A Quick Tour of Scots Law and Taxation - Warnings and Opportunities

It is 303 years since the Union of the English and Scottish Parliaments took place, and 13 years since a parliament returned to Edinburgh, with devolved powers under the terms of the Scotland Act 1998.

Many will be aware of Scotland’s distinctive legal system, which was specifically preserved in the terms of the Union of Parliaments between Scotland and England in 1707, but perhaps the more commonly held view internationally is that Scots Law may be regarded as an off-shoot of English Law, like the legal systems of Ireland (North and South).

This would be a mistaken perception.

In fact, Scots Law is closely aligned with the mainstream European Roman based systems of law, but is clearly heavily influenced by English law since the Union of 1707. This distinction would be obvious to those who have been involved with both systems of law, the contrast being between the inductive, case-based, nature of English Law, compared with the principled, deductive nature of Scots Law.

Devolution of most legislative powers to the Holyrood Parliament in Edinburgh is helping to preserve the distinctive nature of Scots Law in terms of detail, as well as its fundamental guiding principles.

Nevertheless, until, or subject to, any future devolution of significant tax powers, tax remains the preserve of the UK Government in Westminster, with uniformity across the UK being the policy.

The only significant tax power in the devolved Scottish Parliament enables the variation of basic rate income tax by 3 per cent, up or down, a power which, thus far, has not been exercised. Neither the previous Labour/Liberal Democrat Administration, nor the current Scottish National Party (SNP) Government of Scotland have been persuaded that any deviation from uniformity of the UK income tax rate is merited.

Uniformity in taxation has not always existed during the period of the Union. Customs and Excise controls remained in place between England and Scotland until the 19^th century. Even today, while uniformity is the general aim, there are differences which arise as a result of attempting to put a uniform tax regime onto such fundamentally different legal systems.

The differences in the legal systems also need to be taken into account when clients are undertaking tax and succession planning. In some cases, the application of Scots law presents opportunities which are not available in England.

It may be illustrative if a few examples are considered.

Legal Rights – Inheritance Tax and Succession Planning

It is a feature of English Law and other common law legal systems that individuals have the fullest possible testamentary freedom. This is in contrast to the civil legal systems, where concepts of forced heirship are prevalent. Scots law follows this principle. Although a testator is free to make a will making any testamentary provision he or she wishes, even to the exclusion of his children or remoter issue, it is nevertheless the case that the distribution of the estate is subject to claims of legal rights by children.

For historical reasons, legal rights are only available on the moveable estate. Where there is a surviving spouse, children can, between them, claim one third of the net moveable estate. Were there is no surviving spouse, the share claimable rises to one half of the net moveable estate. No claim under this category lies against heritable estate (real estate). This claim is referred to as legitim.

A similar right is available for spouses who may otherwise face disinheritance, referred to as ius relicti or ius relictae. The claim is for one third of the net moveable estate when there are surviving issue raising to one half if there are none.

Legitim may be, and often is, discharged within ‘functional’ families, but if unclaimed, the rights persist until prescription after 20 years (or even longer in the case of minor children).

This has major implications for tax planning. In the UK inheritance tax is set at 40 per cent above the nil rate band of aggregated transfers, which is currently GBP325,000. A common strategy is for one party to the marriage to leave everything to the surviving party on the first death, under testamentary provisions, taking advantage of spouse exemptions for inheritance tax.

On the second death, when the combined estate passes down a generation, inheritance tax would be chargeable at 40 per cent on the excess over the nil rate band (which for the surviving spouse may be doubled to GBP650,000). However, this may be pre-empted by judicious lifetime gifts by the surviving spouse, avoiding inheritance tax after seven years survival. What this means is that commonly, on the first death of a married couple, there is no inheritance tax to pay, no matter what the extent of the estate.

This outcome is not automatic in Scotland, even if a will is made leaving everything to the surviving spouse. Because the surviving issue have a right to claim legal rights, it would be presumed, for tax purposes, that such rights will be claimed. The amount potentially claimed does not qualify for the spouse exemption, and this may result in a liability to inheritance tax.

Example

Donald McBain dies leaving estate, including moveable estate of GBP4,200,000 to his wife under his Will. He has one son Eric who has not been in contact for many years. Eric has a potential claim of GBP1,400,000 (one third of the moveable estate). Assuming the full nil rate band of GBP325,000 is available, the remaining GBP1,075,000 is taxable at 40 per cent, giving rise to an inheritance tax charge of GBP430,000.

In the event of legal rights being disclaimed by one or more of the potential claimants within two years of the death, then the condition will be reprieved. The disclaimed share of estate will pass to the surviving spouse under the will, and the inheritance tax spouse exemption will apply to the relevant part of the estate.

However, if there is a delay in discharging the legal rights, and more than two years passes, then inheritance tax will be assessed, based on the amounts claimable by the issue. This applies even if they subsequently, within the 20 years prescription period, disclaim their rights. This has a further adverse consequence. As well as losing the spouse exemption on the amount of the original legal rights claim, the subsequent discharge outwith the two year period is treated as a gift by the child then disclaiming, with the possibility of further inheritance tax consequences were he or she to die within the following seven years.

These rules are varied when children under the age of 16 years, (the age of the majority in Scotland) are involved, but the same general considerations essentially apply.

Intestate Succession

In terms of intestate succession in Scotland the rules again are fundamentally different from those which apply in England and Wales. Historically, provision for the surviving spouse was rather poor, and this was addressed in terms of the Succession (Scotland) Act 1964, which made amended and enhanced provision for surviving spouses.

The resulting position is somewhat complex, being a mixture of the modern statutory provisions, together with the common law provisions, including the matter of legal rights discussed above. These legal rights are claimable by spouse or issue on both testacy and intestacy, but subject to a spouse’s statutory ‘Prior Rights’, which apply on intestacy only.

Prior rights, as the name suggests, take precedence. The surviving spouse will have a right to:

• The deceased spouse’s interest in the home of the surviving spouse (usually the matrimonial home) up to a maximum value of GBP300,000.
• Furniture in the home of the surviving spouse up to a maximum value of GBP24,000.
• A cash right of GBP42,000 (if there are surviving issue) or GBP75,000 if there are no surviving issue. 

It will be noted that in the case of a deceased person with a modest estate (indeed the majority of citizens would fall into this category), then the surviving spouse would take the whole estate, which would be exhausted by the prior rights.

Where there is estate left over after prior rights, then spouse’s legal rights, as discussed above, are claimable out of the excess. This would give the surviving spouse a right to:

• One third of the remaining moveable estate (if there are issue) or one half (if there are no issue).
• Issue of the deceased may likewise claim their legal rights.

Thereafter, the remaining ‘ free estate’ will pass to the children or close blood relations of the deceased, failing which to the surviving spouse, failing which to more distant blood relations. There is no limit in terms of the distance of blood relations, who may benefit other than that imposed by the practical difficulties of tracing them.

Comparison with the equivalent provisions in England would demonstrate that the spouse provision may differ significantly. In England, the provision made for a spouse in an intestate estate is broadly:

• Chattels (furniture and personal effects)
• A statutory legacy of GBP250,000 (if there are issue) or GBP450,000 otherwise
• Half the residue as a life interest (if there are issue), or as an absolute interest otherwise. 

The differences in distribution between two similar estates in Scotland or England would depend on the composition of the estates. Where there is no heritable property (real estate), in the estate, then the spouse provision in Scotland may be significantly less generous. The subsequent inheritance tax liabilities will differ markedly.

Example

Angus McIntosh dies intestate leaving moveable estate of GBP900,000, plus modest furniture. His wife inherits the furniture, cash of GBP42,000 and claims legal rights of GBP286,000. His children take the remainder of GBP572,000, subject to inheritance tax of GBP98,800. If he had been English domiciled, his wife would have been entitled to cash of GBP250,000 and a life interest of GBP325,000. The balance of GBP325,000 would pass to his children with no inheritance tax payable.

Jointly Owned Property

In England, joint property can be held under a tenancy in common (each party having a separate interest, which they can bequeath by their wills), or by joint tenancy (under which at the death of one of the owners, the property passes to the surviving co-owners). Although the underlying law relating to ownership of property is fundamentally different in Scotland, the same overall effect can broadly be achieved through title to heritable property being owned in separate pro indiviso shares, or by incorporating a special destination in the title, so that the title passes automatically to the survivors on the death of one of the owners. It is important in succession planning to check on these provisions, to ascertain whether shares in property can competently be bequeathed in terms of a will.

Where property is held subject to a special destination, this will take precedence over any testamentary provisions in a will. It is possible to amend the title provisions. In England, this is achieved through severing the joint tenancy, which has its own special rules. In Scotland, this can be achieved either by a re-conveyance of the property by the parties (to one without the special destination) or by evacuation of the special destination. There are particular rules determining whether or not such a procedure is competent. Generally, where parties buy a house jointly, and share the purchase price, it is not possible to unilaterally evacuate the special destination relating to one party’s share, and the process must be undertaken jointly, with further special rules to be observed. In all cases, legal specialist advice in Scotland should be obtained, before attempting to deal with any share of heritable property in terms of a will.

In the case of married couples owning property, these rules will have direct inheritance tax consequences, of course.

Valuation of Joint Property

It should also be noted that the processes by which parties may realise their interests also has a bearing on the valuation of each party’s interest in joint property, and hence has inheritance tax consequences.

Example

Mr and Mrs Smith are domiciled and live in England, owning their property under a joint tenancy. They may each be able to sever the joint tenancy to own the property as a tenancy in common. However, this will not necessarily make it viable for either of them to realise their separate interests in the property. This has the effect of limiting the value of their respective half shares, there being no ready market for purchasing shares of property, burdened with the occupancy rights of the other owner.

The valuation of either Mr or Mr Smith’s half shares would be limited accordingly. This will have direct tax and tax planning consequences.

Mr and Mrs McDonald, domiciled and living in Scotland also own their property in joint names.

As a matter of general law in Scotland either Mr and Mrs McDonald has an absolute right to realise their half share of the property. They can do this by forcing their co-proprietor to join in the sale of the whole subjects, through court action if necessary. Accordingly, Mr McDonald’s share of the property would be valued without such a generous discount as would be applied to a half share in England. The only modification would be a reduction in the value to reflect the cost of pursuing the court process involved in realising the interest. Generally this reduction in value is unlikely to exceed GBP15,000. Accordingly, a half share of a property in Scotland is likely to be valued at more than a half share of a property in England, having the same overall value.

Proper Liferents

In Scotland, as in England, it is possible for a property to be held in trust, with a beneficiary having a life interest in the property, known in Scotland as a ‘liferent’. This would mean the title to the property would be held by trustees.

It is possible, however, to achieve the same position without any trustees, or trust provisions. This involves title to the property actually being held by the liferenter, specifically in a ‘proper liferent, and by the ‘fiars-in-fee’ (being equivalent to the remaindermen and the reversionary interest).

Although these are actually forms of ownership, and not trust provisions, the inheritance tax legislation in the UK makes specific provision for these proprietorial interests to be treated in the same way as a liferent trust. In other words, the liferenter would be taxed as if they were absolute owners of the property, while the fiars’ interest is exempt from inheritance tax.

This provision is attained through Section 43 (4) of the inheritance tax Act 1984, which extends the meaning of a ‘settlement to include a proper liferent.

It is interesting to note that while specific provision is made for such proprietorial interests in Scotland, it does not extend to equivalent proprietorial interests in other countries e.g. a usufruct in Spain. There it may be argued that a deceased person who had a usufruct held this as an asset which attained a zero value on death, resulting in no inheritance tax being payable in the UK, whereas in Scotland the equivalent liferenter would be assessed on the full open market value of the property.

Unilateral Gratuitous Obligations

A significant difference in the law of personal obligations arises in Scotland and England in respect of unilateral gratuitous obligations – in other words, promises. The general rule in Scotland is that such an obligation, once communicated, is legally binding. It does not have to be a contract, or with any consideration being paid, but the effect overall, is similar to the rights arising under a contract.

Example

Mrs McKenzie advises her niece, Morag, in a letter on 14 March 2010 that she is going to make a gift of GBP500,000 to her. On 14 April 2010, she writes a cheque, and sends it to her niece. After some delay, on 14 May 2010, her niece lodges the cheque with her bank. However, before it clears, Mrs McKenzie dies on 17 May 2010, and her bank account is frozen, leaving the cheque unpaid. Morag is entitled to the money from Mrs McKenzie’s estate. She was absolutely entitled to the money as soon as she received the cheque in April, and indeed as soon as she received the letter in March, when the promise was first made.

The sum of GBP500,000 is therefore a liability on Mrs McKenzie’s estate, reducing its value. In England, no such liability would arise, and this would be Morag’s loss.

What this would mean, at first sight, for inheritance tax purposes, is that in Scotland, the gift would have been a lifetime transfer (with the possibility of annual exemptions being deductible against it). Moreover, had Mrs McKenzie survived until April 2017, then very different inheritance tax consequences would have arisen. The gift might be thought to escape the seven year clawback for inheritance tax purposes, although it would fail to achieve this in England until May 2017.

However, specific provision has been made to combat this by section 5 (5) of the inheritance tax Act 1984. The effect of this is that Mrs McKenzie’s obligation to pay funds to Morag is not deductible as a debt for IHT purposes, until the cheque has actually cleared, even though it is a legally enforceable liability. While, in one sense, this may be seen as achieving the same position which would obtain in England, in another sense, it does mean that a valid legal obligation on Mrs McKenzie’s estate is not, in fact, deductible for IHT purposes. Moreover, there is the possibility that if Morag were to die during April 2010, her estate would include the legally enforceable right to the gift, and be taxed accordingly, while at the same time, the gift would be treated on Mrs McKenzie’s estate, as if it had not been promised at all.

It should be noted that there are no equivalent provisions for capital gains tax legislation. If a promise of an asset is made in Scotland, then, upon the gift actually being effected, the disposal is deemed to have taken place at the time the promise was made, not on the date of actual transfer, which would be the case in England.

Powers of Attorney

One of the first acts of the new Scottish Parliament was an overhaul of the law on Powers of Attorney in Scotland. The resulting regime was apparently so successful, that a few years later, many similar provisions were enacted in England and Wales. There remain significant differences, however, between the operation of ‘Continuing Powers of Attorney’ in Scotland and ‘Lasting Powers of Attorney’ in England and Wales.

For tax planning purposes, it is important to appreciate the flexibility which is available to persons having granted a Scottish continuing power of attorney. This may include specific provision for the making of gifts by their attorneys. The process is far less straightforward in England, generally requiring court approval. For this reason, clients who are in the position of exercising a choice of legal systems in relation to power of attorney may prefer to opt for the Scottish option. This is available to clients who are, or have previously been habitually resident in Scotland, or who are UK citizens having their closest connection with Scotland, rather than any other part of the UK.

Trusts

Trusts in Scotland operate in many respects with a greater degree of flexibility than in England. In particular, trusts in Scotland are not subject to any perpetuity period, and can last indefinitely. The fact that anyone can set up a trust in Scotland, whether they have any personal connection with Scotland or not, affords the possibility of avoiding some of the more cumbersome rules inflicted upon English trusts.

Another specific example relates to the ownership of indivisible property (such as a house) owned by a trust for children. Where a group of children respectively attain a vested interest in the trust estate at the age of 25 years, say, this can result in difficulty in England. The interest of a child reaching the vesting age may still be subject to trust provisions, due to the indivisible nature of the assets.

This problem does not arise in Scotland, where it is quite possible for each child to acquire an absolute pro indiviso share in the trust property, with the trust accordingly coming to an end for tax purposes in respect of such share on the child’s 25^th birthday.

Conclusion

Although the policy has been to achieve uniformity of taxation between Scotland and England, the different legal systems give rise to important differences in otherwise similar situations. It is essential that in tax and succession planning, these differences are taken into account. It is risky for those accustomed to English law to presume that similar actions undertaken in Scotland will have equivalent tax consequences. The reverse is equally applicable, of course, but Scottish practitioners, operating in proximity of their larger neighbour, are more accustomed to taking such differences into consideration.

The moral is that where there is a Scottish element involved, legal advice should be sought in Scotland.