Inheritance Tax (IHT) is usually paid on assets held at death but can also apply to trusts or gifts made within someone’s lifetime and also trusts or gifts within seven years of death.
According to Her Majesty’s Revenue and Customs (HMRC) most estates do not have to pay inheritance tax because they are valued at less than the threshold which is currently £325,000 (Tax year 2012-2013).
Any amount over the threshold is payable at a rate of 40% or reduced rate of 36% if the estate qualifies as part of a charitable donation.
For married couples and civil partners the threshold can be as high as £650,000 if one partner transfers the "nil rate band", their unused Inheritance Tax threshold, to their other half when they die.
Inheritance Tax Exemptions and Reliefs
There are circumstances where assets can be passed on without paying inheritance tax. These include:
Spouse or Civil Partner Exemption
Leaving an estate to a spouse or civil partner or gifts to them during your lifetime, is exempt from IHT. The spouse or civil partner must have their permanent home based in the UK.
Inheritance tax (IHT) is not only a tax on assets held at death, but also applies to gifts made by individuals within seven years of death, and transfers into most trusts.
On death, transfers or gifts made in the previous seven years are added to the value of assets then held by the deceased and tax is assessed by reference to this total. Similarly, the total value of chargeable transfers made in the last seven years determines the tax payable on the last transfer.
Once seven years have elapsed since the making of a gift, it can generally be ignored. It is not then taken into account for the calculation of tax on later lifetime transfers, and is not added to the rest of the estate on death.
What Are the Tax Rates for Inheritance Tax?
With effect from 6 April 2008 the first £312,000 of value transferred in life or on death is taxed at a nil rate. This slice is known as the nil rate band. Chargeable lifetime transfers exceeding £312,000 within any seven year period are taxed at 20%. The excess over £312,000 passing on death, or gifted within seven years preceding death, is taxed at 40%. The tax rate is reduced by taper relief for gifts made more than three years before death with a credit for any IHT already paid.
Any unused nil rate band can now be transferred to a surviving spouse or civil partner. This means that where the second death occurs on or after 9th October 2007, the benefit of any unused nil rate band on the death of the first spouse is transferred to the estate of the surviving spouse, even where the first death occurred before 9th October 2007.
The amount of the nil rate band potentially available for transfer will be based on the proportion of the nil rate band that was unused when the first spouse died.
The nil rate band is increased annually, unless Parliament determines otherwise. The threshold has been announced for the following two years, as follows:
- £325,000 in 2009/10
- £350,000 in 2010/11.
Furthermore, in his first Pre–Budget Report on 9th October 2007, Alistair Darling undertook to consider house price inflation when setting the nil rate band in the future.
Who is Affected by IHT?
The key issue for IHT is the taxpayer’s domicile rather than his or her residence as for other taxes. UK domiciled individuals are chargeable to IHT on all their world-wide assets. Those not UK domiciled are chargeable to IHT on their UK assets only. In most instances, an individual’s domicile will be in the country of their father’s birth. Special rules are likely to deem non–UK domiciled individuals to be treated as UK domiciled for IHT purposes, if their residence amounts to at least 16 complete tax years, out of the last 20 or if they were actually domiciled in the UK within the previous three years.
Shareholders in close companies can suffer an IHT charge, for example where there are alterations to their share rights.
In addition to taxing the assets of individuals, IHT also taxes life interests in trusts by treating the assets of those trusts as though they were owned by the beneficiaries if that interest was held before 22 March 2006 and only in restricted circumstances for interests created after that date. There is a separate regime for the taxation of other trust interests. IHT charged on trusts is payable by the trustees.
What Exemptions are Available?
A number of exemptions and reliefs are available to reduce the impact of IHT. Exemptions include:
- unlimited transfers between spouses and civil partners, except where the donor is UK domiciled but the recipient is not. In such cases the exemption limit is £55,000
- potentially exempt transfers (PETs), being lifetime gifts to individuals, where the donor has retained no benefit from the gift. These are not chargeable if the donor survives seven years from making the gift
- gifts to charities, heritage bodies, political parties
- gifts out of surplus income
- gifts on marriage (within set limits)
- the first £3,000 of lifetime gifts in any tax year
- small gifts (£250 or less to each individual).
What tax reliefs are available?
There are two principal reliefs from IHT, namely:
- business property relief
- agricultural property relief.
Both types, subject to certain ownership conditions, operate by reducing the chargeable value of qualifying assets. The reductions are as follows:
- 100% for business interests and, with effect from 6 April 1996, all shareholdings in qualifying unquoted companies (including those listed on the Alternative Investment Market (AIM))
- 50% for control holdings of shares in qualifying quoted companies
- 50% for land, buildings and certain other assets used in a business controlled by the transferor
- 100% for interests in agricultural land, including certain tenancies that commenced after 31 August 1995
- 50% for most other tenanted agricultural land
The effect of these reliefs is to remove many business interests and farms from the charge to IHT.
Deeds of Variation
The destination of assets passing on death will be determined either by the rules of joint property, by the provisions in the will or, where the deceased has died without making a valid will, by the laws relating to intestacy. IHT depends to an extent upon the terms of the will or intestacy (ie if assets are gifted by will to an exempt beneficiary such as the spouse, IHT may not be payable).
Where the will is unsatisfactory, unsuitable to the needs of the beneficiaries, or out of date, it may be desirable for the beneficiaries and executors to alter its effect after the death.
Although under general law a will or intestacy stands as written, for IHT and capital gains tax (CGT) purposes it is possible to rewrite these using a deed of variation or similar instrument. It is also possible to vary the provisions of a joint tenancy. The result is that IHT is re-assessed as if the new basis of distribution had actually been made by the deceased in the will. Reliance should not be placed on the ability to rectify with a deed of variation. Correct drafting of the will during lifetime is to be preferred.
What are the key planning points?
- Ensure that maximum use is made of all exemptions and reliefs (eg £3,000 exemption per tax year & marriage gifts)
- Try to use the nil rate band in full by making chargeable lifetime transfers of £312,000, and PETs of larger amounts. These will fall out of account after seven years
- Try to avoid gifting assets qualifying for 100% business or agricultural relief to exempt beneficiaries (eg spouses). Instead, give non-qualifying assets to exempt beneficiaries, and qualifying assets to non-exempt beneficiaries
- Ensure there is a valid will in place and, where appropriate, ensure that it maximises the use of any the nil rate band or any balance thereof remaining at death. For further details, contact us about our factsheet on Discretionary Trusts in wills
- Consider the use of insurance to pay for the IHT liability
Gifts with reservation
Care has to be taken to ensure that the donor of gifted property never receives a benefit from that property following the gift. Failure to do so may result in the ‘gift with reservation’ rules operating so that the gifted asset is regarded as still forming part of the donor’s estate. Even though no longer owned by the donor when he or she dies, it may still be taxable at that time.
Therefore, settlors of trust property must exclude themselves as potential beneficiaries of that trust if the gift into settlement is to be effective for IHT. Similarly, care must be taken where residential properties in which the donor continues to live are the subject of a gift. Before entering into this type of arrangement, speak to your professional adviser.
Income Tax Charge On Pre–Owned Assets
With effect from 6 April 2005 and subject to certain exemptions, an individual may be chargeable to income tax on previously owned assets that have been transferred anytime after 17 March 1986, but from which the individual continues to benefit. Specific advice should be sought whenever it is intended that an asset is to be transferred and the donor is not to be specifically excluded from benefiting from the asset in the future.
Where Do The Legal Techniques Apply?
This article is a summary of the legal position in England and Wales. Different legislation may apply in Scotland, Northern Ireland and other jurisdictions..
Who Should I Contact?
Close liaison with your tax adviser is necessary to ensure that all uncertain areas are clarified before making gifts or signing wills.
If you need advice on the tax planning issues for your estate please contact your Independent Financial Advisor or Find an IFA. Please also ask for help with Wills and estates, Use of trusts, Using powers of attorney and Discretionary trusts in wills.