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If you could change one thing about inheritance tax what would it be? Well the Government would like to know. The Office of Tax Simplification (OTS) has been conducting a review of the existing system by asking individuals, advice professionals and representative bodies for their experiences, and any suggestions as to how the IHT framework and processes can be improved.

This is separate from the consultation on trust taxation (expected later in the year) announced in the 2017 Autumn Budget.

The IHT rules can be complex. And understandably this will be a key focus for many of your clients. Any changes made to simplify IHT will be welcome but, in the meantime, advice must be based the rules as they stand. We’ve picked out the ten most common areas where we are asked to clarify understanding.

1. Pensions and IHT 

In most cases, lump sum death benefits from a pension scheme will be IHT free. That’s because the pension scheme trustees/scheme administrators normally choose who will receive the cash – they have ‘discretion’ over the payment of benefits.

However, certain actions your clients take with their pension whilst in poor health could result in IHT becoming payable upon their death. For example:

• transferring benefits to another scheme;
• paying contributions; or
• placing buy out plans or retirement annuity contracts in trust. 

The value transferred will be nil if they are in ‘normal’ health at the time. HMRC will assume someone is in normal health if they survive the above actions by 2 years.

This is why it's important to ensure that clients who wish to benefit from all the flexible retirement options are in the right pension as soon as possible - preferably while they're in good health. Moving it to a more modern and flexible pension while in poor health may still be the right thing to do for a particular client, but there could be an IHT impact. 

If a client dies within 2 years, the client’s executors must report this to HMRC on form IHT409.

2. Residence nil rate band

There is currently an extra £125,000 (rising to £175,000 by 2020/21) nil rate band available where the family home passes to direct descendants. But not everyone will benefit:

• Anyone without children or grandchildren.
• Those with estates of more than £2 million could lose some or all of the allowance. Making lifetime gifts can help to re-instate the full allowance and, for this purpose, it doesn’t matter if a gift is not survived by 7 years. Or when the first partner dies, instead of leaving everything to their surviving spouse and inflating their estate, make gifts to others using the nil rate band – maybe even a gift into a trust.

There are special rules to ensure that those who have downsized, sold their home to pay for residential care, or perhaps moved in with relatives, can still benefit from the residence nil rate band (RNRB). Even though the physical property is not being left to direct descendants, a related value after a ‘downsizing adjustment’ can still available. But this adjustment calculation can be complicated, especially if the estate is being left to a number of beneficiaries, not all of whom are direct descendants.

3. Transferable nil rate band

When someone dies, their executors can claim the unused nil rate band from any spouse or civil partner who died before them. Added to their own nil rate band, it could mean that £650,000 of the deceased’s estate is IHT free. This is helpful given that the standard nil rate band has remained frozen at £325,000 since transferability was introduced in 2009.

The amount claimed from the first to die will be reduced by gifts they made to people other than their spouse, both from their estate and gifts made in the 7 years before they died. This can present difficulties, especially when the first death was many years ago, as a copy of the original will and grant of probate will be required to claim the allowance of a former spouse to determine the gifts made.

And the maximum additional nil rate band which can be claimed is limited to 100% of the current nil rate band, irrespective of the number of deceased former spouses your client may have. If your client is likely to be in such a position and they themselves have remarried then it's possible to prevent wasted inherited nil rate bands by making gifts during life or using a trust on death. An appropriate legal adviser will be able to provide specialist advice in this area.

4. Lifetime gifts - who pays the tax?

Typically the recipient of a gift is responsible for any IHT which becomes due. But gifts may be exempt (no IHT impact), potentially exempt (no immediate IHT impact ) or chargeable lifetime transfers (immediately assessed to IHT ). Gifts to a spouse or civil partner are exempt from IHT, so there won’t be any tax to pay.

Gifts to other individuals are outside the estate once the donor survives for 7 years. These are known as potentially exempt transfers (PETs). But if they fail to survicve the 7 year period, the gift becomes chargeable and is added back into the estate. If any part of the gift exceeds the nil rate band to which the deceased is entitled to on death, it's the recipient of the gift who's responsible for the tax due on that gift.

Gifts to certain trusts, such as discretionary trusts or interest in possession trusts, will be chargeable lifetime transfers (CLTs). There will be an initial 20% tax charge if the total CLTs in the last 7 years exceed the nil rate band. This is just the current nil rate band, ignoring any transferable or residential nil rate band.

Any tax is the responsibility of the trustees. Often the settlor may pay the tax on behalf of the trustees and, if so, this will need to be treated as a further gift to the trust, known as ‘grossing up’.

If death subsequently happens within 7 years, the tax payable is recalculated at the 40% death rate and may be added to any earlier PETs which have become chargeable. This may increase the chances of a CLT being above the nil rate band. But this is countered by the fact that the nil rate band will now include any transferable and residence nil rate bands. Credit is given for tax already paid at the 20% lifetime rate.

It should be remembered that because lifetime gifts use the nil rate band before the death estate, the knock-on effect is that the IHT bill for the estate may be greater.

In short, the interactions between these different types of transfer, and the circumstances which can give rise to changes in the value of the available nil rate band, can result in complex calculations, and sometimes uncertainty into who ultimately pays the tax.

5. CLTs and the '14 year rule'

One area that understandably cause some confusion is the interaction of gifts and how a gift made up to 14 years ago can still impact the tax payable on subsequent gifts.

There's no tax payable on any gifts made more than 7 years before death. However, a CLT which is outside the 7 year period can still affect the tax payable on later gifts that are still within 7 years of death. That’s because the earlier CLT will continue to reduce the nil rate band available to any chargeable transfers (both CLTs and failed potentially exempt transfers) which are within the 7 years before death.

The easiest way to do this is to look at each gift made in the 7 years prior to death and individually turn the clock back a further 7 years to check for earlier chargeable transfers. The result is that the recipients of gifts in the 7 year period to date of death may have more tax to pay because of a transfer made up to 14 years before death.

6. Taper relief

There's a common misunderstanding that taper relief can reduce the value of gifts made within 7 years of a donor’s death. Taper relief reduces the tax payable on the gift and not the gift itself.  So it only applies if the gift was in excess of the available nil rate band.

Taper relief is available where a gift was made between 3 and 7 years before death. The relief reduces the tax payable by 20% for each complete year from year 3 onwards. For example, if death happens during year 6, instead of paying 40% on the excess over the nil rate band, the rate will be reduced by 60%, i.e. the recipient will only have to pay 16%.

7. Gifts with reservation

To be effective for IHT, a gift must be made with no strings attached. If the donor can still benefit from the property, it will continue to form part of their estate, i.e. the gift will have been made with a benefit reserved. This includes giving away the family home to the kids and continuing to live there. However, the gift with reservation rules won't apply where the home is given away but:

• the donor pays full market rent to live there;
• only part of the property is gifted and both parties live in it, provided both co-owners contribute to their share of the running costs.

8. Normal expenditure out of income

Regular gifts made out of surplus income are immediately exempt from IHT. Provided the gifts are of a regular nature (one off gifts don't count) and made out of income without affecting the donor’s usual standard of living, there's no 7 year clock ticking.

But what counts as income isn’t the same a taxable income. Instead, income for this purpose is measured using the accountancy definition. This is essentially the natural income yield. Withdrawals from investment bonds may be subject to income tax under chargeable event rules, but they're deemed to be capital payments for the purpose of the exemption. So they're not added to income to assess the surplus from which regular gifts can be made. 

Pension income from defined benefit schemes and annuity income purchased from pension savings will also count towards income for this exemption, as will income taken under flexible drawdown provided that income is likely to be sustainable for life. However, larger income withdrawals taken under flexible drawdown are less likely to count towards income for this purpose, even though the income will be taxable. ISA income on the other hand is not subject to income tax, yet it can increase the amount of surplus income. 

9. Reduced rate for charitable trusts

Making a gift in a will to charity which is more than 10% of the net estate reduces the rate of IHT from 40% to 36%. The amount given away will always be greater than the tax saved. However, wills need to be carefully drafted to ensure the 10% test is met. It can become quite complex where there's jointly owned property or settled property (trusts) which form part of the deceased’s estate. These aren’t distributable in accordance with the will but remain assets of the estate. 

10. BPR - trading businesses

Business property relief (BPR) is available for transfers of business property, including unlisted shares. The relief reduces the IHT value of the business asset transferred. The business property must usually have been owned throughout the 2 years prior to the transfer.

To qualify for BPR, the company must be a trading business. There's no relief available where the business exists wholly or mainly for the purpose of holding investments. This includes landlords or businesses established to hold ‘buy to let’ properties.

Summary

These 10 areas are what we're most commonly asked when it comes to helping you help your clients arrange their affairs efficiently and maximise the inheritance they leave for their loved ones. Planners will continue to be faced with these complexities until any changes take place.

We will, of course, share the outcome of this survey when it's published. Hopefully steps will be put in place to simplify the framework and processes, making planning easier for you, and providing  your clients with a more certain future.