Introduction
Inheritance Tax (IHT) is a widely unpopular tax, but planning ahead can limit IHT exposure.
IHT is a tax on transfers of value by individuals. It may be payable on certain lifetime transfers, on the value of an estate at death, on certain transfers into and out of trusts and on some transfers made by or to close companies. A transfer will either be a chargeable transfer, a potentially exempt transfer (PET) or exempt. IHT is levied on 'chargeable transfers'.
When valuing a transfer one looks at the loss to the donor and not the benefit to the donee.
Broadly, a UK domiciled or deemed domiciled individual is subject to IHT on chargeable transfers of worldwide assets, while the IHT exposure of a foreign domiciliary (non-UK deemed domiciled) is limited to UK-sited assets. The Government has proposed changes to the rules around deemed domicile and these are expected to be introduced from 6 April 2017. Separate briefing notes are available on these proposed changes.
The IHT provisions for registered civil partners are identical to those for spouses, so for brevity this note only refers to spouses.
Nil-rate band
The nil-rate band is the amount that is subject to IHT at 0%. In calculating the nil-rate band available, one determines the cumulative value of the chargeable transfers made in the previous seven years. This figure is deducted from the nil-rate band available in the year in question to determine the unutilised nil-rate band.
For the tax year to 5 April 2016, the nil-rate band remains at £325,000. It has been announced that the nil-rate band will be frozen at that level until 2020/21.
Transferable nil-rate band
Where an individual dies, the executors can claim that the deceased's nil-rate band should be increased by the unused portion(s) of the nil-rate band(s) of any spouse(s) who died before the deceased, although the deceased's maximum nil-rate band cannot exceed twice the current band.
Transferable residence nil-rate allowance
A new transferable residence nil-rate band will be applicable where a person dies on or after 6 April 2017 to reduce the tax payable on death, when a qualifying residence is passed to a direct descendant or other qualifying person. The final details are still to be enacted, however the latest proposals are as follows.
The band will be introduced at £100,000 commencing in the tax year to 5 April 2018, and will increase incrementally to £175,000 per person for the tax year to 5 April 2021. Consequently, for married couples who jointly own a 'family home' and wish to leave this to their children, their nil rate bands will eventually be up to £1,000,000 in total.
In addition, the band will be available when an individual downsizes or ceases to own their home on or after 8 July 2015, and equivalent assets up to the value of the additional rate band are passed to a qualifying person.
The band will taper where the net value of the estate exceeds £2,000,000. The band is also restricted so that it cannot exceed the net value of the property after deducting liabilities such as debt. It will not apply where there is a lifetime transfer of a property, which subsequently becomes chargeable to IHT on death.
Homes held in discretionary trusts will not qualify for the additional nil-rate band. Please get in touch with your usual Smith & Williamson contact if you are concerned these changes may affect arrangements or planning previously undertaken to mitigate your own or a trust's IHT exposure.
Exempt transfers
Where there is a transfer of value, the amount subject to IHT may be reduced in whole or in part as a result of one or more specific exemptions. Deductions are made before considering the nil-rate band availability.
IHT is not applicable (and a transfer of value is deemed not to have taken place) where a disposition is for the maintenance of close family or dependents or where there was no gratuitous intent (such as a bad bargain).
Some transfers are exempt whether made during lifetime or by will. The following are examples of such transfers:
- gifts to charities, housing associations, and for public benefit;
- gifts to qualifying political parties;
- gifts to a spouse (though see below for a restriction to this rule).
There are a number of specific exemptions for lifetime transfers of value. An individual has an annual exemption of £3,000 (which, to the extent that it is unutilised, can be carried forward and added to the exemption for the following tax year). There are also specific exemptions for small gifts, gifts in consideration of marriage and for regular gifts out of income. There are also exemptions applying to qualifying business assets or agricultural property as well as woodlands (see later).
Non-UK domiciled spouse
The exemption for transfers from a UK domiciled (or deemed domiciled) spouse to a non-UK domiciled spouse (who is not deemed UK domiciled) is restricted to £325,000 for transfers after 5 April 2013 (though certain international estate duty treaties override this in part). The limit was previously £55,000 for many years, although the Government has announced that it will be linked to the nil-rate band in future.
In addition, a foreign domiciled spouse is able to make an election to be treated as UK domiciled for IHT purposes. The election enables a foreign domiciled spouse to receive assets of any value from their UK domiciled spouse on death, free of IHT. However this will mean that all their worldwide assets will be liable to IHT subsequently.
If there is any question as to domicile status, specialist advice should be sought.
PETs
The following lifetime transfers are potentially exempt:
- an absolute gift to another individual;
- a disposition to a qualifying disabled person's trust; and
- a disposition to a bereaved minor's trust on the coming to an end of an immediate post-death interest.
There is no IHT payable when such transfers are made. However, IHT may be payable if the donor dies within seven years of making the transfer (see below).
Chargeable lifetime transfer (CLT)
A CLT is a lifetime gift which is neither exempt nor a PET. A lifetime gift to establish or add property to a trust will generally be a CLT. IHT at the lifetime rate of 20% is due on the value of the transfer in excess of the unutilised nil- rate band.
The IHT can be paid by the donee or the donor. Where the donor pays the IHT the tax payable is also a chargeable transfer meaning that the effective rate of IHT is 25% on the net gift before tax.
POAT
Pre-owned asset tax (POAT) is an annual income tax charge, which can apply to individuals who are UK resident. It may be triggered where a transaction has been structured so as to allow an individual to benefit from property transferred (or property derived from the original property transferred) while avoiding an IHT charge under both normal principles and the gift with reservation of benefit (GWR) provisions. The rules are complex with specific regimes for:
- land;
- chattels; and
- intangible property (including cash, stocks and shares) comprised in a settlement where the settlor retains an interest.
Specialist advice should be sought.
IHT on death
On death IHT can be charged on:
- gifts made within seven years of the date of death;
- the value of a person's estate on death; and
- assets caught by the GWR provisions.
Gifts (PETS and CLTs) made within seven years of the date of death
On death, IHT has to be recalculated on every lifetime transfer made within seven years of death. Once the cumulative transfers exceed the nil-rate band, IHT will be payable on the excess at 40%.
Where the donor has survived for at least three years the rate of tax is tapered, effectively giving a reduced IHT rate (the reduction being greater for each additional year of survival). The donee is responsible for paying any tax triggered by the death.
The death estate
The death estate comprises the net assets of the individual less reasonable funeral expenses, all property to which the deceased had a qualifying interest in possession and non-settled property over which the deceased had a general power of disposal. IHT is charged at 40% on the value of the death estate after it has been reduced by appropriate exemptions and reliefs and by the unutilised nil-rate band.
The deceased's personal representatives are responsible for paying the tax on the death estate. Where relevant, the trustees are responsible for paying any tax due with respect to a qualifying interest in possession of the deceased.
Assets caught by the Gift With Reservation (GWR) provisions
Broadly speaking, straightforward gifts where the deceased retained some benefit are caught by the GWR provisions. Such gifts are deemed to form part of the donor's estate immediately before their death. The donee is responsible for paying the IHT due.
No charge will arise where full consideration is paid by the donor for any subsequent use of the asset. For example if an individual gave his house to his son, but continued to live there, neither GWR (nor POAT) would apply provided the donor paid a full market rent.
Quick Succession Relief (QSR)
Where an individual dies after receiving an inheritance, the transfer will not only increase the IHT on his estate but tax may also have arisen on the earlier transfer. A form of relief is given where death is within five years of the earlier transfer, even if the property is no longer part of the death estate.
Reduced rate of IHT
A reduced IHT of 36 % is applied to 'components' of an estate where the relevant charitable legacies exceed 10% of the component(s).
Limiting the deduction of liabilities for IHT purposes
Outstanding loans are closely tied to the asset that was purchased with the loaned funds. Generally speaking no deduction is allowed for a liability to the extent that it has been incurred directly or indirectly to acquire property that is excluded from the charge to IHT. However certain pre-existing loans (those taken out before 6 April 2013) can continue to qualify for such relief.
A deduction for a liability is only allowed to the extent that it is repaid to the creditor from the death estate, unless it is shown that there is a commercial reason for not repaying the liability and it is not left unpaid as part of arrangements to obtain a tax advantage.
Reliefs for assets which qualify as business or agricultural property
Business property relief (BPR) and agricultural property relief (APR) may reduce the amount chargeable to IHT by either 100% or 50% depending on the type of asset. APR only covers the property's agricultural value. In contrast, BPR covers the entire value of the property. Eligibility for both reliefs is subject to various conditions such as use of the property, the business activities and length of ownership.
The conditions for both reliefs can be complicated and professional advice should be sought.
Payment of IHT
There is a fixed IHT payment deadline of the following 30 April for lifetime transfers made between 6 April and 30 September. IHT for other lifetime transfers is payable six months after the end of the month when the transfer was made.
IHT on death is due on the earlier of six months after the end of the month when the death occurred and the delivery of the IHT return.
IHT on either a lifetime transfer or on death can be paid in ten annual instalments where the IHT is attributable to land, shares or business assets, the qualifying conditions are met and a claim is made. The outstanding IHT will be payable if the property is disposed of. There is also a specialised IHT payment relief available for qualifying woodlands.
Planning for IHT
It should be possible to anticipate the impact of IHT by reference to current asset valuations. Individuals should consider the use of the various exemptions available during lifetime.
The way a will is drafted may affect the IHT payable and so this should be reviewed regularly.
A common method of managing the impact of an IHT liability is through the use of life assurance policies. Life assurance and pension arrangements should wherever possible be written in trust so as to fall outside the death estate for IHT 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.
