Simplifying the Design of Inheritance Tax

On 5 July the Office for Tax Simplification (“OTS”) published its second report on proposed reform and simplification of Inheritance Tax (“IHT”). The report suggests amendments to the existing IHT framework rather than tackling policy issues such as replacing IHT entirely with a tax on gifts or other annual wealth tax.

The OTS has focused on three main areas which we will cover across three separate blog instalments. The main themes of the report are:

• Lifetime gifting,
• The interaction between IHT with Capital Gains Tax (“CGT”), and
• Businesses and Farms

Taking the themes in order, we will firstly explore the suggestions on changes to the treatment of lifetime gifts.

Exemptions

The report highlights the complexity and misunderstanding of the various exemptions currently available for lifetime gifts including the £3,000 annual allowance and gifts in consideration of marriage. The OTS has suggested:

• Consolidation of current exemptions into a single personal gifts allowance.
• Replacement of the current exemption for gifts made from surplus income with either a percentage of income limit or a higher personal gift allowance of £25,000.

Whilst general consolidation of the exemptions seems sensible and an increase in the relatively small £3,000 annual threshold will be welcomed by many, the suggestions on gifts from surplus income could be more controversial. The rules on this exemption are not very well known and the scope often misunderstood, however capping the level of gifts which have previously enjoyed no upper ceiling could significantly disadvantage taxpayers with fluctuating levels of annual income.

The Seven Year Clock and Taper

In order for a gift to fall out of the donor’s estate, he must survive for a period of seven years. The OTS suggest that this period is too long and leads to cumbersome record keeping for Executors. This burden is further exacerbated for taxpayers who have made both outright gifts and transfers into Trust, in which case the clock can run for up to 14 years.

IHT which becomes payable on lifetime gifts made more than three years before death is currently tapered on a sliding scale. Again the relief is misunderstood with many consultation respondents believing that tapering applies to the gift rather than the tax.

The OTS recommendation is therefore:

• A shortening of the current seven year period to five years.
• Removal of the current potential 14 year period.
• Abolition of the tapering provisions.

Here again we can see potential winners and losers. Few would take exception to a shorter five year window and doing away with the need to take account of any gifts made outside of that (or even the seven year) period. It has however been accepted by the OTS that the complete removal of taper relief may lead to an inequitable “cliff edge” for those who make a gift say, 5 years before death (no IHT) and those who make a gift one day later (40% IHT). It may also make term assurance premiums less affordable as cover will not decrease after three years.

Nil Rate Band Allocation and Payment of IHT

Finally in relation to lifetime gifting, the report acknowledges that very few gift recipients appreciate that they are responsible for paying any IHT which becomes due. Similarly the allocation of the available nil rate band in date order is not well understood. Suggestions put forward are for either a reform option or an amendment option:

• Reform – Allocation of the nil rate band proportionately across all gifts made within seven (or possibly five) years of death, and IHT liability due from estate,
• Amendment – IHT liability due from estate only out of assets held by Executors and due to be distributed to the gift recipient in question; otherwise tax responsibility remains with the recipient.

It is hard to see how these recommendations in present form will help to simplify the IHT system. The proposed allocation of the nil rate band will make it difficult to plan for future gifts and will be especially troublesome for taxpayers who wish to utilise the full nil rate band allowance against an immediately chargeable gift into Trust ahead of outright gifts to individuals. The suggested IHT payment changes are quite different in their respective effects. On the one hand, the reform option removes from the recipient all IHT obligations. So, good news for the recipient but the donor then has potential liability to be settled from his estate, further decreasing the wealth he leaves on death. On the other hand, under the amendment option the recipient would still ultimately suffer the IHT payable on the gift but may not be required to make a payment personally if he is a legatee of the donor’s estate. This will not be of much comfort to a recipient who, for example, does not know whether he is actually written into the Will. Worse, the recipient may initially be included in the Will only to be disinherited later having already spent or squandered the gift on which he now has to pay an IHT bill.

In summary, the task of simplifying the lifetime gifting regime is an unenviable one but the OTS have certainly succeeded in generating debate. It will be interesting to see what actions, if any, HMRC take on the recommendations put forward.

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