Inheritance Tax Review

Inheritance Tax (IHT) is a deeply unpopular tax. People dislike the thought of double taxation; an extra layer of tax on assets which have been accumulated by thrift and saving from income or capital gains which have been taxed already.

Although IHT is indeed one of the most hated and feared taxes, a recent report by the Office of Tax Simplification (OTS), (and yes, there really is one!), reminds people that very few pay it and in fact there are some very generous, and often under used, reliefs available.

Drawing on data from the 2018-19 tax year, the report concluded that only about 4% of estates actually paid IHT. Of course, some estates are exempt not because they are too poor to pay the tax but because the deceased left everything to a spouse or civil partner. Even a death bed marriage with an emergency registrar performed in non-approved premises can save millions. This was demonstrated by the comedian Sir Ken Dodd who died aged 90 and married his long-time partner only days before his death saving more than £10 million in IHT.

Figures show that about two thirds of people die without leaving a spouse. Even so, only about 1 in 17 estates actually paid any IHT. Although the number of estates paying IHT has fallen since 2014, the amount of tax collected is rising, reaching a record of £5.4 billion last year, the equivalent of adding one penny to the basic rate of income tax.

IHT has a long history of controversy and complexity and it has become clear in recent years that reforms are necessary. Having sought the views of interested parties and the public, the Office of Tax Simplification has now set out a series of measures designed to make the tax easier for the taxpayer to understand and for HMRC to operate.

It is worth remembering that the OTS is not a policy making body and there is no guarantee that the recommendations will ever be taken up by Parliament, but future legislation could be influenced by the recommendations.

Highlights of the report are as follows:

Lifetime Gifts

Under the current rules there is an annual gift exemption of £3,000 as well as exemptions for gifts on marriage, small gifts of up to £250 a time and regular gifts from surplus income. The latter requires the donor to keep detailed records of income and expenditure going back 7 years. Under the new proposals these exemptions could potentially be replaced with an overall personal gift exemption.

There is no specific recommendation as to the appropriate level of that allowance although it is feared that it might be restrictive for those gifting significant sums on a regular basis. The annual exemptions have not been updated for decades so those gifting modest amounts may well find that the changes give them more scope.

Gifts in excess of the exemptions currently take 7 years to pass out of the estate completely with any potential tax charge tapering down after three years. It is worth highlighting that tracking back so far can be problematic for executors unless records have been safely kept.

The report recommends reducing the 7 year period to 5 years whilst abolishing the current taper relief available after year three.

Payment of IHT on Gifts

Confusion reigns as to who pays the tax on a gift that fails the exemption test, for instance where the individual dies within 7 years. Is it the estate that should pay or the recipient of the gift?

In cases where the nil rate band has already been used, it is the recipient who faces the tax charge. This often comes as a nasty surprise, especially if the funds have been invested in property or used to pay down debt and there are no liquid funds to meet the IHT liability.

Two possible options have been suggested by the OTS:

Have the tax fall on the estate and allocate the nil rate ban proportionately across all gifts or
Amend the rules so that the executors can pay the tax that HMRC have not been able to claim directly from the recipient.

Further consultation is needed to explore these options.

Businesses and Farms

The OTS also exposed the huge cost of exemptions from IHT given to farms and businesses but thankfully there is no suggestion of removing these exemptions from IHT for privately held trading businesses or agricultural property. Business property relief was introduced to allow businesses to pass down the generations tax free. This exemption was later extended to cover many shares in unlisted or AIM companies, leaving the way open for major tax avoidance. The OTS revealed that these reliefs cost more than £1billion a year between them. Abolishing both would fund a reduction in the rate of IHT from 40% to 33.7%. However, the OTS proposed no significant change.

Indeed, the suggestion is that the rules for IHT and capital gains tax in terms of determining what constitutes a trading business should be reviewed and ideally harmonised. The report does however question whether business relief should apply to third party investors in AIM traded shares but does acknowledge the governments previous commitment to protecting the role business relief plays in supporting family owned business and growth in the AIM market.

Life Assurance

A welcome recommendation is that death benefits from term insurance and life policies should automatically deemed to be outside the estate of the deceased. By doing so it would avoid the need for policies to be written in trust and thus reduce the paperwork and documentation burden.

Pension Transfers

The report recognises that people are increasingly moving their pension benefits between schemes in order to take advantage of flexible drawdown and cost savings, as well as consolidating retirement savings in one place to make them easier to manage. Indeed, government policy has been to encourage the use of the new pension flexibility rules.

However, in theory, if a member dies within two years of transferring, HMRC may contend that the transfer is subject to IHT unless it can be proved that there was no gratuitous benefit intended by the transfer—broadly that it was not done to benefit someone else. In practice this can be difficult to prove, even if the beneficiaries before and after the transfer are the same.

Whilst the OTS understands that it is unusual for HMRC to argue that there has been a transfer of value, they ask the government for greater clarity. This would be a welcome outcome for advisers as it would provide a level of certainty on the consequences of a potential transfer.

There are no other recommendations in the report relating to pension transfers.

Interaction between IHT and Capital Gains Tax

Another recommendation is to remove the capital gains tax uplift on death if those assets benefit from business property relief (BPR), agricultural property relief (APR) or the spousal exemption.

It is accepted, almost without question, that when someone dies, there is no capital gains tax charge on the assets they own, just an IHT charge. The beneficiaries of the estate will acquire assets at market value at date of death. This is commonly known as ‘market uplift’.

This avoids both IHT and CGT being charged on the same asset on death. However, concerns have been raised that where an asset is subject to an IHT relief or exemption, neither IHT nor CGT is payable.

The proposed change would mean there is still no charge on death but instead assets would be transferred on a ‘no gain, no loss’ basis, similar to the treatment of lifetime transfers between spouses. That is to say that the beneficiaries will acquire the assets at the cost to the deceased.

The report suggests that the rules could affect the actions of certain individuals. Clients may hang on to assets with gains until death so that the surviving spouse can acquire them with a spouse exemption for IHT and market uplift for CGT. But, the report argues, this unknown future date may not be the optimum time for selling or gifting.

Similarly, it could conflict with the objectives of business property relief (BPR) and agricultural property relief (APR). These reliefs are essentially to ensure the smooth transfer of businesses to the next generation so that they can continue to operate without disruption. CGT market uplift, however, can act in the opposite direction, as owners may be tempted to hang on to control until death to benefit from market uplift and still claim BPR/APR.

However, this may not prove to be the best decision commercially and it is necessary to consider the future health of the business as well as the IHT implications.

Summary

To be clear the government is not obliged to take on any of the recommendations from the OTS report and indeed some suggestions may never find their way onto the statute book. The report does however show how thinking on future legislation may be influenced.

It also highlights the areas of difficulty where clients will benefit from good advice under the rules as they stand.

As a matter of course we will review all clients’ overall estate planning position as part of our regular annual planning reviews. If gifting is on your agenda, please talk to us and we can help to design an appropriate plan using trusts where necessary for asset protection or to simply start the 7-year (or maybe 5 in due course) clock ticking.

As always, we are available at any time if you have any queries or concerns.