07 January 2021

UK Inheritance Tax Reform: rates, reliefs and responsibility


Introduction

The current UK IHT system is often perceived as unfair and unduly complex, so a review of the system and subsequent report was welcomed by many. As it currently stands, a deceased’s estate is taxed at 40% on the transfer of value in excess of a static tax free allowance (referred to as the Nil Rate Band which has remained unchanged for several years now) unless certain limited reliefs and exemptions apply (for instance business property relief or the spouse exemption). These issues were part of the IHT system review conducted by the Office of Tax Simplification (the ‘OTS’) and the All-Party Parliamentary Group on Inheritance & Intergenerational Fairness, (the ‘APPG’).

The APPG report, published in January 2020, recommends a complete rethinking of the UK IHT system. It is fair to say that the OTS recommendations (contained in its second report published in July 2019) are not as radical, showing a more conservative approach. But, several areas are touched upon and considered ripe for change by the OTS and the APPG.

In Part 1 of our 3 part series examining the suggested reforms, we focus on those most relevant to private individuals. Part 2 considers the impact on insurance policies and pensions. Part 3 considers where the European equivalents of the IHT system can provide further inspiration for achieving change and we give our concluding comments on the reports and their adoption.

Tax rates

Of fundamental importance in the context of any reform is the question of rates. A flat 40% tax rate is perceived as excessive and this is the reason why most people put in place estate planning strategies aimed at deferring or mitigating the tax charge. The OTS’s report has flagged that the effective rate for very large estates (i.e. estates over £7m) is, in fact, in the region of 10% once all relevant reliefs and exemptions are properly applied.

The OTS has not made any specific recommendation in this area for the time being and instead suggests a partial reform by addressing and amending the various reliefs and timeframes relating to IHT. By contrast, the APPG’s core recommendation is a reduction of the rate of IHT to 10% for estates whose value is lower than £2m and a flat of 20% for estates over £2m. The rationale behind this is greater simplicity: the rate should be low enough for the tax to be broadly based without the need for complex reliefs.

Lifetime gifts

The APPG’s recommendations involve taxing lifetime gifts immediately, thus removing the concept of a ‘potentially exempt transfer’ (known as a PET), subject to an annual exemption and possibly retaining a complete exemption for gifts to spouses and charities. The current selection of smaller reliefs (such as the small gift exemption, the current £3,000 annual exemption, gifts in consideration of marriage and normal expenditure out of income) would be replaced by a single and more generous annual allowance of £30,000 which cannot be carried forward if not used in full. If a gift in excess of the annual allowance is of cash, then the burden will be on donor to retain 10% (the suggested tax rate for gifts) and to account for this to HMRC. If a gift is of an illiquid asset, the donor will be given the option to pay the tax by instalments over 10 years subject to payment of interest.

The OTS suggests retaining the concept of PETs but with a reduction of the 7 year period to 5 years and an elimination of taper relief. However, it acknowledges the confusion surrounding the various lifetime gift exemptions and recommends an overall personal gifts allowance (a suggested figure is not given).

The first approach would certainly simplify the administration of estates by relieving executors from the often arduous duty to account for lifetime gifts made within the previous 7 years of death and calculations of how this impacts the available nil rate band. Furthermore, it would enable the prompt collection of taxes as the tax could be paid (by the donor) within a short period after the perfection of the gift.

However, the position suggested by the OTS would certainly be more easily achieved. It remains to be seen how the public will respond to the immediate taxation of lifetime gifts, but this could be acceptable in light of the APPG’s suggested substantial reduction of the IHT rate.

Interaction with CGT rules – CGT rebasing on death

Currently, the interaction between CGT and IHT has the effect of discouraging lifetime disposals of assets. Under the present rules, a failed PET can result in a perceived double taxation (on a lifetime gift, CGT is payable and if the deceased fails to survive by 7 years there could be a further charge to IHT) whereas if the asset passes on death, where a relief or exemption applies there could be no taxation at all (no IHT because of business property relief and the benefit of an uplift for CGT purposes).

The OTS’ solution is to remove the CGT uplift on death to the extent that no IHT is payable on death (as a result of a relief or exemption). The APPG’s report recommends a more extreme abolishment of the CGT death uplift on all assets: these assets should pass on a no-gain and no-loss basis. It also suggests that gains on lifetime gifts could also be held over: the recipient would in the end pay a (higher) gain on a disposal out of the sale proceeds and the donor would pay IHT immediately or on instalment but at a lower tax rate.

This approach (in either form) would require the donor/testator to retain evidence of the historical base cost of assets which may be disposed many years after the gift/inheritance.

Abolishing / reforming many special reliefs, including business property relief and agricultural property relief

The APPG’s recommendation is to abolish BPR and APR completely. This recommendation has come as a surprise as these reliefs are genuinely relied on to protect the value of (often very illiquid) businesses from a tax charge so enabling them to continue trading. However, the APPG has affirmed the much lower tax (at 10% or 20%) payable on transfers of family businesses and farms could be paid over a period of 10 years by interest free instalments, allowing the 1% (or 2%) charge to be paid annually out of net income.

In an effort create a consistent approach across IHT and CGT, the OTS recommends aligning the trading thresholds. The 50% trading threshold for IHT would be replaced by the higher 80% threshold (which currently applies in the context of CGT). This may make BPR much harder to claim, especially for those businesses whose assets include investment assets.

Such suggestions are a long way from becoming law, and any changes to IHT of such a fundamental nature would need to be very carefully thought through and consulted upon by the government, but the nature of the two reports might be seen to be an indication of a potential future direction of travel in this respect. There is still more to consider, so in Part 2 we will look at the impact on insurance policies and pensions.

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