Patrick reviews the recent case of Buzzoni & Ors v HM Revenue and Customs where the Court of Appeal looked at the application of the gift of reservation of benefit rules on a gift of sublease
In the recent case of Buzzoni & Ors v HM Revenue and Customs  EWCA Civ 1684, Mrs Kamhi held the leasehold title to a London property. During her lifetime she made a gift of an underlease of the property to a trust created for the benefit of her two sons.
The underlease was created for a period of 86 ½ years, following which the leasehold would revert to Mrs Kamhi. The leasehold would revert to her exactly two days prior to the expiry of the headlease granted to her by the freehold owner of the property.
The underlease was gifted by Mrs Khami in November 1997 and she passed away in 2008. Having survived more than 7 years from the date of the gift, the gift was deemed by her executors to be an exempt transfer and was therefore not included in her estate for inheritance tax purposes.
At the date of Mrs Khami’s death the headlease in reversion was valued at £50,000. The headlease with vacant possession would have been valued at approximately £2.1 million. The gift saved Mrs Khami’s estate approximately £715,000 in inheritance tax (based upon a nil rate band of £312,000 being available to her estate).
HM Revenue and Customs asserted that the full value of £2.1 million should have been included in the estate for probate purposes. They said that the gift with reservation of benefit rules under s.102(b) Finance Act 1986 applied to the gift of the underlease.
s.102(b) Finance Act 1986 states that a donor of a gift is deemed to reserve a benefit for inheritance tax purposes if:
‘at any time in the relevant period the property is not enjoyed to the entire exclusion, or virtually to the entire exclusion, of the donor [‘the first limb’]and of any benefit to him by contract or otherwise [‘the second limb’].’
HM Revenue & Customs claimed that the positive covenants between Mrs Khami and the trust under the terms of the underlease comprised a benefit to Mrs Khami by contract or otherwise under the second limb of s.102(b) Finance Act 1982.
Essentially, the trustees assumed the burden of all but the covenant to pay rent in the headlease.
As such, HM Revenue and Customs argued that Mrs Khami derived the benefit of being guaranteed that the property would be in good condition when the possession of the property reverted to her on expiry of the underlease. They were successful in their argument in both the First Tier and Upper Tier tax tribunals.
The Court of Appeal disagreed with HM Revenue and Customs’s analysis of the benefit derived by Mrs Khami. The court stated that Mrs Khami could derive no real benefit from the covenants as the benefit alleged by the revenue was consumed by the owner of the freehold title, not by Mrs Khami. The Court of Appeal found that HM Revenue & Customs’s interpretation of s.102(b) Finance Act 1986 was too narrow and that both limbs had to be satisfied for the gift to be deemed a reservation of benefit and that detriment to the recipient of the gift, in this case the trustees, was essential if a gift with reservation of benefit could be shown. As the trustees had obtained the underlease at a significant undervalue no such detriment was present.
This decision will undoubtedly be seen as sensible by practitioners. It allows leasehold owners to make a gift of an underlease without bearing the risk of financial penalties from breaches of covenant outside of their control. The decision also takes due stock of the commercial realities of modern underletting agreements, namely, that most landlords (as in this case) will not allow the property to be underlet unless the sublesee is bound by the same positive covenants as the original lessee.
As a matter of good public policy, long term leases should be treated comparably to freehold property ownership where possible. Leasehold properties are valued similarly to freehold property on the open market and are recognised as homes, not short-term accommodation. There is no sensible reason why a leasehold owner should be unfairly impaired from gifting their property to their family due to an inflexible application of statutory language.
The decision does however appear to have its limitations. The judgement is unlikely to extend to the addition of positive covenants between the sublessor and the sublesee that do not mirror those in the headlease. In such circumstances the freeholder arguably would not consume all of the benefits that the sublessor would receive.
Professional advice should always be sought before any gifts of leasehold property are made for tax planning purposes in order to ensure that the reservation of benefit rules do not apply.
For another interesting insight into gifts with reservation of benefit please see my colleague Samantha Jones’s blog on the relationship between gifts with reservation of benefit and joint bank accounts.
No reliance should be placed upon this type of arrangement now as the settlement was created in November 1997. As such, the gift preceded the implementation of s.102A Finance Act 1986 which was added by the Finance Act 1999.
s.102A Finance Act 1986 would now prevent Mrs Khami from remaining in possession of the property for the 7 years required for the gift to become exempt. s.102A(3) Finance Act 1986 provides that a right to remain in possession of the property until a set date is a significant right and that would make the gift subject to a reservation. The starting period for the potentially exempt transfer would now be from the date that the trust obtained vacant possession.