On 4 July 2019 the Office for Tax Simplification published its second report “Simplifying the Design of Inheritance Tax.”
It is difficult to know at this point whether the report will just sit on a shelf somewhere collecting dust or will be taken forward by the government to implement change. The report was commissioned by Philip Hammond when he was Chancellor, so following a change of leadership and Brexit, Brexit, Brexit who knows…
The Residence Nil Rate Band (“RNRB”) was not within the scope of the OTS review since it is “too new”. It was also a flagship policy which enabled George Osborne to say he had fulfilled his promise of a £1m nil rate band. Trusts were also outside of the remit of the OTS due to the fact that HMRC is already looking at changes to trust taxation.
The OTS made 11 recommendations in the report concentrating on three key areas of Inheritance Tax:
1 Lifetime gifts, including liability for paying any tax due on such gifts
2 Interaction with Capital Gains Tax
3 Businesses and Farms
I will take this opportunity to consider the current basis of IHT in the UK, along with the OTS proposals. I will look at each of the three key areas in a separate article to be published over the next three weeks. In this article I will consider key area 1 – lifetime giving.
The current regime
When Inheritance tax was introduced in 1986, to replace capital transfer tax, it was designed to encourage lifetime giving. There are a number of reliefs and allowances available in respect of lifetime gifts.
In each tax year, an individual may make exempt transfers of property up to the value of the annual exemption of £3,000.
Unused annual exemption may be carried forward to the next tax year. If not used in the next year it is lost. If two or more transfers are made during a year, the annual exemption is attributed to the transfers in chronological order.
An individual may make tax-free gifts up to and including £250 (in total) each tax year to any one recipient. The exemption does not apply to exempt part of a gift that exceeds £250.
Normal expenditure out of income
A transfer is exempt if:
- it is made as part of the normal expenditure of the transferor
- taking one year with another, it is made out of surplus income (not capital)
- taken together with all the transfers that form part of his normal expenditure, the transferor is left with sufficient income to maintain his usual standard of living
Normal expenditure is typical or habitual expenditure. The first gift in a series may be exempt if it can be proven that the donor intends to make further gifts (e.g. by setting up a direct debit in favour of the donee).
Unlimited gifts can be made to a spouse free from inheritance tax, with just one exception and that being where the recipient spouse is not UK domiciled and therefore their estate is outside the scope of UK IHT. In this situation the spouse exemption is limited to £325,000.
Gifts in consideration of marriage
An individual may make an exempt gift to another person in consideration of that person either marrying or entering into a civil partnership.
The amount of the exemption depends upon the relationship of the donor to the recipient :
- for a parent of the bride or groom the maximum exemption is £5,000
- for a grandparent (or great-grandparent, etc) of the bride or groom the maximum exemption is £2,500
- for the future spouse the maximum exemption is £2,500
- for any other donor the maximum exemption is £1,000
If the value of a gift exceeds the maximum amount of the exemption, any excess is treated as a potentially exempt transfer (see below).
The above are the main reliefs and exemptions which will apply when a gift is made from one individual to another. There are various exemptions in other circumstances such as gifts to charity or to a political party but I will not cover those here.
Nil Rate Band
Every individual has a Nil Rate Band (“NRB”) of £325,000. Gifts which are not covered by one of the exemptions and would otherwise be chargeable can be covered by the NRB with tax being charged at 0%. Unused NRB can be utilised on death with any balance being transferred to a spouse or civil partner.
As can be seen from the above there are a number of different exemptions. Working out the interaction between them can be quite complex and cause confusion, with the amounts involved in most cases being quite small. Research by both the OTS and HMRC have found that a lot of people who responded did not have a good understanding of the exemptions available.
The government should, as a package:
- replace the annual gift exemption and the exemption for gifts in consideration of marriage or civil partnership with an overall personal gifts allowance
- consider the level of this allowance and reconsider the level of the small gifts exemption
- reform the exemption for normal expenditure out of income or replace it with a higher personal gift allowance
Potentially Exempt Transfers
The treatment of a transfer of property as a Potentially Exempt Transfer (“PET”) is an important aspect of the IHT regime, as it suspends a charge to IHT arising on the vast majority of gifts made by a donor during his lifetime that do not otherwise qualify for exemption or relief.
The principal qualifying ‘transferee condition’ for a PET, which applies to gifts made both before and after 22 March 2006, is that the gift is to another individual. In summary, a gift made by an individual to another individual, which is not excluded, exempt or relieved by any other provision, is a PET.
For recipients who are not individuals i.e. trusts, there were changes to the rules in 2006. Most gifts in to trust after 21 March 2006 will not be PETs, but a Chargeable Lifetime Transfer.
When an individual makes a transfer that is a PET it is assumed to be exempt from the date on which the transfer is made until the earlier of:
- the seventh anniversary of the date on which the transferwas made
- the death of the transferor
If the earlier date is the seventh anniversary, then the transfer becomes fully exempt. But if the transferor dies before that date, the PET is said to fail and it becomes a chargeable transfer.
On death IHT will be due on the transfer, however taper relief will apply to reduce the amount of tax due based on the amount of time which has elapsed between the transfer and the date of death.
Under the taper relief provisions, the amount of tax payable on death in respect of a chargeable lifetime transfer or a failed PET is reduced as follows:
|Date of CLT or failed PET||Percentage of tax charged|
|Between three and four years before death||80%|
|Between four and five years before death||60%|
|Between five and six years before death||40%|
|Between six and seven years before death||20%|
Example 1 – John
At the age of 50, John sold his business and his house and retired to Cornwall to run a gift shop.
He decided to give £150,000 to each of his five children. Three of his children were over 18 and his two younger children were under 18.
He made gifts to his adult children as follows :
On 1 May 2014 he gave £150,000 to his son Kevin
On 14 May 2014 he gave £150,000 to his daughter Jean
On 15 May 2014 he gave £150,000 to his daughter Maureen
On 1 May 2014 he instructed his solicitors to draw up a deed of trust for the benefit of his two younger children. On 1 August 2014 he signed the Deed and transferred £300,000 to a trustee bank account.
In the year 2014/15, the gifts to the adult children were PETs to the extent that they exceeded the annual exemptions. As John had not made any previous gifts, the £3,000 annual exemptions for 2014/15 and 2013/14 were available. Consequently, the value of the first PET to Kevin was £144,000.
The gift into trust for the younger children is a chargeable lifetime transfer (CLT). When considering the value of the CLT, the annual exemptions have already been used on the PETs and no deduction is available. The value of the CLT is £300,000 but as this was the first chargeable gift to be made, it falls wholly within the available NRB. No tax was paid on the CLT at the date of the transfer.
On 1 Jan 2019 John passed away.
|Failed PET to Kevin||£144,000|
|Nil rate band||(£144,000)|
|Failed PET to Jean||£150,000|
|Nil rate band||(£150,000)|
|Failed PET to Maureen||£150,000|
|Tax @ 40%||£47,600|
|Taper relief||Death between 4 and 5 years from date of gift – 60% of tax charged||£28,560|
Chargeable Lifetime Transfer
The gift into trust would lose the benefit of the nil rate band and become fully taxable at the death rate of 40%. Tax of £72,000 (£300,000@ 40% is £120,000 subject to 60% taper relief) would be due.
Taper relief is not widely understood by many of the population and the way it works can be counterintuitive – in the fact that it is a taper of the amount of tax due not of the amount of the gift.
Executors have also expressed difficulty in practice with the 7 year look back period in relation to lifetime gifts. In a lot of cases bank statements are only available for a 6 year period.
The government should, as a package:
- reduce the 7 year period to 5 years, so that gifts to individuals made more than 5 years before death are exempt from Inheritance Tax, and
- abolish taper relief
The OTS stated that it is aware of the cliff-edge effect that the abolition of taper relief will have. A gift 5 years and 1 day before death would be completely free from IHT and a gift a day later could potentially be liable for IHT at 40%. However it considered that the reduction in period from 7 years to 5 years should outweigh the drawbacks as well as making the system simpler. It is unlikely that everyone will agree with this.
The 14 year Rule
It is quite well understood that Inheritance Tax may be payable on gifts made within 7 years of death. However, to allow executors to identify the gifts on which tax may be payable, they may need to consider gifts made up to 14 years before death.
It becomes necessary to look back up to 14 years before death when, for example, there has been a lifetime gift made into trust followed by a lifetime gift to an individual, after which the person who has made the gift dies within 7 years. This is because in considering the amount of nil rate band available at the date of the gift, regard must be made to the amount already utilised against chargeable lifetime transfers in the 7 years before the date of the gift concerned.
Example 2 – Ellen
December 2007 – Ellen makes a gift of £325,000 into trust
January 2013 – Ellen made a gift of £20,000 to Trisha
March 2018 – Ellen dies
To calculate the IHT on the gift made to Trisha in January 2013, any gifts into trust made in the preceding 7 years must be considered. The gift into trust made in December 2007 uses all of the nil rate band and so Inheritance Tax of £8,000 is payable on the gift to Trisha (ignoring taper relief).
The government should remove the need to take account of gifts made outside of the 7 year period when calculating the Inheritance Tax due (under what is known as the ’14 year rule’).
Lifetime gifts: payment of Inheritance Tax and the Nil Rate Band
There are situations where the value of relevant lifetime gifts is so high that the applicable NRB has been used up so that on death there is some IHT to pay in respect of those lifetime gifts.
It is possible for an individual to provide for all Inheritance Tax due on the lifetime gifts they make to be paid by their estate, by specifying this in their will.
Unless this has been done, individual gift recipients are liable for any Inheritance Tax due on a lifetime gift. However, if the recipient does not pay the tax within 12 months of the death, then the deceased’s estate becomes liable for any unpaid tax together with the gift recipients. The nil rate band is allocated to lifetime gifts given in the 7 years before death before assets remaining in the estate and is allocated in chronological order, so that the earliest gift receives the nil rate band first.
Unless the total value of all lifetime gifts given during the 7 year period exceeds the nil rate band, no Inheritance Tax is payable on any such gift. However, the lifetime gifts use up the nil rate band, so that the amount available to offset against the deceased’s remaining assets is reduced.
Some lifetime gifts, for example a transfer into trust (other than a disabled trust), are immediately taxable, if the amount transferred exceeds the available nil rate band (and no relief is available such as normal expenditure out of income, APR or BPR).
These are called Chargeable Lifetime Transfers (“CLT’s”). The person making the gift is primarily liable for the IHT on CLT’s.
As well as creating inequality between recipients that may have not been intended by the donor, this can lead to situations where gift recipients have spent the funds given to them but then find themselves liable for IHT.
This can be seen if we return to consider Example 1 – John.
The first two gifts he made to his children Kevin and Jean will be covered by the NRB and no tax will be payable on his death. The gift to Maureen however will be liable for £28,560 of IHT after taper relief. Unless he has specified in his will that the tax will be payable from his estate then Maureen will be liable for this tax. This is purely due to chronological application of the NRB, and if John was unaware of this and the payments were made on slightly different days for purely practical reasons then this may not produce the result he had intended.
A wide range of comments have been made on this topic by those who responded to the OTS’s call for evidence. Some felt strongly that it is unfair to chase after the recipient of a gift for IHT when they may have received the gift some years ago and may have spent the money. Others felt no less strongly that it would be unfair for the burden of the tax to fall onto the estate if gift recipients do not pay.
The OTS had heard that the allocation of the NRB to lifetime gifts in preference to the death estate, and to the earliest gifts first, is one of the most widely misunderstood aspects of Inheritance Tax. It can cause inequalities between gift recipients in situations where someone has given lifetime gifts that have used up their NRB.
The government should explore options for simplifying and clarifying the rules on liability for the payment of tax on lifetime gifts to individuals and the allocation of the nil rate band.
The OTS suggested that the two different alternatives set out below be considered.
- any IHT due in relation to lifetime gifts to individuals should be payable by the estate, and
- the NRB should no longer be allocated to lifetime gifts in chronological order but, rather, first be allocated proportionately across the total value of all the lifetime gifts, with any remainder then being available to the death estate
- for executors to be liable to pay IHT relating to lifetime gifts only out of assets they handle, and which are due to be distributed to the gift recipient in question, and if it has not proved possible for HMRC to collect the money directly from the gift recipient
Should either your or your clients require assistance in relation to any aspect of IHT, including lifetime giving and upon death then please do not hesitate to contact us.