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Shariah Tax Planning in the UK
By Riyazi Farook, Islamic Finance New, 26th January 2007 (Vol. 4, Issue 4)
In the UK, a 40% inheritance tax (IHT) is imposed on certain assets in excess of £285,000 (US$564,860) of a deceased person’s estate for the tax year 2006/2007. This individual allowance, which is revised annually, is known as the nil rate band (NRB). There are ways to substantially reduce or even eliminate any IHT liability, if arranged prior to death. ReliefsWhilst there are many exemptions and reliefs available, the following provides a summary of the most relevant principles.
Gifts of any value made by the deceased to the surviving spouse, before or on death, are exempt from IHT. However, these gifts may be liable to IHT on the death of the surviving spouse. English law does not recognize the Islamic Nikkah (solemnization) ceremony if undertaken in the UK, with the exception that the ceremony is used to obtain a civil marriage certificate. If the surviving spouse is not UK domiciled, the inter-spouse exemption is limited to £55,000 (US$109,023). A popular use of this exemption is to ensure that on death all assets in excess of the NRB are passed to the surviving spouse. Gifts of any value made to a registered UK charity are exempt from inheritance tax (IHT).
Gifts of any value are deemed to be exempt from IHT if made seven or more years prior to death. Otherwise, IHT is payable in full on gifts made less than three years prior to death, and on a sliding scale if made between three and seven years prior to death. Gifts in which the donor retains some beneficial interest, such as a house in which the donor continues to reside rent-free, are considered to be “gifts with reservation” and are liable to full IHT.
Business property relief
The transfer of shares owned for two or more years by the deceased in an ongoing business concern is exempt from IHT. This is crucial for business owners, as the vast majority of trading companies and partnerships qualify for this relief. Investment companies or properties – both commercial and residential – generating rental income normally do not qualify for business property relief.
A single gift of £3,000 (US$5,947) per annum can be made which is exempt from IHT. Any unused annual exemption can be carried forward one tax year, enabling a maximum of £6,000 (US$11,894) to be gifted.
Deeds of variation
The beneficiaries of an estate are able to retrospectively revise a will after death, usually for religious, family or tax reasons. In order for a deed of variation to be accepted by the Inland Revenue, all beneficiaries must be over 18 and sane, and give their written consent within two years of death. Deeds of variations are typically very costly and time-consuming.
Advanced inheritance tax planning
Where a client’s assets are considerable, the above rules will need to be augmented to ensure tax is mitigated. Listed below are some of the more popular advanced techniques which typically apply to those whose assets are valued in excess of £1 million (US$1.966 million). Quite often these methods involve some form of capital gains tax (CGT) planning. The following are merely simplified solutions – more complex solutions need to be discussed with professional tax planners.
DT and IIP
Assets can be transferred into a discretionary trust (DT) on death. A DT also allows assets up to the NRB (£285,000 (US$564,860)) to be exempt from paying inheritance tax. Anything over this amount owned by the deceased is placed into another type of trust called an interest in possession (IIP) trust, which also allows for tax mitigation. Technically the assets in the IIP trust are held for the benefit of the spouse, although the trustees will only give the spouse what is due to her under Shariah rules. Consequently, once the trustees distribute the assets from the IIP, a potentially exempt transfer lasting for seven years is created on the spouse. The DT can also be used to reduce the assets of someone who pro-actively wishes to reduce the value of their estate during their lifetime. Typically, in this scenario one is discouraged from making gifts, as gifts made to any person apart from the spouse will automatically trigger a CGT charge. The value of a DT is that the CGT charge can be deferred by placing assets into the trust.
Declaration of trust
Ownership of an asset to be deemed as shared by a group of individuals, rather than just the legal owner (or indeed just one individual other than the legal owner) is allowed under declaration of trust. This is crucial for married couples, as it allows both NRBs to be applied to the value of the family home if it was initially purchased in a single name. For example if the husband initially purchased a house now valued at £500,000 (US$991,082), this would exceed his NRB by some £215,000 (US$426,171). By completing a deed of trust (DoT) on this property, and allowing half the property to be owned by his wife, the two sets of NRB can be offset against the value of the property. These would be worth £570,000 (US$1.12 million), which is greater than the value of the property at £500,000 (US$991,082), thereby eliminating any tax charge.
Principally, offshore planning is the ability to hold assets in an environment where they are exempt from both inheritance and CGT, and relies on one obtaining a non-domicile status. This strategy is for the very wealthy whose assets exceed the £5 million (US$9.91 million) mark.
Conversion to tenants in common
Couples who own their family home as joint tenants would have the house automatically passed to the surviving spouse in the event of one partner’s death, regardless of any provisions made in the will. This situation does not conform to Shariah law and would likely lead to a tax charge when the surviving partner eventually dies. A couple owning a £500,000 (US$991,082) home as joint tenants would have the house passed to the wife upon the husband’s death, making her the sole owner. A tax charge would arise on her death. Owning a home jointly as tenants in common allows for the half owned by one partner to be included as an asset in their will on death, instead of passing to the surviving spouse. This arrangement not only allows Shariah law to be applied to the half owned by the deceased, but also avoids a tax charge on the death of the surviving partner, as their share is now worth £250,000 (US$495,509), which is less than the NRB.
The Importance of Inheritance in Islam
Many can speculate as to why Islam has placed such an emphasis on the laws of inheritance and making a will. One could argue that it prevents family conflict on death, or that it represents a means via which needy relatives can benefit from a wealthy family member. The Muslim law of inheritance has been praised all over the world, including from western quarters, for its refined and elaborate set of rules on the transference of property.
The Hadith states: “A man may do good deeds for seventy years but if he acts unjustly when he leaves his last testament, the wickedness of his deed will be sealed upon him, and he will enter the Fire. If [on the other hand], a man acts wickedly for seventy years but is just in his last will and testament, the goodness of his deed will be sealed upon him, and he will enter the Garden.” (Ahmad and Ibn Majah).
With such compelling instructions in the Shariah, one would expect every adult Muslim to give priority to making a will. Unfortunately this priority has to a large extent been neglected. Muslims who reside in the UK are hit by a double whammy because of their apathy. UK tax authorities have imposed a whopping 40% tax on assets over a certain threshold held upon death. For the tax year 2006/2007, this amounts to £285,000 (US$564,860). In addition, English law dictates the “law of intestacy” on a person who passes away without a valid will in place. This effectively distributes their assets in a pre-determined, un-Islamic fashion, to the heirs. Invariably this predetermined distribution will not be tax-efficient and often will be contrary to both the wishes of the family of the deceased and contrary to Shariah. (There are also practical considerations concerning the Islamic rites of burial such as janazah (funeral prayer), ghusl (ritual washing), kafn (burial shroud), dafn (burial not cremation) along with any wasiyyah (bequests) such as avoiding post mortem, and also fidya (compensation for missed fasts/prayers, etc) to consider.) The preparation of a valid will is not just an obligation for Muslims, but is also vital to mitigate tax, protect one’s assets, to ensure one’s wishes are followed after death and to ensure potential family disputes are minimized.
Shariah law is very clear on debt settlement and the subsequent distribution of wealth. Only after fully settling the deceased’s debts and burial costs can his wealth be distributed. Shariah allows the deceased to bequeath up to a third of his estate to anyone other than a recipient entitled to a share from the remaining two-thirds.
Heirs to the estate
After the distribution of up to a third of one’s assets, heirs to a Muslim’s estate as defined in Shariah are the fixed share inheritors (wife or husband) and the residuary inheritors (usually sons and daughters), whose exact percentage of inheritance is not fixed.
Shariah inheritance law is not recognized by UK law and so Muslims should prepare their wills, incorporating trusts into which all their assets are placed automatically on death.
Legal and tax concerns
The laws of intestacy apply when a person dies without leaving a will. Essentially, the first £125,000 (US$247,750) plus chattels are given to the wife, and half of the remainder of the estate is placed in a trust giving the wife a right to income for life. On the wife’s death, the assets pass to any children above 18 years of age. Otherwise, the remaining half is held in a trust until they come of age. Evidently, this approach does not conform to the Shariah, as the assets would be trapped under the trust for an uncertain amount of time, often involving the Court of Protection’s consent when administering the child’s assets. This rule also applies in the event of a dispute between inheritors, possibly leading to a court battle. Mutual agreement between all heirs to share the assets could avoid such a distressing situation. However, there is no certainty of this, particularly in cases involving a considerable amount of assets.
Once death occurs, all authorities (such as banks and investment companies) will freeze the deceased’s assets until a probate certificate is received by them. Accounts held jointly escape this freeze and the surviving partner can continue using the account after the other partner passes away.
The presence of a will enables the named executors to obtain a probate certificate. Without a will, the spouse and children would need to get letters of administration. With the certificate of probate, the executors are authorized to manage the assets of the deceased with a view to transferring them to the ownership of the rightful heirs.
The process of probate can be completed within a few months if the assets of the deceased are less than £150,000 (US$297,270) and if there are no inheritance tax concerns. Otherwise, it can take years to conclude. A probate certificate will only be issued once the inheritance tax liability is paid. There are ways to resolve this situation and manage the probate process efficiently from an Islamic as well as a legal perspective.
It is clearly very important for a Muslim to plan his financial affairs adequately prior to death. The Shariah strongly supports this view. For Muslims owning substantial wealth, the Islamic philosophy, however, must be accompanied by sophisticated trust-based tax planning in line with UK taxation laws. Failure to achieve this may render the entire Islamic planning void, and result in a 40% tax charge. It is recommended that Muslims utilize trust-based will solutions. These are legally valid, thereby avoiding the laws of intestacy. Furthermore, by placing assets on death into trust, the trustees are able to ensure an Islamic distribution occurs. Finally, certain types of trust are effective at mitigating inheritance tax as well as providing asset protection. Careful drafting of one’s will, including the right type of Shariah compliant tax effective trusts, along with choosing honest trustees, will allow the preparation of a legally valid, tax efficient and Shariah compliant will.
What follows is a clear illustration of the case, based on a real life case study, where the estate value exceeds £575,000 (US$1.13 million) but not £1.5 million (US$2.97 million).
Sufiyan is married to Ameena and they have a son and two daughters. Sufiyan has an estate worth £950,000 (US$1.88 million), excluding business property worth £1 million (US$1.98 million), from his IT firm which he founded and still owns. In addition, Ameena owns assets worth £285,000 (US$564,860). Sufiyan’s personal pension fund totals £200,000 (US$396,478). The question then arises on the potential IHT liability: how it can be reduced and how should these estates be distributed in an Islamic way through their wills?
The potential liability amounts to £266,000 (US$527,275) (40% tax applied to the difference between Sufiyan’s estate less the NRB). To reduce the tax liability, a will in accordance with the Shariah and inserted with two key trusts needs to be created. The trusts are the DT, as defined earlier, into which assets equivalent to the NRB will pass on death (referred to as a NRB discretionary trust). In addition, an interest in possession trust (IIP), which has a life tenancy for the living spouse, is set up. A life tenancy is simply the right to income for life. As the wife holds a life tenancy in the IIP, all transfers to the IIP are free of IHT on death. A transfer to an IIP is essentially the same as an inter-spouse exemption for taxation purposes. Naturally then, the balance above the NRB on the first death will be passed into the IIP to avoid any taxation.
Adequate planning of one’s financial affairs is crucial for Muslims, as laid out in Shariah law. Those who own substantial wealth not only need to properly follow through with rules set out under the Shariah (see below), but must also acknowledge the importance of trust-based tax planning, in line with UK taxation laws. Failure to observe these laws would cause a hefty tax charge of 40% to the heirs. Islamic tax planning utilizing trust-based will solutions is legally binding and avoids the laws of intestacy. Placing assets into a trust also ensures that the trustee can distribute the wealth according to Shariah principles. Moreover, certain types of trust are also effective at mitigating IHT and providing asset protection.