not all assets be used up for this purpose.

Is there an argument the above could be done if capital still remains in the trust - i.e. a nominal amount of £5 and claim the total indexation due when the last £5 is administered from the trust?

Thanks for your help
Jade

2

I am not sure you can “call in” the IOU and leave the indexation outstanding., presumably with the expectation that the indexation amount does not attract any further uplift.

If the original amount of the IUO is paid off, I suggest that it might either:

  • first be applied to satisfy the indexation amount, with the surplus reducing the capital outstanding; or
  • be applied pro rata to the indexation amount and the original amount outstanding as at the date of the payment.

To my mind the first would apply, being the more straightforward calculation.

Paul Saunders FCIB TEP

Independent Trust Consultant

Providing support and advice to fellow professionals

3

I agree with Paul that option 1 the default position. However I think the parties may choose to identify the debt as paid first

4

If the debtor pays any sum less than the aggregate of the IOU and the indexation augmentation then you have a partly repaid loan, don’t you? Does not the will/loan agreement provide for part repayment?

How are the relevant clauses worded?

5

Everything depends on the contract for the issue of the debt.

Subject to that, I think the starting point is that the indexation element is simply a revalorisation of the capital sum repayable, which is why HMRC are wrong in seeking to tax it because it is just not income. NS&I’s index-linked bonds are a case in point (motoring away recently I’m glad to say). It is simply not in principle a separate item of property that is capable of being transferred separately. You can in theory make a valid equitable assignment of part of a debt but only I think of a fixed amount equal to accrued indexation and not an uncertain future amount, though if for value and not gratuitously it might operate as a contract to assign future amounts as and when they accrued due.

Of course, it would be possible to ensure that A was entitled to the indexation and B to the rest but that would either have to be part of the loan’s intrinsic contractual rights, e.g. in effect “couponising” it in some way, or within a trust. But in my view these entitlements would remain capital in nature. So distribution of the indexation from a trust to A would be a capital distribution. I imagine you could transfer an index-linked debt to A and B jointly to be held by them on a bare trust for themselves as tenants in common with B entitled to the initial principal and A to the indexation (and outside the TRS!).

I can see that it would be possible to waive the indexation because that is tantamount to forgoing part of the repayable principal, but I would strongly prefer that to be integral to the contractual terms of the loan. Then the waiver could be permitted contractually to be made under hand, whereas otherwise a deed would be required, as although there would be consideration for the loan there would not for the waiver.

A trust deed may well, even usually, give the trustees lending power and power to waive interest, though not usually indexation, but it cannot bind the borrower to accept a waiver under hand unless that is a term of the loan and furthermore specifically gives the borrower good discharge, because otherwise it would not do so. I accept that equity might not allow trustees with dirty hands to enforce payment of the amount waived.

For the same reason I cannot see how the debtor would have a unilateral right to pay off the indexation first or the creditor to appropriate it preferentially. I think these rights would have to be incorporated in the instrument’s profile. The tax system is cute enough at specifically taxing sophisticated financial instruments or transactions according to their economic effect or accounting treatment and not their strict legal nature e.g stock lending, manufactured dividends, repos, carried interests and see generally Parts 5-8 CTA 2009.The point here is that these are specially statutory schemes that diverge from normal principles into which they either would not fit easily or at all.

I repeat that HMRC have no right to tax indexation of an IOU differently from index-linked gilts where the minimal interest is taxable as income and the index linking is not interest. This is an example of HMRC’s selective cerebral bifurcation. Their dropped toast always lands on the very side that suits them. To keep their options open there is no analysis in SAIM of the tax treatment of the indexation element. They will tell you on which side the toast has landed after you have dropped it.

Jack Harper

6

I think that HMRC would disagree with you, Jack. See here:

(I love the headline it makes it seem that HMRC’s opinion is the last word on the topic.)

But even if it’s not interest it is likely to be disguised interest (ITTOIA 2005 s 381A).

7

The link doesn’t work properly, so here is the text:

HMRC has confirmed, in its Trusts and Estates Newsletter for April 2017, that where an index-linked loan is repaid to trustees, it will treat the index-linked element as interest, subject to income tax, and continue to challenge arrangements on that basis.

HMRC has confirmed, in its Trusts and Estates Newsletter for April 2017, that where an index-linked loan is repaid to trustees, it will treat the index-linked element as interest under section 369(1) of the Income Tax (Trading and Other Income) Act 2005 and subject to income tax in the hands of the trustees.

This issue often arises in the context of a nil rate band discretionary trust, where the trustees have made a loan to the surviving spouse, linked to the Retail Price Index, or similar index.

HMRC has said that it will write to taxpayers known to have entered into such arrangements, inviting them to consider their position and settle the income tax. If trustees choose not to settle, it will issue closure notices and defend any resulting appeals.

There has been some debate on this issue, with some commentators disagreeing that income tax is due (see, for example, James Kessler QC and Charlotte Ford, Drafting Trusts and Will Trusts (Sweet & Maxwell, 13th Ed, 2017): Appendix 4 - Tax on payment of index-linked nil rate sum, although the authors do point out that their comments only apply to the draft documents in that book). Ultimately, the tax treatment will depend on the terms of the particular arrangement.

Source: HMRC Trusts and Estates Newsletter: April 2017.

8

It is not disguised interest under s381A because the amount of indexation bears no relationship to the time value of money or a commercial rate of interest: subs (4)(a) and (b).

I regret to say that although I accept entirely and have read all the sources you cite I believe HMRC are wrong. Many clients are apt to accept the official view just because it is such. Entirely understandable. For me, and many of my former clients, if we thought they were wrong and the cost/benefit was favourable we would be prepared to take them on. Some had to be held back!

One example. A UK resident subsidiary issued a deep discount security to its parent company, resident in a non-treaty company, because it avoided withholding tax. It was issued on pinpoint commercial terms backed by banking opinions so as not to offend transfer pricing. Instead of issuing one 5 year security five were issued for 1, 2 , 3, 4 and 5 years respectively so that the CT deduction would fall into each future AP of repayment and not only just in AP5. HMRC did not like it but had to accept it. If HMRC had previously announced (legislation by proclamation) that this did not work my particular clients would still have gone ahead because no one on the Board wore brown trousers, the reward was really significant, and the alternative of a straight loan at interest very unattractive.

HMRC’s position on anything is a formidable fact to be recognised and a client must be warned about it, and indeed that HMRC may disown it if it suits them. To do something that will challenge it needs careful evaluation of cost, hassle, uncertainty of and delay in outcome, inequality of arms as to funding endless appeals even if TWM, unwanted publicity, blacklisting after victory, and trustee clients are not staking their own money. But an adviser’s duty is to point out all these things and the likelihood that HMRC are wrong in law. An adviser that does not do so is in a spot if someone else takes them on and wins; even if that is not actionable it will not be great for his or her ongoing client relationship and/or perhaps professional reputation.

Furthermore it is most unlikely that trustee loans of this kind would be caught by the GAAR and that they are made without reference to tax avoidance as a legitimate choice of route; to maintain the value of the money lent which would not be compensated for merely by a commercial rate of interest. This is economic reality, the very lifeblood of the capitalist marketplace, Reverse Trussonomy. Why is it do you think that HMRC have not bothered to obtain legislation to enact their position since 2017 but have relied on an ex cathedra encycyical? My guess is that they are not confident of it, so in terrorem is a better strategy and that this has been swallowed whole by trustees and their advisers which is why there is no case law. So the threat has worked! File problem in out tray.

No client, especially not trustees, wants to blaze a trail at the cost of the trust fund and largely for the gratuitous benefit of others but I am surprised that apparently no trustees, finding themselves in the situation, have pressed an appeal at least to the FTT where they will not have to pay HMRC’s costs and, as many taxpayers do, have represented themselves or forgone representation, and relied on the probity and self-evidently trustworthy legal knowledge of the Tribunal judges. HMRC have an unfair advantage in being not only one party to every tax case but able to investigate all potential cases and manipulate the list to get on first a weak case for the taxpayer.(Oh no they don’t; Oh yes they do). Even so will someone please give it a go? And also on many of the other different issues that HMRC decide unconstitutionally by official dictat.

Jack Harper

9

We know that HMRC consider that the index-linked element of a loan is taxable as interest when the loan is repaid, typically to the trustees of a nil rate band discretionary trust.

Do readers know whether HMRC accept that the index linked element is also to be treated as income for IHT purposes, and thus not liable to IHT on any ten-year anniversary or exit charges from the trust?

Also, if the trustees appoint the trust fund between the beneficiaries absolutely before the loan is repaid, do HMRC accept that the index linked element is taxed as interest of the beneficiaries at their individual tax rates?

Given that the nil rate band debt and charge arrangement was frequently used before the nil rate band became transferable, presumably many readers have experience of dealing with HMRC on these issues. Any guidance would be appreciated.

10

As I know from my direct personal experience as an investor my index-linked gilts are only taxed on the interest. HMRC accept this unequivocally and the type of loan in the OP is absolutely on all fours with such gilts. Not to concede that is rank hypocrisy and intellectual dishonesty on their part but I understand that they do indeed maintain the position. As ever there has been ample opportunity for them to change the law but they choose instead to tax by proclamation.

They have so far managed, again as ever, to exploit the understandable reluctance of trustees to be forced into the appeal system with all its attendant hazards. There has been no decided case as far as I know.

A guide to the technical weakness of their view is the fact that they obtained legislation to tax deep discount securities partly as income, plus the “Accursed” Income Scheme, a tacit admission that otherwise the capital uplift would escape income tax just like the indexation element when the gilts above are sold or redeemed.

See TSEM3200 for the myriad items of capital already specifically treated as taxable income precisely because otherwise they would not be on general principles. See also the practice on “disguised interest” in SAIM2700 e.g.2730: index-linking of capital has nothing to do with the time value of money but rather with the erosion of the value of the loan principal through inflation.

The entire regime of Loan Relationships for corporate taxpayers is designed to dispense with the capital/income distinction by taxing debits and credits, those mysterious artifacts of the arcane science of GAAP.

The ineluctable corollary is that trustees are surely entitled to treat the index-linked element as income for all tax purposes so, as you say, for RPT ITH charges. Tax payable on it will go into the pool of a relevant trust. HMRC must accept that this logically follows: they cannot blow hot and cold as it suits them save by intimidation via threats of endless “punk“ litigation, totally without merit, backed by a very deep pocket.

Jack Harper