The Office for Tax Simplification (OTS) was asked to conduct a review of the complex and poorly understood Inheritance Tax (IHT) regime and invited both professionals and the public to submit their views. Its recommendations have been delivered in a 107 page report entitled ‘Simplifying the design of Inheritance Tax’.
I outlined the existing rules in an earlier article
. Notably, the OTS has refrained from recommending major policy changes, as this is outside its remit of simplification. Nor do they advocate an uplift for the nil-rate band (NRB) of £325,000 per individual which, if it had kept pace with inflation, would be worth £423,000 today.
Moreover, there is also no mention of reconsidering the recently introduced residence net rate band (RNRB) which has drawn criticism for discriminating against childless couples as the property can only be passed to a direct descendent. Many respondents had called for it to be scrapped and the NRB increased. However, the OTS did acknowledge it places some groups at a disadvantage.
Instead, the OTS has focused on simplifying the rules for passing on wealth while still alive (perhaps a nod to the much talked about ‘generational unfairness’). It also aims to lessen the burden for executors of estates by reducing the onerous record keeping required. Some of the key recommendations are highlighted below.
Lifetime gifts - potentially exempt transfers (PETs)
PETs allow you to give money or assets away to other people while you are alive but you must survive for seven years after making one, or else the gift comes back into your estate on death and is potentially subject to IHT. The OTS recommends reducing this to five years as it can be difficult to locate bank records for any longer.
At present, any tax owing is paid by the recipient of the gift, who may not be aware of the potential liability, so the OTS suggests that it should instead be paid from the estate. It also recognised the problem of using up the NRB in chronological order and recommends amalgamating it. This addresses the case where a large gift to one child could be tax free while a subsequent one to a sibling could generate a tax charge.
However, any benefits are diluted by a call to remove taper relief which currently reduces the amount of tax owing on any gifts which exceed the available NRB on a sliding scale. This will mean if someone dies a day before the 5 year deadline, their beneficiaries could be faced with up to a 40% tax bill, whereas if they died a day later there would be nothing to pay.
Furthermore, the OTS has asked the government to reconsider ‘gifts with reservation’, such as giving away your home but continuing to live in it, which accrues income tax on the benefit.
Annual gift allowances
Everyone has an annual £3,000 allowance (which can be carried forward for 1 year) and there is an additional marriage gift allowance of up to £5,000 from each parent (£2,500 from grandparents and £1,000 from others). Finally, the £250 small gifts exemption can be given each year to any number of people who haven’t benefited from the £3,000.
The report proposes merging the first two into an annual personal gift allowance. It doesn’t quantify a figure for this but illustrates what current allowances, frozen since 1981, would be if adjusted in line with inflation. For example, the £3,000 would be worth nearly £12,000 which could make a significant difference if helping, for example, with the deposit on a house. The small gifts amount should also be reconsidered.
Lifetime gifts - normal expenditure out of income
The OTS expressed a number of concerns about the little-known but potentially valuable ‘normal expenditure out of income’ rule. This allows individuals to gift ‘excess income’ free of IHT yet provides no clear definition of what it actually means. The gift must be ‘regular and not affect your standard of living’ and, significantly, the 7 year rule does not apply. It has allowed large amounts to be gifted with, theoretically, no limit for those with high disposable income.
Hence, the report calls on the government to reform or replace this exemption. One option is to impose a limit, possibly a fixed percentage of income, that can be gifted and remove the need for it to be regular. An alternative would be to replace it, and the other annual gift exemptions outlined above, with a higher personal gift allowance, to be made out of either capital or income.
The Capital Gains Tax (CGT) uplift
The OTS recommends the government drops the CGT uplift on death. At present, someone inheriting an asset is treated as having acquired it at the value at the date of death of the owner, rather than the original price paid.
CGT is not charged on death, on the assumption IHT will be charged instead on amounts above the available NRB. However, the OTS found some beneficiaries were incurring both taxes while others paid none (if reliefs such as spouse exemption were available, or the asset was sold quickly).
If accepted, this change means that the sale of an inherited asset will be subject to CGT on any gains on the original price. For example, if a husband leaves a buy-to-let property to his wife, she could incur a large CGT bill, having avoided IHT.
The rationale seems to be that the CGT uplift encourages people to hold onto assets until they die, restricting the flow of assets through generations.
Other tax free transfers
All transfers between spouses and registered civil partners will remain free of inheritance tax and surviving partners can also retain the tax benefits of an ISA by using the inheritable ISA allowance.
SIPPs and other types of Defined Contribution pensions (but often not final salary schemes) can be passed on to nominated beneficiaries free of tax if death occurs before 75 and subject to income tax at the recipient’s marginal rate if death occurs at 75 or older.
Death benefits from life insurance policies
The OTS concluded that there are many advantages to writing a life insurance policy in trust yet many people don’t do it. So, they recommend that all death benefits be IHT free whether placed in trust or not. Nevertheless, a trust does mean families can benefit sooner, without the delays of probate.
The proposals are a step in the right direction in simplifying the administration of estates; although only around 5% of estates are liable for IHT, up to half have to complete detailed and ultimately unnecessary paperwork.
If the governments adopts the proposals, there will be a consultation period before they are implemented. Clearly, the current government has more pressing matters to deal with at the moment and, of course, a different party in power could introduce more far-reaching policy changes. The Labour Party has indicated its intention to replace the current IHT system with a single lifetime allowance of £125,000 for everyone, with sums above this incurring income tax at the recipient’s marginal rate.
So, the fact remains it is very hard to plan ahead when we do not know what our future needs, and indeed the rules, will be. The best course of action may be to have a range of investments in tax wrappers, while relatively generous allowances are still available, and perhaps think about passing some assets on to children or grandchildren.
: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.