Techzone

Few areas of tax planning create as much confusion and dread as the IHT ‘14-year rule'. With Jeremy Hunt seemingly rejecting calls to abolish the tax altogether by insisting there will be no tax cuts in his Autumn Statement, it appears the much-maligned gifting rule is here to stay.

Gifts made more than seven years before the donor’s death are always free of IHT. However, the impact of the 14-year rule is that certain gifts which were made more than seven years before death and consequently outside the estate, could still affect the amount of tax payable on later gifts which were within that seven year period.

We take a look at how the gifts interact and the impact they can have on the tax due and how this could affect further gifting.

Making lifetime gifts

Lifetime gifting is a core element of IHT planning. But often when financial planners recommend making gifts, they're not faced with a clean slate and there may have been previous gifts to consider.

Understanding how the 14-year rule works will help clients with the timing and value of gifts to achieve better IHT outcomes. It may still mean that, in certain circumstances, clients may still wish to cap the amount they gift or defer gifting until a later date. But in others, there may be scope to safely make larger gifts.

When gifting consists of only making chargeable lifetime transfers (CLTs) into discretionary trusts, most clients will want to keep the seven-year cumulative value of CLTs to below the nil rate band. If they exceed the nil rate band, there will be an immediate lifetime charge on the excess of 20%.

However, if a client wishes to gift more than the nil rate band, they may consider making direct gifts which qualify as potentially exempt transfers (PETs). These will never attract a tax charge during the donor’s lifetime and will be exempt once the donor has survived seven years. If the donor dies within seven years, the PET becomes chargeable and this may impact on IHT payable. But how?

IHT calculations on death

Essentially, there are two calculations on death – one for the tax on the estate itself, and the other on ‘failed’ gifts in the last seven years.

IHT on the estate

The tax on the estate is broadly the value of the estate less any available nil rate band. This includes the residence nil rate band (RNRB) and any transferable nil rate band and RNRB from a deceased spouse or civil partner. 

The available nil rate band will be reduced by all the chargeable transfers, including PETs that become chargeable, in the seven years before death. Any gifts older than seven years can be ignored – the ’14-year rule’ does not apply here.

However, it is imortant to remember that the chargeable transfers do not reduce the residence nil rate band including any transferred RNRB from a deceased spouse.

IHT on lifetime transfers

We must also revisit each lifetime transfer in turn for the seven years prior to death, including PETs that have now become chargeable, to see what tax would have been paid at the time they were made. This could pick-up chargeable transfers in the seven years prior to the transfer in question, which means that chargeable transfers made up to 14 years before death could still influence IHT payable – this is the so called ’14-year rule’.

Each transfer is looked at as a separate calculation, using the current nil rate band and any available transferable nil rate band each time. However, the residence nil rate band cannot be used.

Taper relief may reduce the amount of tax paid on lifetime transfers made more than three years before death. Remember that if the cumulative value of the transfers is within the available nil rate band, then there will be no taper relief.

Example

Alec is a single parent of two children, Jack and Jill, and grandfather to 5 grandchildren.

His gifting history is as follows:

Year 1 – £300,000 into a discretionary trust (CLT)

Year 4 - £100,000 gift to Jack (PET)

Year 7 - £50,000 gift to Jill (PET)

Year 9 - £75,000 into discretionary trust (CLT)

Year 13 - Alec dies with estate of £800,000 (including family home valued at £400,000). The whole estate is to be split between his two children.

(Assume the gifts are made on the same date each year and the £3,000 annual allowance is already used).

IHT on the estate:

The transfers in year 9 (£75,000 CLT) and year 7 (£50,000 PET to Jill) will be included in the estate at death.

Alec is entitled to a nil rate band of £325,000 and the residence nil rate band of £175,000. However, his standard nil rate band of £325,000 is reduced by the two transfers within seven years of death (£75,000 + £50,000) leaving £200,000 of availble nil rate band. Note: lifetime transfers do not reduce any residence nil rate band.

So the tax on the estate is (£800,000 - £200,000 - £175,000) x 40% = £170,000.

IHT on the lifetime transfers:

We must also look back to re-assess what tax would have been paid on the lifetime transfers in the last seven years. Each time we perform a fresh calculation, starting with the full current nil rate band.

The PET made to Jill in year 7 has now become chargeable. We must include any chargeable transfers in the years prior to the gift to calculate the tax due. This will include the £300,000 CLT made in year 1 but not the PET made to Jack in year 4. This has become exempt because it was made more than seven years before Alec’s death. The total £350,000 exceeds the current nil rate band by £25,000. This means there will be an IHT liability of £10,000 (£25,000 x 40%). This would be further reduced by taper relief. As Alec died between 6-7 years from the date of the gift to Jill, only 20% of the IHT due will be taxable leaving a tax bill of £2,000 for Jill to pay.

Next we need to re-asses the £75,000 CLT made in year 9. Looking back seven years, we only need to bring in the year 7 gift (the failed PET to Jill). The year 4 PET to Jack is now exempt, and the year 1 CLT was made more than seven years previously. The total of the year 7 and year 9 gifts is £125,000 - well under the nil rate band of £325,000. Therefore, the trustees of the discretionary trust have no further tax to pay on the year 9 CLT.

The transfers made in years 1 and 4 do not need to be revisited because they were made more than seven years before death.

Analysis

The total IHT payable is £172,000 (£170,000 plus £2,000).

Had the gift to Jill in year 7 been limited to £25,000, there would have been no tax on it, but then there would have been an extra £25,000 in the estate. Ignoring growth, this would have resulted £10,000 additional tax.

However, if the gift to Jill had been delayed by a year it could have avoided tax altogether by ensuring there was more seven years between the gift to Jill and the original £300,000 gift into trust.

Of course, this must be balanced against the likelihood of the client surviving their gifts by seven years – the earlier a gift is made, the sooner it will be outside the estate altogether.

Unfortunately, advice will be different for each client’s circumstances – there is no prescriptive solution to fit all.

Other considerations

Returning to the example, what if Alec had been widowed a number of years ago? If none of his late wife’s nil rate band had been used on her death, it would be available to Alec when calculating the IHT on his estate and when revisiting each of the lifetime transfers.

There would have been no tax on the estate as the total nil rate band (including the residence nil rate band) is £1,000,000 compared to the estate value (including lifetime gifts) of £925,000.

With regards to the two gifts in years 7 and 9 which became chargeable on Alec’s death, a nil rate band of £650,000 (do not include the residence nil rate band here) would have been available for each retrospective calculation on death, and so there would have been no further tax on these either. In fact, this time there would have been scope to make a larger gift to Jill.

Summary

The ’14-year rule’ does not automatically mean that gifting should be ruled out just because a gift was made into a discretionary trust within seven years of a later gift. It will have to be considered, but there may or may not be any impact. Unfortunately, this does involve number some crunching.

Ultimately the decisions will be influenced by:

• Tax on the estate at death
• The health of the donor at the time of making a gift
• The potential tax on the gifts
• Availability of ‘taper’ relief which can reduce the tax paid on gifts made more than three years before death
• The availability of nil rate bands, including transferable values from a previously deceased spouse or civil partner