The curious case of the Bishop and the Chinese vase

People often like to make gifts of their personal items for sentimental, rather than value, reasons. However, unexpected tax consequences can arise – particularly where the item’s true value is not appreciated at the time the gift is made.

A recent example of this was the tale of the Bishop of Grimsby and the Chinese vase. The vase was owned by Mrs Robertson Rodger, had been passed down several generations of her family and Mrs Rodger had apparently assured her niece, Jennifer Watson, that she would inherit it. However, instead of including a specific legacy of the vase, Mrs Rodger’s will contained a flexible gift of chattels with a non-binding side letter requesting her executors (among whom was the Bishop of Grimsby) to pass the vase to Jennifer Watson free of inheritance tax (IHT).

True worth

When Mrs Rodger died in March 2011, the valuer acting for the estate realised the vase was far more valuable than anyone had realised, being worth £9m. In accordance with usual principles, IHT was payable at 40 per cent on the total value of the estate after factoring in Mrs Rodger’s available nil-rate band allowance. The executors estimated that making the gift to Ms Watson free of IHT would result in the rest of the estate bearing an IHT burden of over £3.6m. Understandably they investigated whether they could take steps to ameliorate this position.

Letters of wishes were not legally binding on the executors, and so they decided to disregard Mrs Rodger’s wishes and to sell the vase. This ensured the IHT bill could be paid and that the deceased’s other assets could be retained for the other beneficiaries under her will. Although initially Ms Watson strongly objected to a sale, a settlement was later reached allowing the vase to be sold in November 2011 for £9m.

This case raises some interesting points for those thinking of passing on chattels.

Consideration should be given as to whether an outright legacy in the will, or a non-binding flexible gift, is most appropriate. If a specific legacy had been included in Mrs Rodger’s will, Mrs Rodger would have had much greater certainty that the vase would pass to Ms Watson. However, this would have made it far more difficult for the executors to mitigate the tax bill.

Additionally, a flexible gift can be preferable as it allows the testator to update his wishes simply by writing a new side letter rather than going to the expense of amending his will. Clients should of course be informed that letters of wishes are not legally binding, although they are usually followed – unless there is a good reason, as there was here, not to do so.

Whichever method is chosen, if the donor retains the asset until his death its value will be in his estate for the purposes of calculating the IHT due.

Some individuals with valuable chattels may wish to obtain advice on the availability of the conditional exemption. The test for chattels is whether they are ‘pre-eminent’ for ?their national, scientific, historic or artistic interest. While this exemption may seem a relatively easy way to escape IHT in appropriate circumstances, it only allows IHT charges to be deferred (rather than avoided) and the conditions are strict, including allowing public access to the items in question. If these conditions are breached at any stage, ?or if the item is gifted or sold, this can trigger the deferred IHT charge. There can also be capital gains tax liabilities at this stage, so care should be taken to consider longer-term planning before claiming this exemption.

Present and correct

If the donor is confident that he will have no use for the item, he may wish ?to give it to the intended recipient during his lifetime. He will have the pleasure of seeing the chosen beneficiary enjoying the item while ensuring its value is outside his estate for IHT purposes (assuming he survives the ?gift by seven years).

However, there can be tax implications of lifetime gifts too and potential donors should always seek to ascertain the market value of the item in order to consider the tax consequences before making the gift.

An outright gift to another individual will (provided the donor survives seven full years from the gift) attract no IHT charge. However, if the donor dies within seven years, then (unless the conditions of the gift specify otherwise) the donor’s nil-rate band will be reduced by the value of the gift – and the liability to pay the IHT will fall on the recipient.

Particular caution should be taken where the donor intends to make a gift of a personal item but still benefit from that item in some way as, even if made more than seven years before death, these gifts can be caught by the ‘reservation of benefit’ rules. Essentially, if the donor continues to receive some benefit from the asset at any point during the seven years immediately before his death, the value of the asset is taken into account for IHT purposes on his death – for example, if Mrs Rodger had given the vase to Ms Watson by formal deed of gift but actually kept it on her own mantelpiece until her death. These rules mean the value of the asset remains in the donor’s estate long after he thought he had made the gift. While it is possible for a donor to continue to benefit from an item gifted in certain circumstances, these exemptions are complex.

No information is available on the value of the vase when Mrs Rodger inherited it (her ‘base cost’ for CGT purposes). However, if we assume for the sake of argument that it was worth £2m at that stage then, simplistically, a gift to an individual during her lifetime would have triggered a ‘deemed gain’ of £7m charged to CGT at 28 per cent, i.e. a £1.96m CGT bill. There would also have been a risk of Mrs Rodger dying within seven years, also triggering a liability to IHT. Although she may have been able to insure against the IHT risk, the CGT bill alone would deter most people from making the gift.

Percentage game

An alternative may be to pass assets with large inherent gains into a discretionary trust in order to claim holdover relief from CGT, but there will be an immediate charge to IHT at 20 per cent if the value of the asset is over the donor’s available nil-rate band. The donor needs to survive a full seven years from the gift before their nil-rate band will be available again, and trusts are subject to their own tax regime which may render this option unattractive.

Where an asset carries a large inherent gain and a lifetime gift would be prohibitively expensive because of tax, it can be sensible for the owner to retain it. This is because there will be an uplift in the CGT base cost to the market value at the date of death, i.e. the probate value, eliminating the inherent gain. Keeping an asset in an individual’s estate could of course have unpleasant IHT implications on the owner’s death, but it may be possible to avoid these, for example, by providing for the asset to pass to the individual’s surviving spouse (securing the spouse exemption). The spouse can then choose to give the item to the intended recipient shortly afterwards, with little or no CGT to pay. The spouse needs to live at least seven years from the date of their gift to avoid this being taken into account as part of their own estate for IHT purposes, and it may be appropriate for the spouse to take out term insurance against this risk.

Making a gift of a personal item to a person can be straightforward, depending on the gift and its value. However, complications can arise, and it is prudent where appropriate to make sure that the donor has an up-to-date market value of any personal items he wishes to give away, either during his lifetime or by will and to obtain proper advice on the tax implications of gifts of such items, particularly where the donor wishes to retain any use or enjoyment of the asset after the gift is made as reservation of benefit rules may render all the IHT planning in relation to that asset pointless.

Elizabeth Field is a solicitor at ?Mills & Reeve