Inheritance Tax update: a time-limited chance to save tax
Right now, families have a chance to save tax that may not come again for many years. Why? Because the Conservative Party, whether you like them or not, will be in power for a while but, at the end of their term, and maybe sooner than that, we may see changes to Inheritance Tax (IHT) that hit families hard. The rules might change, and families may wish that they had taken action under our present system. This note is long and technical but persevere: failure to read it could seriously damage your wealth.
The present situation
IHT is too complicated. In a highly targeted policy decision, families were given extra relief for the value of the family home. This is the Residential Nil-rate Band (NRB). The complications arise through the various exceptions to the rule, such as the way that the home is held, who inherits it, and how large is the estate of which the house forms part. Extra relief was brought in to help those who had ‘downsized’ to a smaller house, etc. It would have been far simpler just to increase the NRB, which is the part of the estate that suffers no tax.
IHT is too complicated. There are many separate exemptions or allowances from the tax in respect of lifetime gifts, and others that apply only on death. There is an exemption for ‘regular’ lifetime gifts out of income but, when the person dies who has made such gifts, the executors must produce details, not only of the gifts but of the donor’s entire income and expenditure for the years concerned. Few people keep the records that are needed.
IHT is too complicated. There are annual exemptions, the size of which has not been increased with inflation. Gifts to family members getting married are exempt in different sums depending on who is making the gift; and some wedding gifts, if not made outright, qualify for no relief. There are rules covering gifts between spouses where exemption is lost if one spouse is not ‘domiciled’ in the UK; the rules for domicile are themselves complicated.
IHT is too complicated, especially where a person has set aside money or assets for future generations, using a trust to hold the assets until the family members are old enough to look after wealth responsibly. Here, in fact, the rules are so difficult to administer that there are currently significant delays at the offices of HM Revenue and Customs dealing with tax returns. Working out the tax bill is so complicated that the professional cost of doing the sums can come to more than the tax itself.
Now a previous government recognised all this, and the Office of Tax Simplification (OTS) covered some of the issues in its Inheritance Tax Review, issued in July 2019. This is a second bite at the cherry: the OTS issued an earlier report on technical administration issues back in November 2018. Whilst the recommendations may be good in the long term; families may find that it would have been better to work within the old rules.
As a package, the recommendation is three-fold:
- Replace the annual gift exemption and the marriage/civil partnership exemption with one overall allowance;
- Review the level of the allowance; and
- Reform the exemption for normal expenditure out of income and replace it with a higher gift allowance.
The seven-year rule
This rule is not well understood. See my comments under this heading in my page ‘Walking direct from the site‘. The proposal is to reduce the period to five years and to abolish taper relief. Actually, for most families, this would work well: as can be seen in that other article, the abolition of taper relief would not hurt most people.
The fourteen-year rule
This is technical and seldom met in practice. Families would benefit.
IHT on lifetime gifts: interaction with the NRB
The NRB is used up or eaten into, where a person makes large lifetime gifts and dies within 7 years. The NRB is allocated to the gifts in chronological order, so the first recipient is in a much better position than a later one. On death, within 7 years there is a reckoning, and the person who received a lifetime gift that was not covered by the NRB may have a substantial tax bill. All this also complicates the calculation of tax on the estate at death.
The OTS suggests two ways around the problem. For details, read the report (or seek professional advice).
Capital Gains Tax (CGT) and IHT
At present, gains on assets held at death are ‘washed out’. The person who inherits does so at current market value, even though the asset may have increased enormously in value over may years. This can distort behaviour. For example:
George owns a farm, but he is elderly. Business has not been good, and he makes virtually no profit. The land is now worth far more than George paid for it. He relies on subsidies to survive. If George were to give some of the farm to his daughter Sally, she might, with youth, enthusiasm and help from the bank, manage to develop the business. At present, a gift might trigger liability to CGT, if George cannot claim reliefs; but George knows that if he hangs on until death, there will be no CGT. So he does nothing.
The recommendation from OTS is to remove the tax-free uplift on death and treat the person inheriting as acquiring at the historic base cost of the person who has died.
A moment’s thought will show that this change could make a massive difference to families that hold assets for a long time. They might suffer far higher CGT bills under the new regime if it were to come into force.
Businesses and farms
This is a key area of worry if the rules change. The present regime is benign, and families should work hard to exploit the rules that we currently have. The OTS recommends a package:
- Set the level of commercial activity needed a bit higher than it is at present;
- Review the tax treatment of indirect non-controlling shareholdings in trading companies; and
- Treat furnished holiday letting businesses the same way as for CGT, involving various onerous conditions.
These recommendations would, in nearly every case, increase the IHT liability.
Limited liability partnerships
These are now common, especially among professional firms. The OTS recommends a review to tighten up treatment and the ‘trading’ requirement. That cannot reduce the IHT liability.
These are often a problem because their value may, wholly or in part, qualify for IHT relief. The OTS recommends a review. It may be argued that the relief is in any case hard to justify on policy grounds. Whilst there are Members of parliament who live in farmhouses, other owners may relax but if the current Prime Minister was right in accepting that votes had been lent to him in 2019. If a government of a different persuasion were to come to power, things could look very different. Owners of farmhouses should, therefore, look to see if they can, by any means, preserve the present favourable tax treatment. This is a difficult technical area but one on which we can advise.
Proper valuation of farms and businesses is costly and intricate. If the asset qualifies for full relief, that cost may in effect be wasted. The OTS recommend clearer guidance. This would help us all.
Life assurance and pensions
Here the OTS have good ideas. They recommend that death benefit payments from term assurance should be free of IHT even where the policy has not been written in trust.
Pre-owned Asset Tax (POAT)
POAT was brought in to stop a particular form of tax dodge. Like so much anti-avoidance legislation, POAT has been incredibly difficult to administer and has generated litigation and long-standing problems in the administration of estates. The OTS suggest a review to see if POAT still operates as was originally intended and whether it is still needed.
So what’s the problem?
Although any simplification of tax is good, on any change there are nearly always winners and losers. All governments need to raise money. The present government, led by a man not noted for his grasp of detail, may wish to tidy up areas of tax and to make some popular and sweeping changes. Parliament seldom allocates enough time to the consideration of new tax laws, and we often see errors that need sorting out later. Families that might benefit from using the existing rules should get on and do so, taking advice as necessary.
What if this government fails to deliver on all the promises made during the recent election? What if Brexit turns out to be the financial disaster that some people fear? How will people vote next time? If the opposition parties were to come to power, we could expect major increases to IHT because it is seen as affecting only the rich, who should, it is argued, pay much more than at present. We might see a repeat of the Labour party promise to repeal the Residential NRB. The simplicity would be very welcome, but the higher IHT bills might not.
What is the solution?
The solution is hard, and may not be simple. Families should take the time to review their exposure to IHT and CGT. If the tax bill is likely to prove uncomfortably high, families should get advice. There is nearly always something that can be done to improve matters.