As the Office of Tax Simplification completes its review of inheritance tax, Technical Connection take a deeper look at its recommendations
In 2015/2016, only one in 20 estates suffered inheritance tax, although more than nine in 20 estates needed to submit a return. The taxpayer ratio then increased before the effect of the introduction of the residence nil rate band (RNRB) started to remove smaller estates from charge (in 2015/2016, 87% of estates subject to tax were valued at less than £500,000).
Certainly, the Treasury has been enjoying record inflows of inheritance tax (IHT) in recent years with the tax take hitting a record £5.4bn in 2018/2019. This is partly attributable to the fact that the nil rate band of £325,000 has been frozen since April 2009. However, the introduction of the RNRB from 2017/2018 has changed the picture somewhat, with IHT receipts flatlining. This effect will wear off in the next few years, once the RNRB reaches £175,000 in 2020/2021 and then becomes subject to annual indexation.
IHT planning is an important area of business for the financial adviser with an array of trust packages available. Even if the main objective of financial planning is not to mitigate IHT, advisers need to ensure that overall financial planning is as IHT-efficient as possible. Protection life assurance policies are a classic example of this. It is therefore important that financial advisers are aware of any future possible changes in this area.
In January 2018, then chancellor, Philip Hamond, asked the Office of Tax Simplification (OTS) to review the current rules on IHT and suggest how the system might be simplified. In February 2018, the OTS published a letter setting out the scope of its ‘IHT General Simplification Review’, confirming that its aim was to publish a report with “specific simplification recommendations for government to consider”.
The OTS split its report in two, with the first report covering administrative matters issued in November 2018. The second report, examining the structure of the tax, was published on 5 July 2019.
Of course, a lot of Brexit water has passed under the bridge since the report was first commissioned and there is still a good deal to flow through. Unless it is triggered earlier, a General Election is due on 5 May 2022 and it is likely that the significance of the OTS report will, in many ways, depend on the outcome of that next Election.
But if the Conservative Party remains in power, we can expect them to give serious consideration to the OTS recommendations. On the other hand, if Labour is elected, we could see quite radical changes to the tax system – including the replacement of inheritance tax with a new, harsher, gifts tax. In such circumstances, the recommendations in the OTS report may fall on fallow land.
The OTS report also included a raft of useful information about IHT, including hitherto unpublished HMRC data, which we refer to below.
The OTS recommendations broadly cover four key areas. In what follows, we will consider the current position, the proposed simplification and then comment on any relevant implications that may arise for the financial adviser and his/her clients.
Currently, a person can make a gift of £3,000 each year, free of IHT. If not used in a previous tax year, the unused allowance can be utilised in the following tax year
1. LIFETIME GIFTS
a) Gift exemptions package
Annual gifts/small gifts and marriage gifts – current position. This has three elements:
- Currently, a person can make a gift of £3,000 each year, free of IHT. If not used in a previous tax year the unused allowance can be utilised in the following tax year provided the full annual exemption of the current tax year is used first.
- Currently, a person can also make a gift in consideration of marriage or civil partnership within the marriage gifts exemption. This ranges from £5,000 (gifts to children who are marrying) to £1,000 (gifts to friends).
- Currently, a person can make a gift of £250 to as many people as they like in a tax year. This exemption cannot apply to gifts of more than £250.
- The OTS propose the replacement of the £3,000 annual gift exemption and the exemption for gifts in consideration of marriage or civil partnership with an overall ‘personal gifts allowance’. The OTS does not put forward a specific figure but points out that had the annual exemption been uprated with inflation (RPI and CPI, as appropriate) since it was last increased in 1981, it would now be £11,900.
- The OTS suggests that the level of the small gifts exemption is reviewed alongside the new personal gifts allowance. Again, the OTS uses an inflation adjustment (from 1980, in this instance) to reach a revised but not specifically recommended figure of £1,010.
Normal expenditure exemption – current position
Currently, a gift will qualify for the normal expenditure out of income exemption if:
- it is made out of income; - on a regular basis; and
- it does not affect the donor’s standard of living.
There is no limit on the size of the gift. It could be £100 or £1m. A huge benefit of using this exemption is there is no requirement to live seven years for the gift to be exempt.
The OTS recommends either:
- Reform to the normal expenditure out of income exemption by removing the ‘regular’ requirement and fixing it at a percentage of income limit (possibly based on a tax return figure); or
- Replacing it with a higher personal gift allowance. Although the OTS again avoids a specific suggestion, the document refers to the impact of fixing the enhanced allowance at £25,000.
Those people who may qualify for a significantly higher level of normal expenditure exemption than that proposed by the OTS may like to start planning earlier rather than later. Don’t forget that if an element of ongoing control is required such gifts can be channelled into a discretionary trust for the benefit of children/grandchildren and other family members with the donor acting as a trustee. Remember also that at present ISA income and drawdown income following a member’s death under age 75 is counted as available for the exemption, a benefit that could disappear if tax returns alone are used to determine income.
b) Gifting period and taper package
Currently, gifts made within seven years of death that cause the individual to exceed the nil rate band can suffer IHT at death rates – although the tax on the gift can be reduced by taper relief if the individual survived it by at least three years. Moreover, the nature of the seven-year cumulation period can mean that chargeable lifetime transfers made up to 14 years before death can impact on the calculation of tax on gifts made within the last seven years that are or become chargeable. On death, the full value of gifts made in the last seven years will also be taken into account in determining IHT on the individual’s taxable estate.
Taper relief works by reducing the tax payable on lifetime gifts by 20% per annum once an individual has survived the gift by three years. In calculating the IHT payable, IHT paid when the gift was made can be deducted. This may be relevant for chargeable lifetime transfers that the donor survives by three to five years. If the tax paid when the gift was made exceeds the calculated tax on death, any excess tax cannot be recovered.
The OTS proposes to:
- Reduce the seven-year period to five years, so that gifts to individuals made more than five years before death are exempt from IHT. This would be accompanied by scrapping the so-called 14-year rule which, for example, requires a look back on death at chargeable transfers made in the seven years prior to a failed potentially exempt transfer. Between the lines the OTS recognises that much of what happens more than five years ago is lost in terms of records and/or memory. For example, it is often not possible to obtain bank statements going back more than six years. Furthermore, the IHT collected on gifts made more than five years before death was only £7m in 2015/2016 which, set in the context of a tax that raised £5.4bn in that year, is negligible.
The OTS report provides useful data on gifts made in the seven years before death in 2015/2016 - see table below.
- Abolish taper relief. The abolition of taper relief would remove a poorly understood relief and ease the reporting requirements for executors. However, it would create cliff-edge IHT liabilities just before the five years expiry date so that a death four years 364 days after a lifetime gift could produce an IHT liability at 40% which the OTS acknowledges. If this change was implemented, this would create a need for a five-year level term assurance policy. Those with existing seven-year decreasing term assurances would need to consider whether those policies were still appropriate or needed modifying.
The report rightly notes that “taper relief is complicated and not well understood”.
c) Liability for payment and the nil rate band
The primary liability for any IHT on a failed potentially exempt transfer (PET) falls on the donee(s).
Currently, where a person makes several lifetime gifts and dies within the following seven years, in calculating any IHT liability the earlier lifetime gifts will gain the benefit of the nil rate band. This means that the IHT on later lifetime gifts can be disproportionately greater than the IHT on earlier lifetime gifts.
In this respect, the OTS suggest that the government should explore options simplifying and clarifying the rules on liability for the payment of tax on lifetime gifts to individuals and the allocation of the nil rate band. The OTS refers to problems with the current chronological approach under which the earliest recipient is the winner with the liability for any tax on later failed lifetime gifts falling on the recipient of those later gifts rather than the estate.
2 INTERACTION WITH CAPITAL GAINS TAX (CGT)
Currently, where assets pass on a person’s death, those assets generally have their base cost for CGT purposes uplifted to the value at the date of death. This means that there is no CGT at the date of death and the new owner inherits those assets with a base cost equal to their value at the date of death.
Similarly, there will be no IHT liability where the assets pass to the deceased’s spouse/civil partner (spouse exemption) or they qualify for 100% business relief or agricultural relief.
This can encourage people to retain ownership of such assets until death and not pass them on (with CGT consequences) to the next generation during lifetime.
Where an IHT relief (eg business or agricultural relief) or exemption (eg inter-spouse) applies, the capital gains tax uplift on death should not be available to the asset passing. Instead, the recipient would be treated as acquiring the assets at the historic base cost of the person who has died. The OTS says that this would make the treatment of lifetime gifts and bequests more consistent and avoid the current perverse incentive for people inheriting exempt assets or assets with 100% relief to hold on to those assets until death purely to wash out CGT. However, it would create complications in terms of determining the historic acquisition cost of an asset for CGT and dealing with cases where an asset passed jointly to exempt/non-exempt persons.
This could, of course, be the beginning of a move towards replacing IHT with CGT – something that has been suggested in the past as a way of producing a more consistent result between lifetime gifts and those made on death. However, based on 2015/2016 data (when the standard CGT rates were 18% and 28%), HMRC calculations show that the switch would have produced a greater number of taxpaying estates, but considerably less tax, even if CGT were levied on the main residence:
3 BUSINESSES AND FARMS
As many financial advisers appreciate, business relief can be a valuable relief when looking at IHT planning. In short, if qualifying business assets have been held for two years before death, they will qualify for 100% business relief – effectively meaning no IHT is payable.
Business/agricultural relief has been in the spotlight for the last couple of years with a number of commentators expecting change. How much is it worth?
HMRC estimate that in the five years from 2019/2020, IHT on its current basis is projected to raise £30.43bn from 120,650 estates. Across that period:
- 16,380 estates are projected to benefit from agricultural or business reliefs;
- The cost to the Exchequer of the reliefs will be £5.85bn; and
- The average benefit to each estate claiming relief will be £357,000.
This data emphasises that the number of relief claims is small (about 3,300 a year), but the benefit to each claimant is substantial. This finding was supported by a graph in the first OTS report, which highlighted that the effective rate of IHT dropped sharply from about 20% on estates valued at between £6-£7m to about 10% on estates worth more than £10m.
Here, the main OTS recommendations are as follows:
- Raise the level of trading activity required to qualify for business relief so it is consistent with the level that applies for business gift hold over relief or entrepreneurs’ relief. This implies that a business would only qualify for business relief if ‘substantially’ (80% upwards) of its activity was trading rather than the current ‘wholly or mainly’ (50% plus).
- Align the IHT treatment of furnished holiday lets (FHLs) with that of other taxes. For income tax and CGT, FHLs are normally treated as a trade whereas, for IHT, HMRC normally denies any claim for IHT business relief.
- Revise the treatment of limited liability partnerships to ensure that they are brought into line with companies for the purposes of the business property trading requirement.
There was also a passing reference to scrapping IHT business relief on alternative investment market (AIM) shares. Here the OTS pointed out that “AIM is the only market in the world where investors can receive an inheritance tax benefit. Supporting a market in this way is a different policy objective from supporting passing a business down generations”. In other words, should it be within the policy intent of business relief to make the relief available to third party investors in AIM-traded shares?
HMRC calculations demonstrated that removing both business and agricultural relief entirely would allow only a 6.3% reduction in the overall IHT rate to 33.7%.
4 LIFE POLICIES, PENSIONS AND ANTI-AVOIDANCE MEASURES
(1) Life policies
Currently, if a protection assurance policy is effected under trust, there will, in general, be no IHT liabilities on the death of a life assured when the policy proceeds are paid. Of course, in a few situations there can be a 10-year periodic charge in the event of a claim being made before a 10-year anniversary and the policy proceeds not being paid until after that anniversary. Similarly, such a charge could arise if the life assured dies just after a 10-year anniversary and it transpires that the life assured was in serious ill health at the anniversary so that the policy then had a market value.
In these extreme cases, an exit charge may also arise when cash leaves the trust. These rules are complicated and difficult to understand. They can also give rise to the need for extremely complicated calculations – particularly in the cases of excepted group life policies where the number of previous claims paid can exacerbate the complexity.
In this respect the OTS proposes that death benefit payments from term policies should be free of IHT on the death of the life assured without the need for them to be written in trust. The OTS distinguishes between term policies and whole life contracts but makes no comment about how its proposal would address term assurances written to very advanced ages, eg 100-years-old.
This proposal, although welcome, raises a number of other questions. For example, how would the settlor/life assured control who benefits from the policy proceeds on their death? Currently, this is achieved via a trust but, if there is no trust, would this mean that there could be a beneficiary designation in the policy? This is something that is extensively used in EU jurisdictions but, to use it in the UK, the law on third party rights would need to
Alternatively, control of the payment of the proceeds could be achieved by suitable provisions in the settlor/life assured’s Will which could, if necessary, incorporate a trust. This would, of course, mean that if such control was required the settlor/life assured would need to make a Will.
As most financial advisers will know, where a person makes a pension transfer whilst in ill health and dies within two years of the transfer, HMRC may, depending on the circumstances, treat that transfer as a chargeable lifetime transfer (CLT). If the calculated CLT exceeds the individual’s nil rate band, an immediate IHT charge could retrospectively arise. At the very least the transfer may absorb some of the individual’s nil rate band and delay issue of the grant of probate.
This is a highly complex area which can raise complicated issues. These were highlighted in the “Mrs Staveley deceased” case, which is now to be heard in the Supreme Court. This case will examine, among other issues, the circumstances in which the “no intention to confer a gratuitous benefit” exemption in section 10 IHT Act 1984 can apply in a pension transfer case.
The OTS made the following observation on this:
“The OTS has heard that the operation of the two year rule regarding gratuitous benefits is causing a high degree of uncertainty for financial advisers because at the time of undertaking such transfers, there can be no certainty as to whether a transfer will be considered to be creating a gratuitous benefit.”
Many feel that HMRC should provide more succinct guidance on when this charge may arise, when the exemption will be available and how the CLT should be calculated.
The OTS feels it would be helpful if HMRC were to provide further detailed guidance (once the appeal process in the Staveley case has finished) on the circumstances in which a gratuitous benefit (and a potential IHT charge) may arise when making certain pension transfers, such as from a defined benefit scheme into a personal pension scheme, shortly before death.
The OTS also suggests that, at some point in the future, the government consider a wider review of the tax system and pensions, possibly carried out by the OTS.
(3) Tax avoidance provisions
The OTS recommended a review of the pre-owned assets tax (POAT) rules and their interaction with other IHT anti-avoidance legislation (gifts with reservation, general anti-abuse rule and disclosure of tax avoidance schemes) to consider whether they are still necessary.
5 AREAS NOT COVERED
There were areas where no firm recommendations were made.
(1) Residence nil rate band (RNRB)
One area where there is continual criticism of the IHT rules is in connection with the RNRB, which can apply to exempt some or all of the value of a residence passing on death to a child, grandchildren (including adopted and step children) or a suitable trust.
The application of the RNRB can be highly complicated – especially where the downsizing rules apply which will be in cases where a residence is sold and the proceeds of sale passed to the next generation. Other criticisms are that the relief is not available on bequests to, say, nephews, nieces and other relatives. And then there is the operation of the taper relief which means that the relief is reduced by £1 for every £2 by which the estate (before any reliefs) exceeds £2m.
Many believe the RNRB should be ditched in favour of an increase in the standard nil rate band.
The OTS received many comments about the complexity of the current rules for the RNRB. It avoided making any recommendations on the basis that “the residence nil rate band is still very new and more time is needed to evaluate its effectiveness”. Nevertheless, it did supply some HMRC projections which demonstrated the impact of the band in terms of both revenue and estates subject to tax. These show that what looks like the obvious solution – increasing the NRB to £500,000 and scrapping the RNRB – would hurt the Exchequer. They also reveal that the RNRB is reducing the number of taxpaying estates by about 40%.
The OTS also noted that if the current £150,000 RNRB were to be replaced with an enlarged NRB at equal cost to the Exchequer, the NRB would increase by only £51,000 (based on HMRC estimates).
(2) Spouse exemption
The OTS report notes that cohabiting spouses and siblings cannot make use of the spouse exemption but felt that this was an issue best dealt with by the government as part of any developments in social change.
No recommendations were made by the OTS on the very complicated area of the IHT treatment of trusts, probably because they feel this will be covered by the current Trust Simplification review that is taking place.
The OTS report made a set of recommendations that many will welcome given the current complexity of IHT, but we need to remember we have been here before and it will be interesting to see how much of
this progresses onto the statute book – particularly given the current political uncertainty.
John Woolley of Technical Connection Ltd