A lower rate of inheritance tax (IHT) of 36%, applies for deaths on or after 6 April 2012, where people leave a charitable legacy of at least 10% of a 'component' of their 'net estate' when they die.
How it works
Where the estate comprises only the deceased's 'free estate', the value of the estate on which the 10% threshold is based (the 'baseline') is the value of the net estate charged to IHT after deducting all available reliefs, exemptions and available nil-rate band, but excluding the charitable legacy itself. The total amount of charitable legacies is compared with the baseline amount to see if the estate qualifies for the reduced IHT rate (the '10% test').
In cases in which the IHT estate includes assets in addition to those in the 'free estate', the 10% test is applied separately to each of three possible categories of assets (or components) that makes up the estate namely:
- the 'free estate';
- jointly owned assets passing on survivorship; and
- settled/trust property trust property being aggregated with the deceased's estate.
The reduced IHT rate is then applied to the assets within a component where the related charitable legacies exceed 10% of its baseline. It is possible to elect for one or more components to be combined to give an aggregate baseline.
It should be noted that in many situations, jointly owned assets passing on survivorship pass to the spouse/civil partner so are likely to be exempt and therefore will not affect the calculations.
The new provisions apply equally to charitable legacies made by Will or, if certain conditions are complied with, by an Instrument/Deed of Variation.
A key aspect of the scheme is the 'cliff edge' qualifying requirement. This means that where the amount of the charitable legacy is close to the critical 10% point, a small difference to the amount of the legacy could have a significant impact on the estate's IHT liability.
Example
An example of the principle is set out below showing how the minimum charitable legacy to pass the 10% test would be calculated, and how the 'incentive' will work. It compares the effects of that legacy on the IHT liability, and its impact on the amount remaining for other beneficiaries, at present and under the regime prior to April 2012. The example assumes there are no chargeable assets outside of the 'free estate'.
Leaving a charitable legacy under the new rules still results in an overall cost to the beneficiaries, compared to not leaving anything at all to a charity in a Will, but a significantly reduced proportion.
How increasing a legacy of less than 10% may increase the distributable estate
However, what if the current Will already has charitable legacies?
In our above example the charitable and non-charitable beneficiaries will all be better off. The tipping point where this beneficial outcome applies is where the current charitable legacies exceed 4% of the net estate.
There is therefore an incentive for those who already have a reasonable level of provision in their Wills for gifts to charity to increase the amounts, to trigger the reduced rate, and potentially increase the residue of the estate for distribution. In drafting Wills, or associated Letters of Wishes, consideration should be given to giving guidance where charitable legacies are to be such that the reduced IHT rate is achieved.
Planning considerations
Depending on the arithmetic in any particular case it may be that increasing a charitable legacy produces a tax saving and increase the amount left to beneficiaries and is possible to achieve back-dating here by using an Instrument of Variation.
The availability of a reduced IHT rate to be applied to an estate should be compared to the tax reliefs for lifetime giving. Making gifts out of income under Gift Aid receives favourable tax treatment but, depending on the figures, deferring larger gifts, for a provision in the Will, could give a larger tax saving.
What about a husband and wife who both intend to leave amounts to charity with the balance, subject to other legacies within the nil rate band, to the survivor? The 10% test will only be applied taking into account the charitable legacies on the subsequent death of the survivor. Deferring such legacies so that they are only made out of the estate of the surviving spouse would avoid 'wasting' their value for IHT rate purposes.
We have taken care to ensure the accuracy of this publication, which is based on material in the public domain at the time of issue. However, the publication is written in general terms for information purposes only and in no way constitutes specific advice. You are strongly recommended to seek specific advice before taking any action in relation to the matters referred to in this publication. No responsibility can be taken for any errors contained in the publication or for any loss arising from action taken or refrained from on the basis of this publication or its contents. © Smith & Williamson Holdings Limited 2015
