Tinkering with inheritance tax
Recommendations by the Office of Tax Simplification to streamline inheritance tax are not fundamental reform but are welcome, says Matthew Duncan
The Office of Tax Simplification (OTS) has published its second report following its independent review of the main complexities and technical issues arising from the way inheritance tax (IHT) works.
The review makes 11 recommendations. The OTS states its recommendations could “streamline gift exemptions [and] change the way the tax works in relation to lifetime gifts” making it simpler and more intuitive.
While the OTS makes various sensible and welcome recommendations, some will give practitioners pause for thought and, if implemented, will require a review of clients’ existing wills and succession planning.
Interestingly, the OTS did not, however, feel the need to make any recommendations to simplify the residence nil rate band and stayed clear of reviewing the IHT treatment of trusts.
The review focuses on three key areas of IHT: lifetime gifts; interaction with capital gains tax (CGT); and business and farms.
The review focused on the tax treatment of gifts made during a person’s lifetime and their interaction with those made on death under a will. Contributors to the review said the present array of gift exemptions creates confusion.
Further, the nil rate band (NRB), annual gifts and small gift exemptions have not kept pace with inflation.
One area that drew particular criticism related to the exemption for regular gifts from normal expenditure out of income.
The OTS was concerned at the level of extensive record keeping required to apply for the exemption on death but many practitioners may argue this is the price you pay for securing the relief and is not a reason to do away with it.
The OTS recommended:
- replacing the annual exemption and the exemption for gifts in consideration of marriage or civil partnership with an overall personal gifts allowance;
- government should consider the level of the personal allowance and reconsider the level of small gifts exemption;
- reforming the exemption for normal expenditure or replace it with a higher personal gift allowance (suggesting government should consider the level).
The removal of the gifting excess income after the deduction of normal expenditure exemption would affect a number of high-income earners
If this valuable exemption is to be reformed, now might be the time to suggest clients make full use of it before its removal.
Gifting period and taper relief
The OTS commented that the seven-year period during which a lifetime gift may become subject to IHT is too long.
Executors can struggle to obtain records going back that far and it’s inconsistent with the requirement to keep income tax records for six years.
The OTS has recommended reducing the period to five years – a measure widely welcomed by practitioners; but it could be argued five years is still a long period of time. It could also be criticised as a giveaway to wealthy individuals, which may not sit well politically.
In relation to taper relief, the OTS says its operation is widely misunderstood and many fail to appreciate that it only applies to those making lifetime gifts that exceed the NRB. It therefore recommends abolishing taper relief.
Payment of IHT on gifts and the NRB
The report notes that where gifts made within seven years of death exceed the NRB, many people are unaware the recipient is liable for any IHT payable on that gift.
As the NRB is also allocated to lifetime gifts in the date order in which they are made, this can lead to differences in the amounts ultimately received by beneficiaries.
The OTS suggested the government consider reforming legislation to ensure any IHT due in relation to lifetime gifts to individuals should be payable by the estate; and that the NRB should no longer be allocated to lifetime gifts in date order
Instead, gifts should be allocated proportionately across the total value of all lifetime gifts – with any remainder being available to the deceased’s estate.
Though it can be argued this would be simpler from HMRC’s standpoint, complications could arise if the estate is then left to a different beneficiary to the recipient of the lifetime gift, and the tax due on the lifetime gift was more than the funds available in the estate.
This would be a fundamental – and not necessarily welcome – policy shift in taxation of gifts and estates.
Interaction of CGT with IHT
The OTS report concluded that the interaction between IHT and CGT is complex and can distort decision making; the capital gains uplift arising on death means an asset can be sold shortly after death without CGT being due.
If that same asset is exempted or relieved from IHT, eg via business property relief (BPR) or agricultural property relief (APR) or the spouse exemption, then the asset could be sold shortly after death without either IHT or CGT being paid.
The OTS recommended that where a relief or exemption from IHT applies, the CGT uplift should be removed and, as a consequence, the recipient of the asset is treated as acquiring the assets at the historic base costs of the person who died.
This recommendation has attracted particular criticism and is probably more about a tax take for HMRC than tax simplification.
Clearly, many people would be significantly worse off and it would necessitate a review of many people’s wills and succession planning.
It would also remove a well-tested area of planning and make it harder for people to sell property without incurring a substantial CGT bill.
Businesses and farms
It’s often said the policy rationale for providing BPR and APR is to prevent the breakup of businesses or farms following a death to finance the IHT due.
There is concern that some of the OTS recommendations are moving away from that policy rationale as its implementation could result in the breakup of small rural businesses.
The OTS report says the requirements around the level of trading activity needed to qualify for BPR are different to the comparable conditions of two of the main business reliefs for CGT.
The OTS argued it could simplify decision-making about when to hand assets onto the next generation if the tests were standardised.
It also said furnished holiday lets are not treated consistently. They are deemed to be trading for income tax and CGT purposes, but are not generally regarded as trading activity for IHT purposes.
The OTS recommended that:
- government should consider whether it’s appropriate for the level of trading activity for BPR to be set at a lower level than that for gift holdover relief or entrepreneurs’ relief, and
- consider aligning the IHT treatment of furnished holiday lets with that of income tax and CGT where they are treated as trading.
However, this would be a significant change and, if adopted, many businesses with investment assets could be faced with IHT on the owner’s death.
The recommended IHT treatment of farmhouses is more welcome. The OTS recommended a review of the eligibility of farmhouses for APR in sensitive cases, eg where a farmer needs to leave the farmhouse for medical treatment or to go into care.
The OTS also said HMRC should be clear in its guidance as to when a valuation of a business or farm is required; and if required, whether this needs to be a formal valuation or an estimate.
The OTS also made a sensible recommendation in relation to the treatment of life insurance, observing that few life-term insurance policies are written in trust, which can result in a significant amount of IHT being paid unnecessarily.
It has recommended that government consider ensuring that death benefit payments from life-term insurance are IHT free on the death of the life assured without the need for them to be written in trust.
Pre-owned tax asset
The pre-owned asset tax (POAT) rules are complex and not widely known or understood, according to the feedback received by the OTS.
The rules were originally introduced as an anti-IHT avoidance mechanism and, in the OTS’s view, government should consider whether these rules are still necessary given the subsequent anti-avoidance legislation.
Several of the OTS’s recommendations are more tinkering around the edges rather than fundamental reform, though some will be welcomed by practitioners.
Will government implement any of the recommended changes? A new chancellor may have other things on his agenda right now, so it remains to be seen.
Matthew Duncan is a consultant at Druces druces.com