What is a Deed of Covenant? A client asked us that question during the week. It’s a question we have on our Income Tax checklist. We send a checklist to clients to fill in before we complete their Income Tax returns. It got me thinking about covenants and the tax benefits for the payer and the recipient.
A deed of covenant isn’t something we see that often now. But it was all the rage years ago. I’m not sure why that is. It has gone out of fashion. A bit like the writer, over the hill, and should be on display in a museum. I saw this for the first time with a new client at the end of last year and because of that, I could see the value of a covenant. We’ll look at
- What is a covenant?
- Tax Relief
- How it works
- Practical uses
- Summary
What is a covenant?
A covenant is a legal agreement to pay another individual a set amount of money. The person paying the money can’t receive any benefit in return for making a payment. The person who makes the payment is the covenantor. The individual who receives the payment is the covenantee or beneficiary.
A deed of covenant, to be a legally binding document must be a document that is
- signed
- witnessed
- given to the beneficiary
Tax Relief
Certain covenants will qualify for tax relief and those are to
- Individuals who are over 65 and
- Permanently incapacitated individuals irrespective of age
There’s no tax relief on a covenant payment to a permanently incapacitated minor child of the taxpayer. Yet it works once the child is no longer a minor.
There is a limit on the tax relief of 5% of total income where a payment is to a person who is over 65.
In the first instance, the covenant must be for more than 6 years. The usual covenant form is for 7 years but it can be for an indefinite period. For example, you covenant to pay your dad €5,000 a year for the rest of his life. Say, he’s 85 and he can live a lot longer than 7 years. If he dies after 4 years the covenant is still effective as it was capable of being more than 7 years at the outset.
The covenantor can get tax relief at their highest tax rate. Plus, my understanding is that it will also qualify for USC relief at your top rate. For a PAYE taxpayer that is an extra 8% and it can be up to 11% for a self-employed person.
However, the payer must deduct tax at the standard rate of 20% from the payment. So, it depends on your circumstances if this is tax-effective or not. It will have limited to no tax benefits if the payer and the beneficiary pay tax at the standard rate. It’s best to look at a few examples to show how it works.
How it works
John Power, aged 78, gets a letter from Revenue saying he has overpaid tax by €400 in 2020. But he has to file his tax return Form 12 for that year to get the money back. John is a quiet man who doesn’t like getting letters from Revenue. A brown envelope with a harp gives his heart a little flutter but his pacemaker kicks in to regulate the issue.
His dilemma is does he want to get involved with Revenue for the sake of €400. Not knowing where to start his lady wife Mary calls the office. They come in for an appointment and we log into his myAccount and see that over the 4 years 2020 to 2023, he has overpaid by €1,600. We can get this back for them, but the Powers are thinking they won’t be much better off after paying our fees. Despite that, they are anxious to have everything up to date and will still have money left over.
Before filing their tax return, we go through the questions on our checklist. They have no other income, but Mary says
“What about the €5,000 that Tommy gives us every year?”
It turns out their son Tommy set up a deed of covenant years earlier. John and Mary gave their land to Tommy in 2015. But to ensure they had enough income after transferring the land they set up a covenant. Tommy would pay them €5,000 every year and he pays that every December.
Tax Implications
John and Mary weren’t aware of the tax implications of the payment. Their other incomes were the State pension and a small employment pension on which John paid €400 tax. The €5,000 payment they get is net of 20% tax, so the gross payment is €6,250.
| €5,000/80% X 100% | €6,250 |
For 2020 their total income was
| State Pension | €25,000 |
| Employment Pension | €4,000 |
| Covenant Payment | €6,250 |
| Total Income | €35,250 |
Because they are over 65 and their total income is less than €36,000, they are exempt from Income Tax. Given they are exempt they will get a tax refund of €1,650 which is
| PAYE on employment pension | €400 |
| Tax deducted on covenant | €1,250 |
They didn’t have to pay USC on the covenant income. The employment pension and the covenant income are less than the €13,000 threshold where you start to pay USC. State pensions are not liable to USC.
So, a great result for John and Mary as their refund went from €400 to €1,650. But what tax benefit does Tommy get?
Tax Benefit – Tommy
Tommy and his wife Rachel are both working. Their combined income for 2020 was
| Tommy’s salary | €50,000 |
| Rachel’s salary | €60,000 |
| Farming profit | €20,000 |
| Total | €130,000 |
| 5% of €130,000 | €6,500 |
Remember the most that Tommy can get tax relief on is 5% of his joint total income with Rachel. As the gross payment of €6,250 is less than €6,500 he’ll get full tax relief on the gross covenant payment.
| Gross payment | €6,250 |
| Income Tax relief 40% | €2,500 |
| USC relief 4.5% | €281 |
| Total | €2,781 |
| Less tax withheld 20% | €1,250 |
| Tax relief | €1,531 |
So, Tommy pays €5,000 and gets tax relief of €1,531. The net cost for him is €3,469. The parents get the €6,250 in full. The €5,000 in December and a refund of the €1,250 withheld by Tommy.
Restricted Payment
Let’s assume that Tommy and Rachel’s Total Income for 2020 was €100,000. 5% of that is €5,000. As a result, the maximum deduction they can get tax relief on is €5,000.
| Restricted payment | €5,000 |
| Income Tax relief 40% | €2,000 |
| USC relief 4.5% | €225 |
| Less Tax withheld 20% | €1,000 |
| Tax relief | €1,225 |
In this case, John and Mary would include the €5,000 as part of their total income and not the full €6,250. They would get a refund of the €1,000 withheld by Tommy.
Remember that no restrictions apply on covenant payments to permanently incapacitated individuals. However, the covenant must be a qualifying covenant in written format for more than 6 years as mentioned above.
Practical uses
The obvious practical use is when you are already paying some of your parent’s expenses. You could be paying their medical insurance, some household bills, or medical costs. This can be a way to get some tax relief for those payments. You’ll need to be mindful of your own and the beneficiary’s personal circumstances.
For example, say you pay medical expenses for a parent or incapacitated child. Then, you can get tax relief at 20% for medical expenses and 40% tax relief for nursing home costs. Plus, would this extra income for a parent limit a payment they get from elsewhere? Some Department of Social Protection payments are means-tested, and this extra income could impact a means-tested assessment.
Summary
The phone call by Mary Power to us worked out well for them. With combined tax refunds over the 4 years coming to €6,500, they were very happy. It works out well for Tommy too. He is committed to paying €5,000 every year no matter what. The fact that he can get some tax relief is a benefit. The €1,500 tax relief for him eases the pain. Plus, he knows that his parents are more comfortable getting the annual payment from him. More spending money for the annual trip to Tenerife.
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