Techzone

The Office of Tax Simplification (OTS) has made a series of recommendations aimed at removing some of complexities in the current IHT rules. These are only suggestions but, if adopted, would see the gifting period reduced to five years, an amalgamation of various gifting allowances into a single larger annual gift exemption and the removal of the 14 year rule.

The OTS was asked by the Government to conduct a review of Inheritance Tax in January 2018. Having sought the views of interested parties and the public, the OTS has now set out a series of measures designed to make the tax easier for the taxpayer to understand and for HMRC to operate. 

It's worth remembering that the OTS is not a policy making body, and there's no guarantee their recommendations will ever be taken up by government. But future legislation could be influenced by the recommendations made.

Here we highlight 10 areas from the report that, if incorporated into legislation, would be significant for mainstream IHT planning and wealth transfer planning with your clients.

1. Lifetime gift exemptions

One recommendation is that there should be a single annual personal gifts allowance on a use it or lose it basis. This would replace the current £3,000 annual exemption and the exemption for gifts in consideration of marriage, neither of which have increased for many years.

This allowance could even include an amount to replace the rather more complex exemption for normal expenditure out of income. In its current form, this exemption has several drawbacks. It's not always clear what is included as income, or what level and regularity of gifting is regarded as ‘normal’ expenditure.

And perhaps worst of all for planners and their clients, there is generally no guarantee at the time of making the gift that the conditions for the exemption have been satisfied. It's only on death that executors make a claim for the allowance, and the success of a claim will largely depend on the quality of records kept, if any, for the period over which gifts have been made.

For those who do wish to make regular gifts from income gifts, it's a good idea to keep a record of income and expenditure and the arising surplus on the HMRC form IHT403. This form doesn't need to be sent to HMRC during the donor’s lifetime, but will assist the executors when the claim is made on death.  

Alternatively, the normal expenditure exemption could be kept separate, but with a monetary limit set, perhaps based on a percentage of income but without the need to prove any regularity of gifting.

These measures would provide greater certainty and even scope for many. However, those clients relying on the exemption to give larger amounts away annually could find themselves more restricted.

2. Gifting periods

It's proposed that the seven year ‘inter vivos’ period for making gifts is cut to five years.

Currently, lifetime gifts made in the seven years prior to death are taken into account for IHT. The OTS believes that this period is too long for the amount of tax it raises, and the shorter period would also help executors with regard to records.

The obvious benefit from this measure would be that those who make gifts up to the nil rate band could do so every five years rather than seven. Over a 20 year period, this would equate to the availability of an extra nil band - and potentially an extra IHT saving of £130,000 (based on the current nil rate band of £325,000).

3. Taper relief

Taper relief should be abolished according to the report. This is on the basis that it's frequently misunderstood.

The tax on lifetime gifts reduces by 20% for each year the donor survives the gift after year three. But often there's no tax to pay on a lifetime gift because it will be covered by the nil rate band, and so there's no benefit from taper relief for gifts between three and seven years ago.

The common misunderstanding is that taper reduces the value of the gift, rather than the tax on that gift, with more IHT payable as a result.

While this measure could mean more tax to pay for some individuals, it removes the complexity and would go some way to balancing the tax saved by shortening the gifting period above to five years.

4. The 14 year rule

The OTS is seeking to get rid of the 14 year rule which causes much confusion as well as difficulties in terms of record keeping. They propose removing the need to take account of gifts made more than seven years before death (or five years if the gifting period changes).

Where does the ‘14 year’ period come from? Where a potentially exempt transfer becomes chargeable because of death within seven years of the gift, tax must be paid as if that gift was chargeable at the time it was made. This means it must take account of any chargeable transfers made in the seven years before it.

This would make the executors job much easier and record keeping less onerous.

5. Liability for payment

The OTS would like to simplify and clarify who has liability to any tax that may arise on a lifetime transfer.

The issue here centres on the perceived fairness or otherwise of how the nil rate band is allocated on death between lifetime transfers and the estate. Currently it's used in chronological order against lifetime gifts first, with any remainder available against the estate.

It can therefore come as a surprise to beneficiaries of the estate that there is little or no nil rate band left, with a bigger chunk of IHT reducing their inheritance. A problem if they were not also the recipients of the lifetime gifts.

It may also come as a surprise to the recipients of lifetime gifts that if there is tax on their gift, they will be primarily responsible for paying it, even if the cash has long since been spent.

Settlors may, of course, avoid such issues and conflicts by stating in their wills that any IHT on lifetime gifts is to be paid by their estate, but they're unlikely to think about this without prompting from advisers.

While the report makes no specific recommendations on this aspect, it considers possibilities such as making the estate responsible for any IHT on lifetime gifts, or alternatively allocating the nil rate band on death such that lifetime transfers and the estate received a fair share. 

6. Interaction with CGT

Another recommendation is to remove the capital gains tax uplift that assets receive on death if those assets benefit from business property relief (BPR), agricultural property relief (APR) or the spousal exemption.

It's almost accepted without question that when someone dies, there's no capital gains charged on the assets they own, just IHT. The beneficiaries of the estate will acquire assets at market value at date of death. This is commonly known as ‘market uplift’.

This avoids both IHT and CGT being charged on the same asset on death. However, concerns have been raised that where the asset is subject to an IHT relief or exemption neither IHT nor CGT is payable.

This change would mean there's still no charge on death but, instead, assets would be transferred on a ‘no gain, no loss’ basis, similar to the treatment of lifetime transfers between spouses. That's to say that the beneficiaries will acquire the assets at the cost to the deceased.

The OTS argues that the rules could affect the actions of certain individuals.

Clients may hang on to assets with gains until death so that a surviving spouse can acquire them with a spouse exemption for IHT and market uplift for CGT. But this unknown future date may not be the optimum time for selling or gifting.
 
Similarly, it could conflict with the objectives of business property relief (BPR) and agricultural property relief (APR). These reliefs are essentially to ensure the smooth transfer of businesses to the next generation so they can continue as going concerns. But CGT market uplift can act in the opposite direction, as owners may be tempted to hang on to control until death to benefit from market uplift and still able to claim BPR/APR. However, this may not prove to be the best move commercially.

Advisers should consider the future health of the business as well as IHT in discussions with clients.

7. AIM shares and BPR

The report questions the availability of BPR to general investors in shares on the Alternative Investment Market (AIM) given that, as mentioned above, the relief was primarily intended to prevent the break-up of smaller businesses on the death or retirement of a principal owner.

Investments in AIM shares have become a popular option in IHT planning as the availability of BPR after two years is a quicker way of reducing a potential liability, although such choices must be balanced by the additional risks that may be present.

Withdrawing this concession would be unpopular move as it could have a negative impact on AIM share prices and make it harder for smaller businesses to raise finance.    

8. Term assurance policies

The OTS recommends that death benefits from term assurance policies are not subject to IHT, even if they're not written under trust.

These policies are generally taken out to protect the family in the event of an untimely death. Those who take advice will normally put the policy in trust to ensure any proceeds don't form part of the estate for IHT, and also to avoid the need to wait for a grant of probate. Those policies not written in trust will form part of the estate and IHT could be payable on them unless they're left to the spouse, or sit within the nil rate band. And the new requirement to register all trusts with the Trust Registration Service could deter even more people from using trusts.

The OTS conclude that given these policies are taken out to serve the same purpose, they should not be subject to IHT even if they're not written in trust. Speed of payment will remain a motive for using a trust however, by removing the need to wait for probate to be granted.

9. Pension transfers

There are no recommendations for pensions, but the report does bring to attention the common issues faced by clients and advisers in relation to pension transfers.

The report recognises that people are increasingly moving their pension benefits between schemes in order to take advantage of flexible drawdown, cost savings and consolidating retirement savings in one place to make them easier to manage. Indeed, government policy has been to encourage the use of the new flexibility rules.

However, in theory, if a member dies within two years of a transfer, HMRC may contend that the transfer is subject to IHT unless it can be proved that there was no gratuitous benefit intended by the transfer - broadly that it was not done to benefit someone else. This can be difficult to prove if required, even if the beneficiaries before and after the transfer don’t change.

While the OTS understands that it's ‘unusual for HMRC to argue that there has been a transfer of value’, they ask the government for greater clarity. This would be a welcome outcome for advisers as it would provide a level of certainty on the consequences of a transfer.

10. The residence nil rate band

Again there were no recommendations for change made on this at the moment, as the band is still relatively new and needs time to bed in.

Unsurprisingly, the OTS received a lot of comments on the complexity and fairness of this legislation from both professional respondents and the public. The report does offer some potential solutions, including an increased nil rate band for everyone, and axing the ‘downsizing provisions’ in favour of a residence nil rate band for everyone who has owned and lived in a residential property in their lifetime. But change in the near future is unlikely.

Summary

To be clear, government is not obliged to take on any of the recommendations from the OTS report. Indeed, the suggestions made may never see the light of day. It does, however, show how thinking on future legislation may be influenced.

It also highlights the areas of difficulty where clients will benefit from good advice under the rules as they stand.