Don’t leave it too late…
Inheritance tax (“IHT”) is seen by many individuals as a form of double taxation and therefore an unfair tax on those that manage their finances wisely. Why should you pay over to HMRC further tax on income and/or capital gains that may have already been taxed? It is often referred to by tax advisers as a “lazy tax” in that you can take steps to mitigate and indeed reduce the exposure to IHT but many leave it too late and some still believe in their own immortality!
Increasingly a good source of tax revenues for HMRC
The latest statistics from HMRC show that IHT receipts for the 2016/17 tax year were at an all-time high of £4.83BN which represents an increase of 4% from the previous year. In the 2009/10 tax year after the introduction of the transferable nil rate band, tax receipts were at £2.39BN so within seven years we have seen a near doubling of the IHT receipts for HMRC. The current forecasts for 2020/21 are receipts of £5.6BN and this takes into account the introduction of the main residence nil rate band which will initially come into effect from 6 April 2017.
The above figures also probably do not include the changes from 6 April 2017 which bring UK residential property into the scope of IHT regardless of the structure used to own the property.
When does IHT apply?
IHT is levied on an individual’s estate when they die and when certain gifts are made during an individual’s lifetime like a transfer to a discretionary trust subject to any nil rate band available. IHT is also levied on assets within a discretionary trust every ten years or when assets leave the trust.
The rate of tax on death is 40% and on chargeable lifetime transfers at 20%. Each individual has a nil rate band upon which no IHT is due and for the 2017/18 tax year it is £325,000. The nil rate band has been frozen at £325,000 since 2009 and HMRC have confirmed that it will remain frozen at this level up to and including the 2020/21 tax year. There is no accounting for inflation and therefore the effect of this freezing of the nil rate band is such that increasingly more estates will have an IHT tax liability. Owning an unencumbered property in London would be sufficient in most cases to trigger an IHT liability on death.
Residence nil rate band
HMRC have accepted that an increasing number of individuals with relatively modest assets and particularly where they relate mainly to the value of the house should not be subject to IHT. From 6 April 2017, they have introduced an additional nil rate band for deaths which occur on or after the 6 April 2017 where the main residence passes to direct descendants. The amount of the relief is being phased in over four years starting at £100,000 in the first year and rising to £175,000 for 2020/21. This is available to each individual and therefore for a married couple this is potentially £350,000. Therefore on the second death of the couple, there will be in effect a total nil rate band of £1m from 2020/21.
The additional nil rate band can only be used in respect of one residential property which does not have to be the main family home but must at some point have been a residence of the deceased.
The residence nil rate band may also be available where an individual downsizes or ceases to own a home on or after 8 July 2015 where assets of an equivalent value, up to the value of the residence nil rate band, are passed on death to direct descendants.
A reduced rate of IHT applies where 10% or more of a deceased’s net estate (after deducting IHT exemptions, reliefs and the nil rate band) is left to charity. In those cases the 40% rate will be reduced to 36%.
Business Property Relief (“BPR”)
BPR is available on qualifying business property such that it can reduce the value of the property either on a transfer during lifetime or on death. BPR relief is given at 100% and is particularly valuable to business owners who own shares in unquoted trading companies. The definition of unquoted trading company includes those shares listed on AIM. There is no minimum holding but the shares do have to be owned for two years to qualify. Particular care needs to be taken where a company holds investments or large amounts of cash to ensure that the wholly or mainly test is met for trading.
Business owners should consider converting loans to the business to shares via a rights issue to benefit from BPR.
Potential Exempt Transfers (“PET”)
A PET is a gift made which is not a lifetime chargeable transfer and is usually made by one individual to another individual. A father making a cash gift to an adult child would be a PET and provided the father survives seven years from making the gift then the entire value of the gift will be outside his estate. If he survives more than three years then the tax rate applied to the gift will be reduced by 20% each year until it falls out his estate after seven years.
The gift has to be outright so if you retain a benefit in the gift then HMRC will consider that the gift is retained in your estate under the gift with reservation of benefit rules such that IHT will be payable on that gift even though you may legally not own it.
Utilising the Nil Rate Band
Lifetime chargeable transfers can be made within the nil rate band without incurring any IHT liability. After seven years, the transfer is not taken into account for IHT in determining IHT on subsequent transfers.
Each individual has a £3,000 annual exemption where gifts can be made without an IHT charge. Any unused annual exemption may be carried forward for one tax year only.
The following gifts are exempt from IHT:
- Gifts between husband and wife are exempt unless they are from a UK domiciled spouse to a non-UK domiciled spouse, in which case the limit is the IHT nil rate band.
- To individuals which do not exceed £250 in total per tax year per recipient.
- In consideration of marriage, by a parent £5,000, grandparent £2,500 and anyone else of £1,000
- To registered charities provided the gift becomes the property of the charity or is used for charitable purposes.
A gift made for family maintenance is not subject to IHT. This is often seen where there is a transfer of matrimonial property made on divorce under a court order. Gifts made for the education or maintenance of children or a dependent relative would also be included.
Regular gifts out of excess income
Individuals who regularly have income in excess of the living requirements can gift that money without any IHT consequences. There are three tests that have to be met:
- The gift must be made out of income and not from the sale of assets or capital;
- The gift must be regular and;
- The gift must not reduce the donor’s usual standard of living
The gifts should be documented with supporting information indicating the income received during the tax year and the expenditure incurred in maintaining the usual standard of living. This is often a relatively easy way of passing down cash to the next generation but is often not considered.
Make a Will and then update it
Just over half of the adult population in the UK does not have any Will in place. With the introduction of the transferable nil rate band and now the residence nil rate band, many of these Wills may not have been reviewed.
It was common before the transferable nil rate band to have a Will which created a discretionary trust on death so as to utilise the nil rate band. Many people changed their Wills when the transferable nil rate band was introduced and put in place mirror Wills.
Having a discretionary trust in the Will may become common place to ensure that the residence nil rate band is utilised on the death of the first spouse where there are cases where the estate is above £2 million such that the residence nil rate band becomes withdrawn.
Wills should now all be reviewed along with the value of the estate to determine the best option available and each case may be different.
The government’s proposals to increase the probate fees from a current flat rate fee of £215 or £155 if done by a solicitor to a sliding scale between £300 and £20,000 based on the value of the estate have currently been dropped.
Life insurance can be an effective tool to mitigate the exposure to IHT. Although life insurance will not reduce the IHT liability it can be used to provide a benefit on death to pay the IHT liability. Always remember to write the life insurance policy into trust otherwise it will form part of the estate and increase the IHT liability on the estate. This is particularly useful where there are illiquid assets within the estate like the family home and protects it from having to be sold to fund the IHT liability.
The cost of the life insurance policy increases with age and is dependent on your medical position. The policy can be for a period of ten years where the premiums are fixed from the outset but the premiums are recalculated after ten years where invariably they will increase. Alternatively the policy can be for the entire life and are fixed from the date the policy is taken out. These will invariably be more expensive but that is because there will always be a payment from this policy on death. These policies are usually written as joint life second death where there is a married couple and the premiums are based on a pay out when both parties have died.
IHT Exempt Assets
There has been a recent trend for investors to make investments into assets which benefit from BPR. There are a number of Enterprise Investment Scheme (“EIS”) portfolios available which will invest into EIS qualifying companies which if the shares are held for two years will qualify for BPR. There is also the added benefit of income tax relief of 30% on the investment and the opportunity for the deferral of capital gains.
There are anti-avoidance tax provisions to consider. For example if you borrowed £200,000 against a property valued at £500,000 and used the borrowed funds to purchase an EIS portfolio, the net estate subject to IHT would be £300,000 which would be below the IHT nil rate band so no IHT will be due. This would make an IHT saving of £70,000. Following the changes in Finance Act 2013, with effect from 17 July 2013 any borrowings will now be deducted against the assets that qualify for BPR so rendering the planning ineffective. Any borrowings taken out before 6 April 2013 will not be affected by the new rules.
UK Trusts are not as complicated as you may think
A nil rate band discretionary trust is an effective way for a gift to be made for the next generation whilst maintaining some element of control of the assets. This can be made during the lifetime or on death. The limit to mitigating an IHT charge is the nil rate band of £325,000 but this can be doubled for a couple.
A standard UK trust does not cost much to set up and the donors can be appointed as Trustees to keep professional costs to minimum. However, the trustees should be aware of their obligations and accepting to be a trustee should not be taken lightly.
Discounted Gift Trusts (“DGT”)
A DGT allows an individual to make a gift of money yet retain the right to receive an income from the amount gifted. This amount is usually set at 5% per annum to tie in with the 5% tax deferred withdrawal limit on an investment bond.
There is an immediate IHT saving on the discount whilst the remainder will be treated as a PET and fall out the estate after 7 years. The insurance company will calculate the discount on the gift that falls immediately out of IHT and this will be based on the individual’s age and health.
The income received can be used to make regular gifts of income to a beneficiary if it is not required by the individual.
Individual Savings Accounts (“ISAs”)
A common misconception is that ISAs are tax free whereas they are included in the estate for IHT purposes. It is now possible to retain the income tax and CGT benefits of an ISA on death when it passes to the surviving spouse on a one off allowance available on death.
Pensions / Qualifying Non-UK Pension Scheme (“QNUPS”)
Pensions are generally outside the scope of IHT and therefore provide an effective shelter if there are other assets available outside the pension plan.
An individual can also make pension contributions for their children or grandchildren. It is often mistaken that this is limited to £3,600 gross. The amount can be more provided the child has net relevant earnings like a salary. The payment into the pension scheme will either be treated as an exempt transfer if one of the allowances (e.g. annual allowance) or reliefs (e.g. regular gifts out of excess income) is available otherwise it will be a PET. The child could then claim tax relief on the pension contribution if they are a higher or additional rate tax payer.
With the reduction of the amount that can be put into a pension from 6 April 2016 particularly those that earn above £210,000 who are restricted to an annual allowance of £10,000, QNUPS may be an alternative solution to making provision for retirement. There is no tax relief on pension contributions and the pension payments are taxed when taken out. The amount that can be contributed is not restricted to net relevant earnings. However, they do have higher degrees of flexibility for investment and can be used to purchase UK residential investment property. Unfortunately, QNUPS are being marketed for IHT planning and HMRC will look very closely at the amounts contributed and whether that represents an appropriate amount for the provision of an income for retirement.
There are many steps that can be taken to reduce the exposure to IHT but the key is to plan ahead and plan early. Many are now planning ahead as the cost of care home fees can often deplete one’s estate quickly leaving little to the next generation.
Mortality is always a difficult conversation and clients often say they don’t care about IHT as it will be a problem for the beneficiaries and they will be dead anyway. However, by taking some simple steps and planning in advance, less is paid to HMRC and more is retained by the family.
How we can help you?
Every individual will have different circumstances and aspirations to consider and the above is an overview of the possible planning opportunities. Please contact our Private Client Tax Director Rakesh Dabasia at email@example.com if you would like to discuss your personal position.
Disclaimer: Please note that this leaflet is not intended to give specific technical advice and should not be construed as doing so. It is designed to alert clients to some of the issues and not intended to give exhaustive coverage of the topic. Professional advice should always be sought before action is either taken or refrained from as a result of information contained herein. This firm is not authorised under the Financial Services and Markets Act 2000 but we are able in certain circumstances to offer a limited range of investment services to clients because we are members of the Institute of Chartered Accountants in England and Wales. We can provide these investment services if they are an incidental part of the professional services we have been engaged to provide.