Income Tax - Covenant Relief

1.1 Covenant Relief - 1995 Budget

Introduction

The Minister for Finance announced substantial changes in relation to tax relief for covenants in his Budget Speech. Since then one of the changes made has been modified. This article outlines the changes as they now stand and shows how they will affect tax relief available to individuals on covenants which were in existence before Budget date and those which were made or entered into on or after Budget date.

Reference in the article to:
Budget Date
Means 8 February 1995

New Covenants
Means those made or entered into on or after Budge date.

Existing Covenants
means those made or entered into before Budget date.

Minor means
an individual under 18 years and unmarried.

Unrestricted Tax Relief
means mainly that the 5% income restriction does not apply.

5% Income Restriction
means where a covenant has a covenant to which this restriction applies, the figure to which tax relief applies cannot exceed a maximum of 5% of that covenantor.s total income, and where a covenantor has more than one such covenant, the figure to which tax relief applied cannot exceed an aggregate amount of 5% of that covenantor.s total income.

Total Income
means a covenantor.s gross income less certain deductions from income such as mortgage interest (to the extent that it is relieved from tax @ 48%), Schedule E expenses, capital allowances etc.

Overview of Budget Changes

The Budget changes apply to the following:

• all new covenants
• all existing covenants from 6 April 1995.

The changes are summarised as follows:-

• As a general rule, tax relief has been abolished on the covenants to minors.
• Unrestricted tax relief still applies for 1994/1995 and 1995/1996 on new/existing covenants to all individuals, including minors who are permanently incapacitated (except where a covenant is from a parent to his/her own permanently incapacitated minor child).
• Tax relief , subject to the 5% income restriction, applied for :

  1995/96 in the case of existing covenants and

  1994/95 and 1995/96 in the case of new covenants:

  • to all individuals (other than minors and incapacitated individuals referred above)
  • for research, teaching of natural sciences and to certain bodies for the promotion of Human Rights.
• Tax relief will continue for 1996/97 and later yeas on convenants:
  • to permanently incapacitated individuals,
  • to elderly (i.e. aged 65 or over) individuals,
  • for research, teaching of natural sciences and to certain bodies for the promotion of Human Rights.

Except for covenants to the permanently incapacitated, these covenants will be subject to the 5% income restriction.

EXAMPLE

A covenator has a total income of £20,000 and has made a covenant for £2,000 , which is 10% of total income.

The 5% income restriction applies to the covenant and the covenantor is therefore limited to tax relief on 5% of total income.

The tax relief is calculated as follows:-

(10% total income)

Restrict payment for tax purposes to 5% of total income

It is important to remember that, when a payment is being made to a covenantee, the amount on which tax is deducted must be restricted to 5% of the total income as in this example.

If a covenantor has a number of covenants to which the 5% income restriction applies, the aggregate amount to which tax relief is applied cannot exceed 5% of total income.

Details of Relief available on covenant payments between particular individuals for 1994/95 and later years

Parents to Children

Minor Child
As a general rule a parent cannot get tax relief on a covenant to a minor child.

Adult Child
Tax relief applied for 1994/95 and 1995/96 only, subject to the 5% income restriction.

Permanently Incapacitated Adult Child
Unrestricted tax relief will continue for all years for covenant payments to permanently incapacitated adult children.

Grandparents to Grandchildren

Minor Grandchildren
Tax relief, subject to the 5% income restriction, applied for 1994/95 on an existing covenant. There is no relief available for 1995/96 or later years, unless the grandchild is incapacitated (see below). No relief is due on new covenants.

Adult Grandchild
Tax relief applied for 1994/95 and 1995/96 only, subject to the 5% income restriction.

Permanently Incapacitated Grandchild
Unrestricted tax relief will continue for 1994/95 and later years for covenant payments to permanently incapacitated grandchildren, irrespective of age.

Covenant from other individuals to Minors

Nieces/Nephews and other Minors
Unrestricted tax relief applied for 1994/95 only on an existing covenant. No relief is available for 1995/96 or later years on an existing covenant. No relief is due for any year on new covenants.

Permanently Incapacitated Nieces/Nephews/other Minors
Unrestricted tax relief will continue for 1994/95 and later years for covenant payments for permanently incapacitated minors.

Covenants from individuals to other adult individuals

All adult individuals who are not permanently Incapacitated

Tax relief applies for 1994/95 and 1995/96 only, subject to the 5% income restriction as follows:-

• if the covenant is new, the restriction will apply for both 1994/95 and 1995/96
• if the covenant is an existing covenant, the restriction will apply for 1995/96 only.

Elderly Individuals who are not incapacitated
Tax relief will continue for 1994/95 and later years, subject to a 5% income restriction as follows:-

• if the covenant is new, the restriction will apply for 1994/95 and later years,
• if the covenant is an existing covenant, the restriction will apply for 1995/96 and later years.

All adult individuals who are permanently Incapacitated
Unrestricted tax relief will continue for 1994/95 and later years for covenant payments to permanently incapacitated individuals.

Covenants for research and teaching of natural sciences and to certain bodies for the promotion of Human Rights

Tax relief applies for 1994/95 and later years, subject to the 5% income restriction as follows:

• if the covenant is new, the restriction will apply for all years
• if the covenant is an existing covenant, the restriction will apply only from 1995/96.

Covenants between Separated Spouses
Covenants, which are part of maintenance agreement, as defined in Section 3 Finance Act 1983, between separated spouses are not effected by the Budget changes.