Getting to grips with inheritance tax

It will be hard to find many people outside the treasury who like the idea of inheritance tax (IHT). Historically used as a means to fund specific projects, e.g. the wars with Napoleon in 1796, IHT now makes up an essential and consistent component of the government’s tax receipts.

Increased asset values, particularly the steep UK house price growth in recent decades, mean IHT receipts are increasing to record levels annually, with another high predicted for 2022/23, as well as the number of estates now caught by the rules and paying tax.

It is hardly surprising the government wishes to cash in on these long-term value increases through IHT, when it offers them such an easy way of doing so. Although a YouGov survey commissioned by Kingsley Napley LLP shows about half the population might favour abolishing IHT altogether, it is highly unlikely the government would agree given the current economic climate, with a purported £35bn black hole to fill in the public finances.

IHT continues to be a hot topic of discussion both among professionals and the media. In recent weeks, the Prime Minister’s wife’s non-domiciled status has been a major topic with IHT implications and the Queen’s death obviously would have potentially resulted in an enormous IHT charge were it not for a unique ‘sovereign to sovereign transfer’ relief. More technical matters have also been widely discussed:

-        The government’s ‘stealth tax’ of freezing the nil rate band threshold beyond its current 2026 expiry, possibly to 2028, enabling IHT to be charged on further inflationary market value increases.

-        Simplification measures have been considered by the Office of Tax Simplification in a series of reports, but ultimately pushed into the long grass.

-        The possible abolition of IHT in favour of a wealth tax or through an extension to capital gains tax.

Surveys suggest a majority would oppose increasing IHT rates and would even support the idea of raising the threshold at which IHT kicks in. If the government is tempted to take active steps to change the IHT rules to plug the public finance gap, it may need to think again. Therefore, it seems IHT is here to stay for the time being, which makes understanding its application as important as ever.

How IHT operates

The IHT legislation is complex and lengthy and the technical application is beyond the scope of this paper. A point to flag at the outset is IHT is not just a death tax; it applies to lifetime transfers too. Strictly, it applies to any ‘transfer of value’ which is defined in the legislation as:

“A disposition made by a person (the transferor) as a result of which the value of his estate immediately after the disposition is less than it would be but for the disposition; and the amount by which it is less is the value transferred by the transfer.”

(section 3(1) Inheritance Tax Act 1984)

This certainly covers lifetime transfers of value and the legislation then clarifies it also applies on death:

On the death of any person tax shall be charged as if, immediately before his death, he had made a transfer of value and the value transferred by it had been equal to the value of his estate immediately before his death.

(Section 4(1) Inheritance Tax Act 1984)

In the most common scenarios, IHT will apply to individuals in the following way before considering any mitigation:

On death

Net value of estate; tax rate:

·        £0 - £325,000; 0 per cent tax rate.

·        £325,000+: 40 per cent tax rate.

On death leaving family home to direct descendants

Net value of estate; tax rate:

·        £0 - £325,000; 0 per cent tax rate.

·        £325,000 - £500,000; 0 per cent tax rate.

·        £500,000+; 40 per cent tax rate.

Gifts in lifetime to individuals:

Survive the gift by; tax rate.

·        3-4 years; 32 per cent tax rate.

·        4-5 years; 24 per cent tax rate.

·        5-6 years; 16 per cent tax rate.

·        6-7 years; 8 per cent rax rate.

·        7 years+; 0 per cent tax rate.

The rate reduces by 8 per cent for every additional year survived. Chargeable on the market value of the gift. Gifts are known as potentially exempt transfers (PETs).

Gifts in lifetime to a trust or company

·        Value transferred; 20 per cent tax rate.

·        Death within 7 years of transfer; 20 per cent tax rate.

·        Survive the gift by 7+ years; 0 per cent.

An immediate charge when making the gift (a ‘Lifetime Chargeable Transfer’).

Value added

The basic application of IHT following the above statistics is relatively straightforward. However, it is obvious to see the potential tax liability can be significant. There are a multitude of different mitigation strategies available, all of which can help to reduce the IHT liability. Whether any applies will depend on the client’s circumstances, for example as follows:

Family:

·        Is the client married or in a civil partnership? Spouse exemption provides 100 per cent relief from IHT for assets left to the surviving spouse or civil partner.

·        Does the client have children? Consider gifting to them during lifetime. Such gifts will be exempt from IHT if made more than 7 years before death.

Assets:

·        Does the client have assets which might qualify for a relief? Common examples are business and agricultural property, which can both offer up to 100 per cent relief.

·        Pensions are not usually subject to IHT, so a client may be recommended to fund his living costs out of his other assets first to preserve the pension.

·        Certain assets are themselves excluded from IHT, e.g. future interests in a trust or offshore trust interests.

Charitable wishes:

·        Gifts to charity benefit from the charity exemption which provides full relief from IHT.

·        Additionally, if the client leaves at least 10 per cent of his/her estate to charity, the rate of IHT applying on death reduces to 36 per cent.

Other considerations:

·        Where other mitigations may be unavailable, or as additional protection, life insurance can cover IHT payable on death and preserve the assets for the beneficiaries. Insurance costs the client so this option will depend on their age, health, means and appetite to pay for it.

·        IHT on death is charged on the net estate after deducting liabilities owed by the deceased. Borrowing can be an effective means of reducing the amount on which IHT is charged, provided it can be and is repaid after death.

·        Assets owned jointly with others may benefit from a discount in their market value due to that joint ownership.

Anti-avoidance legislation:

·        IHT is subject to the General Anti-Abuse Rule and DOTAS.

·        The legislation also includes its own rules, which have developed over the years. Some to highlight which still catch clients out are the gift with reservation of benefit rules (GWROB) and pre-owned assets tax (POAT which is strictly income tax but linked to GWROB). These bite when assets are given away, but the donor continues to use or enjoy them. Essentially the GWROB and POAT rules will cause such planning steps to fail (with limited exceptions). Assets cannot therefore simply be signed over in name only to someone else to avoid IHT!

Each potential mitigation strategy has its own conditions and they are not always straightforward. Often clients will be well-read in options for IHT planning, but do not foresee the traps and pitfalls. This is where solicitors specialising in IHT planning can add considerable value.

Going forward

IHT remains here to stay although it will likely remain a hot topic of discussion. Ultimately, taking advice and the time to plan with an expert’s help gives the client a degree of choice and control, within the limitations of their circumstances, both as to the amount of tax their estate might suffer, when and by whom. IHT is a specialist topic and solicitors are well placed to help clients navigate the complex and sensitive issues associated with it.

Charles Richardson is a partner at Kingsley Napley LLP kingsleynapley.co.uk