Beware Of The Value Shifting Provisions

Sarah Bradford looks at a situation that may trigger a tax charge under the value shifting provisions.

Nigel owns a second property, which he wishes to pass to his daughter Samantha. He is aware that a capital gains tax (CGT) charge would arise if he simply gave her the property. However, he has read that instead of just giving her the property, it may be beneficial to retain a lease over the property.  He is interested to know whether this would be effective and whether there are any potential pitfalls.

Before looking into the grant to lease, it is useful to look at the CGT position that would arise if Nigel were simply to give the property to Samantha. The property has a current market value of £300,000. Nigel bought the property ten years ago for £160,000.

As Nigel and his daughter Samantha are connected persons, were Nigel to give the property to his daughter, for CGT purposes, Nigel would be deemed to have received consideration equal to the market value of the property at the date of the gift, i.e. £300,000. This would generate a chargeable gain of £140,000 (£300,000 - £160,000) on which Nigel would be liable to CGT. Assuming that Nigel is a higher rate taxpayer who has utilised his annual allowance elsewhere, the gift of the property to his daughter would land him with CGT bill of £39,200 (£140,000 @ 28%). As he has not received any actual consideration from the disposal of the property, he would need to find the funds to pay the CGT bill elsewhere.

Where a gift is made to a connected person, the deemed consideration for CGT purposes is the market value of the asset at the time of the gift. It therefore follows that if the market value of the freehold is reduced, the capital gain (and the resulting tax liability thereon) is also reduced. A reduction in the market value of freehold could be achieved by disposing of the freehold whilst retaining a leasehold interest.

If, for example, Nigel were to give the freehold of the property to his daughter but grant a lease to himself, for say, 99 years at a rent of £5 a year, the value of the freehold would be negligible. Although there has been a part disposal for capital gains tax purposes of the interest held by Nigel, the market value of that interest (and consequently the deemed consideration) is negligible. Consequently, there is no large capital gains tax bill to pay in respect of the gift of the freehold.

Problems can arise if the terms of the lease are subsequently changed such that the value of the lease is reduced, but the value of the freehold increased. In this situation a CGT charge may arise under the value shifting provisions.

The value shifting provisions are CGT anti avoidance provisions, These come into play where the value of an asset is changed by passing value from one person to another in a situation that would not otherwise be regarded as a disposal for CGT purposes. 

In relation to property, the value shifting provisions apply if, after a transaction which results in the owner of land or any description of property becoming a lessee of the property, there is an adjustment of the rights and liabilities under the lease, whether or not this involves the grant of a new lease, which is favourable to the lessor. Where this is the case, the lessee is treated as disposing of an interest in the property. The effect of this is to trigger a potential CGT liability, despite the fact that no consideration has changed hands.

Once again, the market value rule comes into play. The lessee is treated as having made a deemed disposal for consideration equal to the amount that would have been obtained from a third party. The lessor is treated as having incurred allowable expenditure of the same amount. 

Returning to Nigel and Samantha, Nigel arranges for the terms of the lease to be altered so that the freehold becomes more valuable to his daughter Samantha. To achieve this, the terms of the lease are varied such that rent payable under the lease is increased to that payable at market value.

Varying the lease in this manner constitutes value shifting. As a result of the alteration of the lease, the freehold has become more valuable and the lease has become less valuable. In changing the lease terms, Nigel has shifted value from himself to his daughter.

Under the value shifting provisions, Nigel is deemed to have made a disposal. The consideration for the disposal is the amount transferred.

For example, if the value of a lease for £5 a year is £300,000 and the value of a lease at market value is £90,000 the value that is deemed to have been transferred from Nigel to Samantha as a result of the variation of the lease is £210,000 (£300,000 - £90,000). Nigel is taxed as if he has received consideration of £210,000 despite the fact that no actual consideration has changed hands. On the other side of the equation, Samantha is treated as having incurred allowable expenditure equal to the value transferred, in this case £210,000.

The cost of the property, which is taken into account in the part disposal calculation, is determined by reference to the proportion of the value transferred as a result of the alternation in terms – in this case £210,000/300,000 x £160,000 = £112,000.

The resulting gain on the deemed part disposal is therefore calculated as follows:

Deemed consideration £220,000

Less: associated cost        (£112,000)

Chargeable gain         £108,000

Assuming Nigel is a higher rate taxpayer who his utilised his capital gains tax CGT annual exempt amount elsewhere, altering the lease terms will trigger a CGT liability of £30,240 (£108,000 x 28%). 

Subsequently varying the terms of the lease so that the value of the freehold is increased and the value of the lease decreased is caught under the value shifting provisions, triggering a deemed part disposal for CGT purposes and an associated tax bill.

Although it is possible to reduce the CGT payable on the gift of the freehold by Nigel to his daughter by carving out a leasehold interest in the property, and thereby reducing the value of the freehold, this may only be a temporary solution. Any subsequent transfer of value effected by varying the lease terms so as to increase the value of the freehold will be caught by the anti-avoidance rules and taxed. However, it can still be useful to structure the transfer in this way, as by timing the lease variations (and thus the transfer of value) to take place in, perhaps, a year where Nigel is a basic rate taxpayer and his annual CGT exempt amount is available, it is possible to reduce the overall tax bill.