The winners and losers of simplifying IHT
A year and a half after the then Chancellor, Philip Hammond, wrote to the Office of Tax Simplification (OTS) asking them to review inheritance tax (IHT), their second report titled ‘Simplifying the design of IHT’ has finally been released. The OTS’s first report focussed on feedback from their consultation and ways of simplifying the administration of IHT. This new report however, covers proposed changes to the tax itself, and whilst the changes are not as radical as many had predicted (if adopted), advisers need to be aware of the major impact they could it have on IHT planning.
The recommendation that grabbed the headlines was the proposed reduction in the period of time that gifts, made by an individual during their lifetime, may be taken into account when assessing IHT on death. For potential exempt transfers, the period would be reduced from 7 to 5 years. For gifts which are deemed chargeable transfers (mainly gifts into trusts) during their lifetime, this would be reduced from 14 years to 5 years.
The responses from the OTS consultation indicated that the current 7 and 14 year periods during which a lifetime gift may impact on IHT are too long. In particular, it can be difficult, or sometimes impossible, for executors to obtain records going back that far, for example, it is not possible to obtain bank statements going back more than 6 years. It was also observed that the calculations in regard to chargeable transfers made within 14 years of death are too complex.
From a negative perspective the report advocates removing taper relief. The supporting point made by the OTS was that very little IHT is raised on gifts made more than 5 years before death of the donor. However, the seemingly obvious reasons for this would be that any IHT due is reduced significantly by taper relief, and gifts may not have been taken into account due to the inability to find records that far back.
It was also apparent that the understanding of how taper relief worked was poor amongst the general public, in that many think it applies to the value of the gift, when in fact it relates only to the actual tax due.
When it comes to the current gift exemptions they are seen as being complex and not well understood. The key issues are:
• the rules covering how each type of exemption applies,
• their interactions with each other, and
• the differing limits.
One of the examples given relates to the issue of ‘normal expenditure out of income’ exemption, where it can require extensive record keeping, and the scope of the exemption can be challenged by HMRC resulting in donor uncertainty.
Another important, and more positive, point made was that the exemptions have not kept pace with inflation. The annual exemption has been frozen at £3,000 since 1981, the small gifts exemption has been £250 since 1980 and the three exemption limits for gifts on marriage or civil partnership go all the way back to 1975.
The OTS believes the small gift exemption should remain but the limit increased from £250 to £1,000 to reflect inflation. This would cut down dramatically the amount of record keeping required by the donor and reflect more realistically the value of gifts made.
The recommendation for the annual gift, gifts on marriage or civil partnership and the normal expenditure out of income exemptions is that they should be replaced with a single annual personal gifts allowance. This would simplify matters considerably for both HMRC and donors. HMRC data shows that a personal gift allowance of £25,000 would cover the value of 55% of all normal expenditure out of income claims. Based on HMRC 2015/16 data, only 261 such estates would have been worse off under these recommended changes.
Another possibility would be to put an annual limit on the amount of normal expenditure out of income that is exempt. This could simply be a fixed percentage of annual income. This would remove the need for the expenditure to be “regular” – a current requirement – which would provide more flexibility and perhaps more importantly, certainty for donors. However, those few individuals with large surplus incomes would lose out. If this option was adopted, the annual gifts allowance would need to be lowered.
It was not all doom and gloom
No matter how small the steps taken to simplify the tax system appear to be, they have to be a seen as a positive given the current position, though we will have to continue to accept that there will still be winners and losers. The proposed reduction in the period of time it takes gifts to fall out of a donors’ estate will benefit many, but for the few making large gifts, the loss of taper relief could prove costly.
One specific piece of good news for the life industry is the recommendation that death benefit payments from term life insurance should automatically be free of inheritance tax (IHT). The fact that currently the death benefits of a term life insurance policy written in trust can be paid free of IHT makes this proposal seem logical. Furthermore, this resolves the issue for many existing policies that are not written in trust, for at present those death benefits are potentially taxable.
Another area looked at was simplifying and clarifying the rules on liability for the payment of tax on lifetime gifts to individuals and the allocation of the nil rate band (NRB). Where gifts made prior to the death of the donor are in excess of the NRB, who ultimately bears the tax can have unintended consequences. It is well understood that the NRB is allocated to lifetime gifts in chronological order. What is not perhaps appreciated is that it is the recipient of a lifetime gift who is liable for any IHT payable on that gift, but if the recipient does not pay the tax within 12 months then the estate becomes jointly liable. As executors are personally liable for unpaid IHT this could lead them to delay distributing the estate until they are absolutely satisfied no further IHT is due on previous gifts.
Consider a simple example, ignoring exemptions, where John gifted £325,000 to his nephew Robert in 2015 and in the following year he gifted the same amount to his niece Karen. John died in 2018; therefore the gift to Robert was covered by the full NRB. The gift to Karen on the other hand is liable to IHT at 40%. This would leave her £130,000 worse off than Robert, and Karen may have spent the money being unaware of a possible tax liability.
Two options have been proposed around the tax on lifetime gifts.
• any IHT due in relation to lifetime gifts to individuals should be payable by the estate, and
• the nil rate band should no longer be allocated to lifetime gifts in chronological order but, rather, first be allocated proportionately across the total value of all the lifetime gifts, with any remainder being available to the deceased’s estate.
• executors to be liable for IHT relating to lifetime gifts only out of assets they handle, and which are due to be distributed to the gift recipient in question, and if it has not proved possible for HMRC to collect the money directly from the gift recipient.
I doubt allocating the nil rate band proportionately on lifetime gifts will actually simplify matters but it will ensure in situations like the one given in the above example that beneficiaries are treated in a fairer manner and reviewing who actually is liable for the tax should prevent unwanted surprises.
Finally, where a relief or exemption from IHT applies, the OTS has suggested that the capital gains (CGT) uplift should be replaced with the recipient being deemed to have acquiring the assets at the historic base cost of the person who has died. In layman’s terms, the person inheriting an asset currently acquires it at its market value on the date of death. Where an asset is also exempted or relieved from IHT (for example, business relief, or agricultural property relief, or where the spouse exemption applies), the asset can be sold just after death without either IHT or CGT arising. This may lead people to defer passing on assets during their lifetime.
By way of an example for this; the owner of a farm may be too old to manage the business and for the future success of the business it may be appropriate to pass it on. However, the option for wiping out any CGT on death justifies the retention by the present owner. The current tax regime could be construed as distorting and further complicating the decision-making process around passing on assets. The proposal not to wipe out any CGT liability on death may make the decision to pass the farm on more straightforward.
The imponderable will be how many, if any, of these recommendations will actually be taken up, the issue of which will be exacerbated by a new Chancellor now being in situ. It is important though, that advisers are aware of these possible changes, how they could impact their clients and whether it is prudent to take any action now.