Deed of variation

Patrick reviews the recent High Court judgment of Vaughan-Jones v. Vaughan-Jones [2015] EHC 1086 (Ch) in which a defective deed of variation was rectified by the court.

The background

Richard Vaughan-Jones died on 18 October 2009 and, under his will, he left his estate to his wife and three sons in equal shares.

On 13 October 2009, Mr Vaughan-Jones’s widow, his executors and his three sons signed a deed of variation, varying the terms of his will so that all of Mr Vaughan-Jones’s residuary estate was left to his wife.

When a deed of variation is properly executed, the terms of the will that are replaced by the terms contained in the deed are treated as though they had always been in the will for inheritance tax and capital gains purposes i.e. the estate’s tax liabilities are calculated with reference to the replaced terms (this is known as the “writing back effect”).

A perfectly executed deed of variation will meet the following criteria:

• it will be in writing;
• it will be signed by everyone whose entitlement from the estate is altered by the changes that the deed makes to the terms of the will;
• it will be signed by the executors of the estate if it changes the estate’s tax liabilities;
• it will have been signed within two years of the date of the death of the person who has passed away if it is to be effective for tax purposes;
• no consideration (i.e. money or money’s worth) will pass to any of the parties to the deed in return for making the deed; and
• the deed will state that the writing back effect applies to the terms of the deed with reference to the relevant legislation.

The reason that the terms of the will were varied in Mr Vaughan-Jones’s estate was to lower the estate’s inheritance tax liability. Anything that you leave to your spouse or civil partner is not subject to inheritance tax (this is known as the “spouse exemption”). In this case, the estate’s inheritance tax liability was reduced greatly because more of the estate was subject to the spouse exemption than under the original terms of the will.

Effective tax planning is the most common reason for creating a deed of variation.

The legal issue

The solicitor who drafted the deed of variation for Mr Vaughan-Jones’s family failed to include a vital clause in the deed he drafted. The missing clause needed to specify that s.142 Inheritance Tax Act 1984 and s.62(7) Taxation of Chargeable Gains Act 1982 were being applied to the deed for the writing back effect to apply to the estate.

This has been the law in England and Wales since the Finance Act 2002 was enacted and applies to all deeds of variation created after 1 August 2002.

The solicitor administering Mr Vaughan-Jones’s estate submitted the estate’s inheritance tax return to HM Revenue and Customs (“HMRC”), the error in the deed was spotted and HMRC refused to apply the spouse exemption. As a result, three quarters of the value of the residuary estate was subject to inheritance tax (before the application of any other inheritance tax reliefs) and the estate’s inheritance tax liability was therefore assessed at £232,000 rather than £32,000.

The application to the court

The solicitor who drafted the deed of variation died on 2 January 2014 and a new firm of solicitors were instructed to finish administering the estate.

The new solicitors made an application to the court to rectify the deed of variation based upon evidence from the previous solicitor’s file that the family’s intention was for the writing back effect to apply to the deed.

Rectification is an equitable remedy which allows for parties to a deed to apply to the court to rectify the deed where it fails to carry out their intentions either because of a clerical error or because of a failure on the part of the person preparing the deed to understand the instructions.

The firm relied upon the fact that the solicitor who drafted the deed was under tight time constraints (the deed was signed five days prior to the second anniversary of Mr Vaughan-Jones’s death) and was relying on an old precedent that predated the implementation of the changes to the law that were effective from 1 August 2002, resulting in a clerical error. In the alternative, the solicitor had failed to keep up to date with the relevant law.

The court’s decision

The court decided that there was convincing evidence that all of the family members who were parties to the deed had intended for the writing back effect to apply for inheritance tax purposes, but the court was not convinced that they intended the writing back effect to apply for capital gains tax purposes.

To be eligible for rectification, the court held that there must be:

• a real issue that needs to be resolved between the parties (i.e. that rectifying the deed will make a real difference); and
• convincing evidence that the intention of the parties to the deed was to create the document as it would be in its rectified form.

In this case, the real issues to be resolved between the parties were twofold. First, the inheritance tax liability of Mr Vaughan-Jones’s estate would change substantially depending on if the deed was rectified. Secondly, Mr Vaughan-Jones’s three sons were at risk of having made substantial lifetime gifts that would affect the inheritance tax position of their own estates if they died within seven years of making the deed i.e. before 13 October 2016. The reason it could affect the sons’ estates is that any gifts made in the seven years before death are included as part of a person’s estate when it is valued for inheritance tax purposes, subject to a taper relief depending on how many years prior to death the gift was made.

The convincing evidence that could be relied upon in this case was the testimony of one of the sons that he was advised and understood that the purpose and effect of the deed was to mitigate inheritance tax and the attendance notes that the solicitor who drafted the deed had kept of his conversations with the family members who signed the deed. The attendance notes clearly showed that the point of creating the deed was to lower the estate’s inheritance tax liability by increasing the amount of the estate that would qualify for the spouse exemption.

How can this affect you?

• Private Individuals
  If you have created a deed of variation in the last seven years to pass your entitlement from an estate to another person, the value of what you have passed onto another will not be treated as a gift for the purposes of your own estate if the deed has been drafted properly.If the deed you have signed does not contain a clause stating that the writing back effect applies to the variation you have made, then you will be treated as having made a gift (potentially exempt transfer) for tax purposes. If you died today, the value of that gift would be added to your estate when your executor calculates the value of your estate for inheritance tax purposes.For example:Your aunt dies in 2014 and leaves you £400,000 under her will. You decide you would rather that your two children share this inheritance instead.If you execute a deed of variation which does not contain a clause stating that the writing back effect applies, with reference to the legislation, and you die today then, despite the gift, the £400,000 value is added back to the value of your estate solely for the purpose of calculating the amount of inheritance tax which would be payable.In many cases, this would use up all of your inheritance tax allowance (“nil rate band”) which currently allows £325,000 of a person’s estate to pass tax free and would leave a balance of £75,000 that would potentially be taxable at 40%. The resulting inheritance tax bill would be £30,000. This would have to be met by your estate or your two children.
• As an executor
  If you have been appointed as an executor of somebody’s estate it is vital that you check if the person whose estate you are administering was supposed to inherit anything in the last seven years before they died. If that person signed a deed of variation to alter this, the deed needs to be inspected.If the deed does not state that the writing back effect applies then the amount that was given by the person whose estate you are administering to another under the terms of the deed must be added to the value of the estate. If there is insufficient nil rate band to cover the value of the gift and the value of the estate, inheritance tax will be payable or, if the estate already exceeds the nil rate band, additional inheritance tax will be payable on the entire value of the gift.

What can you do to protect your position?

• Obtain a copy of any deeds of variation that you or the person whose estate you are administering have signed in the last seven years and check if they contain a clause with a statement like this:

• If you cannot see a clause like this in the deed, seek legal advice on the impact that this deed will have on the value of the estate you are dealing with. If it is an estate you are administering, you will need to confirm what the value of the gift you are adding to the estate is and if there are any tax reliefs of which you can take advantage (such as taper relief). If it is a deed of variation that you have signed, a lawyer can help you value your own estate to see if it would increase the tax liability of your estate if you died within seven years of creating the deed.
• If, after taking advice, it is plain that the deed is defective and will increase your own tax liabilities or the tax liabilities of the estate you are administering, consider seeking a court order to rectify the deed.

How can I fund the cost of court proceedings?

There is precedent under the case of Marley v Rawlings (No 2) that where drafting mistakes are made by a legal professional and court proceedings are required to rectify that mistake, the professional that created the document should pay for the proceedings.

If you are considering court proceedings, a member of our team can help you review the viability of your claim and whether you might be able to claim your court costs from the solicitor who prepared the deed.

Parting notes

The High Court in the Vaughan-Jones case has referred the case to the First Tier Tribunal for tax matters for settlement.

The reason that the judge has referred the matter to the First Tier Tribunal is that HMRC have issued a counter-argument that, even with the deed rectified, the deed of variation does not qualify for the writing back effect because consideration in money or money’s worth has been given by Mrs Vaughan-Jones to her sons in return for signing the deed.

The consideration that HMRC allege has been given is that the attendance notes of the solicitor who drafted the deed of variation show that Mrs Vaughan-Jones’s plan was to vary the terms of the will so that the entire residuary estate was covered by the spouse exemption. As such, her “gift” was to pass as much money as she received from the estate to her sons on her death, in that hope that she would survive seven years from the date of each gift, meaning that the value of the gifts will not be added to her estate when she dies. Mrs Vaughan-Jones has already made some gifts to her sons from the money she has received from her husband’s estate.

The outcome of the proceedings at the First Tier Tribunal will be important for deed of variation based tax planning for spouses faced with will terms like those of Mr Vaughan-Jones’s will.