UK: Government Proposes New Incentive For Charitable Gifts At Death

On 10 June 2011 details of the Government's proposed new inheritance tax ("IHT") relief for individuals leaving at least 10% of their net estate to charity were published in a consultation paper by HM Revenue and Customs and HM Treasury.

Gifts to charity are already exempt from IHT. But the proposed relief if enacted would go further by also reducing the rate of IHT at death on the share of an individual's estate passing to non-charitable beneficiaries. The new relief is intended to be effective for deaths after 5 April 2012 and follows up on a proposal first announced in the Budget (23 March 2011) as part of a package of tax changes to incentivise charitable giving.

The proposal as set out in the policy document is broadly welcome. However, the consultation paper raises a number of issues which have yet to be decided about the exact form of the relief. We mention some of them below. Whether in practice the proposals will result in increased charitable donations on death may depend on whether the incentive is legislated in a form which testators find clear and which personal representatives ("PRs") find administratively straightforward to apply following the death.

This briefing is based on the proposal as set out in the consultation document. The final form of the relief will depend on the outcome of the consultation.

Key points on the new incentive for charitable giving at death

The incentive will apply to deaths after 5 April 2012.

Where at least 10% of a deceased's net estate on death goes to charity ("the 10% test") the remainder of the net estate not going to charity will bear IHT at only 36% (instead of the normal rate of 40%). Thus the relief effectively reduces the cost to the non-charity beneficiaries under the will of the deceased's gifts to charity. (However, the non-charity beneficiaries will never be better off in absolute terms under the proposed new rules as a result of the deceased's gifts to charity under the will.)

In determining the value of the deceased individual's net estate for purposes of the 10% test certain parts of the estate are ignored (thus reducing the value required to go to charity in order for the 10% test to be satisfied). The parts of the deceased's estate to be ignored when determining the amount of the net estate are as follows:

• the deceased's available nil rate band. If fully available, the nil rate band is currently £325,000. Sometimes it will be more – up to £650,000 if the deceased has "inherited" a so-called transferable nil rate band from a pre-deceased spouse or civil partner. However, a deceased person's available nil rate band is reduced by lifetime chargeable gifts (mainly gifts into trusts) or potentially exempt transfers ("PETs") which become chargeable. (PETs are lifetime gifts to individuals or which benefit individuals. They become chargeable if the deceased's death occurs within seven years of making the gift.)
• parts of the death estate which qualify for exemptions (such as the spouse exemption) or reliefs (such as business property relief and agricultural property relief) applicable to the deceased's estate. This further reduces the amount that must go to charity in order for the 10% test to be satisfied.

The part of the estate at death going to charity is included in the deceased's net estate for purposes of working out whether the 10% test is satisfied. In working out whether the 10% test is satisfied only gifts to charity on death are counted. Lifetime gifts to charity are not counted.

Having established the amount of the net estate as above, the next step is to compare the amount or value of the gifts to charity with the amount of the deceased's net estate. If the amount going to charity is at least 10% of the net estate, then the part of the net estate going to non-charitable beneficiaries bears IHT at only 36% rather than at 40%.

Calculation of the deceased's net estate can be illustrated as follows, assuming a post 5/4/2012 death.

In the above example, because the 10% test is satisfied, IHT on £472,500 is at the lower rate of 36% resulting in an IHT bill of £170,100. Compare this with the IHT bill on the same facts for a pre-6 April 2012 death, which is £189,000 (that is 40% x £472,500).

Chargeable lifetime gifts by the deceased individual within the period of seven years before death will reduce his/her available nil rate band for his/her death estate. The proportion of the death estate required to go to charity in order for the 10% test to be satisfied will be correspondingly increased. This is illustrated by the following example, which assumes that the deceased dies after 5/4/2012 having made chargeable lifetime transfers of £125,000.

Since the 10% test is satisfied, IHT on £585,000 is at the lower rate of 36% resulting in an IHT bill of £210,600. Compare this with the IHT bill on the same facts for a pre-6 April 2012 death, which is £234,000 (that is 40% x £585,000).

The 10% test is all or nothing. If the share of the net estate going to charity is only just under 10%, there is no taper or similar mechanism to allow reduced IHT relief. In such a case the proposed new relief would not apply at all.

In practice the deceased is not generally going to know the value of his/her net death estate in advance. Therefore there might be some cases in which a gift left by will, contrary to the testator's intentions, turns out to be insufficient to satisfy the 10% test. Or the beneficiaries might in any event decide that they would like to vary their entitlements under the will in favour of charities whilst also reducing the IHT rate for the rest of the estate going to non-charitable beneficiaries. In such cases it should in principle be possible for the beneficiaries and PRs to enter into a deed of variation of the will in favour of charities within two years of the death in order to ensure that the 10% test is satisfied. However, this will only be possible if all of the beneficiaries are adults with full capacity.

Alternatively if the will contains a discretionary trust, the trustees could in principle (and if they determined that it would be for the benefit of the beneficiaries) appoint capital from the discretionary trust to charity within two years of the death in order to ensure that the 10% test is satisfied.

Key points for consultation on the new incentive for charitable gifts

Should the proposed incentive be limited to the deceased's free estate? A person's estate which he/she can leave by will at death is called his/her free estate. However, a person's estate for IHT purposes might also include other assets, outside his/her free estate. Examples of assets which are included in the deceased's IHT estate but which are outside his/her free estate are as follows

• property owned jointly with another person (often the deceased's spouse or civil partner) under a so-called "joint tenancy". Such property passes "by survivorship" to the surviving joint owner and not under the deceased joint owner's will.
• property in which the deceased had an interest in possession at death (that is the right to receive the income) under a pre-22 March 2006 lifetime trust, or under a will trust qualifying as an "immediate post death interest".. Although the trust assets pass under the terms of the trust and are not part of the deceased's free estate, the trust assets still form part of the deceased's IHT estate.
• property which the deceased had given away before death but in which he/she "reserved a benefit". An example would be where the deceased had given away his/her house but had continued to stay there regularly. The house would not form part of the deceased's free estate but its value would be included in his/her estate for IHT.

Questions raised by the consultation include the following: should value outside the deceased's free estate be taken into account in deciding whether the 10% test is satisfied? Should the 36% IHT rate apply to value outside the deceased's free estate? The consultation proposes that PRs may choose between basing the 10% test (a) only on the deceased's free estate, in which case the 36% IHT rate is limited to the free estate and (b) on the aggregate of the deceased's free estate and all or such parts of the deceased's non-free estate as the PRs shall elect. In this latter case the 36% IHT rate would apply to such parts of the deceased's non-free estate as shall have been elected by the PRs, as well as to the free estate.

Potential problems for charities and PRs in valuing assets in the deceased's estate for purposes of the 10% test. Availability of the proposed new relief will to some extent depend on valuation of assets. Where assets left to charity, such as paintings, are not easily valued this will put a greater burden than before on PRs and charities. This gives rise to a number of issues. How can the administrative burdens be minimised? Should the new rules incentivise gifts of more easily realised assets to charity? Should PRs be allowed to disclaim entitlement to the 36% rate if they consider that the associated administrative burdens outweigh the benefit?

Potential problems with deeds of variation and appointment As mentioned above, fulfilment of the 10% test is likely to depend in some cases on beneficiaries entering into a deed of variation of the deceased's will in favour of charity or, where the will contains a discretionary trust, by the trustees appointing capital to charitable beneficiaries. In such cases the question arises whether availability of the new IHT relief should be dependent on the deed of variation or appointment having been notified to the charity in question (given that such deeds are not public documents, unlike wills). Otherwise the risk arises of the new relief being claimed on the basis of a deed of variation or appointment in having been entered into in favour of charities, but never implemented.

What if IHT is deferred, for example under the so-called conditional exemption for certain categories of heritage property? Where IHT on an estate is deferred (for example, by way of the so-called conditional exemption for heritage property) the consultation suggests that the 10% test could be based on the part of the estate on which tax is not deferred and which, provided the 10% test is satisfied, would bear tax at the reduced 36% rate. Then when the deferred tax later comes into charge (for example on a sale or gift of the heritage property in question) the full rate of IHT at 40% would apply to that deferred part.

How should the relief apply to the estates of individuals who died domiciled outside the UK? In relation to such individuals the consultation suggests that the 10% test be applied only to the part of the estate falling within the IHT net (that is, broadly speaking, the deceased's UK situated estate). On this basis, when working out whether the 10% test is satisfied a deceased non-domiciliary's non-UK assets would be ignored.

Conclusion

Until the issues up for consultation have been resolved it is too early to start reviewing wills specifically to take advantage of the new relief. And charities would also be well advised to hold back on reviewing their legacy literature for the time being.

It is particularly important that the consultation results in a set of rules that are clear and straightforward to apply and operate. To this end we hope to contribute to the consultation and we will provide an update once the detail of the new relief is clearer.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.