What price conditional exemption?
In these days of financial austerity owners are looking ever more closely at ways of reducing their liabilities.
The question of how to hand down family heirlooms in a tax-efficient manner remains as pressing as ever. The traditional answer was often to secure conditional exemption from inheritance tax but the rules in this area have tightened significantly in recent years particularly with regard to public access to the item in question. This article considers that regime for works of art (and other heritage chattels) in particular although the same principles also apply to heritage land and buildings.
Conditional exemption regime
If the owner of a work of art or heritage property wishes to defer Inheritance Tax (IHT), either on death or on a lifetime gift, he or she can consider exemption from IHT under the conditional exemption regime. Capital Gains Tax (CGT) can also be deferred in certain circumstances. If the item or property is of the requisite quality (see further below), HMRC will grant relief from a tax liability that would otherwise be due; in exchange for which the recipient has to give various undertakings, generally in terms of preserving the item in question and providing some sort of ability for the public to view it. IHT and/or CGT are then deferred unless a chargeable event occurs, causing the conditional exemption to end and tax to be “clawed back”.
For a work of art to be eligible, it must: (a) appear to HMRC to be pre-eminent for its national, scientific, historic or artistic interest; or (b) be part of a collection or group of relevant objects which, taken as a whole, appears to HMRC to be pre-eminent for its national, scientific, historic or artistic interest.
The standard of “pre-eminence” is significantly higher that the pre-1998 standard of “museum quality”. A work of art may also be eligible for conditional exemption if it is historically associated with an outstanding building which is subject to conditional exemption. Guidance from HMRC suggests that items which have been in a building for less than fifty years are unlikely to qualify as being historically associated. The work of art may be owned outright or it may be held in trust.
In relation to chattels, the recipient must undertake: (a) to keep the work of art permanently in the UK and not to remove it temporarily except for an approved purpose and period, (b) to take agreed steps to preserve it, and (c) to secure reasonable public access to it.
Before 1998 access requirements could be “by appointment” only. Post-1998, there must be some form of open access, usually in the form of the owner’s house being open to the public. The exact amount of time for which this access will be required is a question of negotiation with HMRC although access for 25 to 30 days per year is not uncommon.
Public access may also be provided by a loan of the work of art to a local gallery or museum. The owner may negotiate to lend for one month a year or for three months every three years. It is often a significant challenge finding a gallery which is willing to borrow the work of art, quite apart from the costs and risks of transporting the item and insuring it throughout.
The undertaking to secure public access includes publishing details of the work of art. Before 1998, the item was simply listed on the “Victoria & Albert list”. Now, much fuller details will be included on HMRC’s website although it is usually possible to maintain some privacy or use a solicitor’s address (or other) as the first point of contact.
HMRC will monitor undertakings by writing to owners every five years for confirmation that all the conditionally exempted chattels are still present. Owners should be encouraged to keep accurate records of their chattels since lists from original conditional exemptions can be lacking in detail.
Finally, for those owners with pre-1998 undertakings, it should be noted that HMRC has the power (subject to taking the matter to Court) to force a variation of pre-1998 undertakings if they provide for access only by prior appointment. Here, legal advice should be sought as many arguments can be put forward to counter such changes, such as disproportionate costs of insurance, security, and so on.
A chargeable event will give rise to IHT and CGT and may consist of one of following three events.
- There may be a material breach of an undertaking. The theft or destruction of a work of art should not amount to a breach of an undertaking but the unexplained loss of a work of art is more likely to be treated as such.
- A sale or other disposal of the conditionally exempt work of art (excluding to certain exempt bodies or to HMRC in lieu of inheritance tax, or where the disposal is itself a conditionally exempt transfer or where the original undertaking is replaced by a new undertaking). Where there is a sale to a Schedule 3 body (as listed in the Inheritance Tax Act 1984, for example, the National Gallery), the sale price is the market value net of the inheritance tax which would otherwise have arisen but (for works of art) with 25% of that inheritance tax added back on (the “douceur”).
- Death – any passing of a conditionally exempt work of art will be a chargeable event unless the recipient themselves then reapplies for conditional exemption and meets the tests then in effect.
Conditionally exempt works of art which are associated with heritage buildings may be supported by heritage maintenance funds. Such funds carry beneficial tax treatment although the income must be applied to preserving the exempted property. Relief from CGT can be clawed back where the conditional exemption for inheritance tax has been lost.
Alternatives to the conditional exemption regime
The simplest alternative is a gift which is a potentially exempt transfer (PET). This relies on the donor surviving for seven years and the capital gains tax not being prohibitive. In the event of the PET failing, the owner may wish to consider conditional exemption.
Where the owner does not particularly want to benefit from the work of art but the intended donee cannot physically take the chattel, it is possible to gift the item by storing it in a room and handing over all the keys to that room. Care must be taken to ensure effective delivery has occurred and that no benefit in the work of art is reserved by the donor. This is also the risk where the owner still wishes to enjoy the work of art in question. A gift may be made but the donor must then give full consideration for their continued enjoyment of the work of art. A gift and leaseback arrangement (at commercial rates and with both parties being independently advised) is an example of this.
A work of art may be accepted by HMRC in lieu of inheritance tax with a similar tax saving as with sales to Schedule 3 bodies. Finally, if the owner is willing to open their house to the public, the most efficient of mitigating inheritance tax may be to run the house as a business and claim business property relief on the works of art which form part of the open house (as well as on the house itself).
Future of conditional exemption
There are many practical difficulties facing the owner of a work of art considering conditional exemption and it may be one of the alternative strategies outlined above is preferable. However, the aim of preserving the nation’s heritage remains a policy of the current government and, despite the economy and despite the reforms in 1998, it seems likely that conditional exemption will continue to play a role for those owners able to provide sufficient public access and yet who are not able to commit to opening their houses fully and running them as businesses.
This article first appeared in the September 2011 edition of Private Client Adviser magazine.