Inheritance Tax - a future of simplification?
In July, following its first report in November 2018 and an 'unprecedented' response to their consultation, the Office of Tax Simplification (OTS) published its second report on the simplification of inheritance tax (IHT). The report sets out a number of recommendations for 'a more coherent and understandable structure of the tax'. In this article we look at the main recommendations and findings and consider what is in store for the future.
Lifetime gifts - the 7 year 'wait and see' rule and Taper Relief
An individual currently has to survive at least seven years after making a lifetime gift for it to fall out of their estate for IHT purposes; otherwise the recipient of the gift may have to pay the IHT attributable to the value of the gift. If an individual dies within seven years, but survives for at least three years, any IHT which may be payable by the recipient of the gift on the donor's death is effectively reduced by 20% each year so that if the donor survives over six years, but less than seven, the IHT on the gift is reduced from 100% to 20%. This is known as taper relief.
The OTS has recommended reducing the seven year period to five years. This would be a welcome change. It would reduce the record-keeping burden on an individual during their lifetime and help to reduce the administrative burden on executors who have a duty to make a detailed examination of the deceased person's financial affairs to find out what lifetime gifts they are required to report.
However, the OTS has also recommended that taper relief should be completely abolished. Whilst this would simplify the IHT calculations, it would mean that if an individual dies five years less one day after making a lifetime gift, the whole amount of the gift would potentially be subject to IHT!
Who pays the tax?
Currently, the general rule is that the recipient of a lifetime gift has to pay any IHT that becomes payable on it. Moreover, IHT is payable on a cumulative basis, so that if an individual makes a number of gifts in excess of his or her nil rate band (currently £325,0000) the recipients of the earlier gifts within the nil rate band pay no IHT, whereas those over the nil rate band have to pay tax at 40%. For this reason, where appropriate, we advise our clients to consider carefully the impact of the order in which they make gifts and, to avoid any nasty surprises, to tell the recipients that there is a chance they may have to pay IHT on the gifts.
The report recommends moving the responsibility to pay the IHT due on a lifetime gift from the recipient to the estate of the donor on their death. For many, this wouldn't make any difference in practice if those who have received lifetime gifts are the same as those who will inherit the donor's estate on their death. However, where this isn't the case, this could produce a result that the donor of the gifts hadn’t anticipated. For example, if within the seven year period he or she requires expensive care, reducing significantly the value of his or her estate, the result may be that after the IHT bill on the lifetime gifts, the intended beneficiaries under the Will receive much lower amounts than the donor had anticipated. Under the present regime, it is open to an individual to specify in their Will that they want any IHT which may become due in respect of lifetime gifts to be paid by their estate, instead of by the recipient, effectively allowing the donor of the gift to decide who pays the tax. If the OTS's recommendation is implemented, it is difficult to see how an individual could specify in their Will instead that the recipient must pay the tax.
The report also suggests that the nil rate band should first be allocated proportionately across the total value of all lifetime gifts made within the relevant period prior to death, rather than being allocated in date order. This would appear to achieve a fairer outcome and (as the report notes) would avoid the situation where some beneficiaries unexpectedly benefit from the nil rate band, while others do not.
Life policies are a useful way of providing a sum which, if written into trust, can be paid very quickly after a person dies. Currently, individuals are well-advised to put a life policy into trust so that the proceeds don’t form part of their estate and become subject to IHT. This also means that the beneficiaries don't have to wait until probate is granted before getting access to the proceeds.
The OTS suggests that life policy proceeds are not taxable as part of an individual's estate, whether the policy is written into trust or not. This is a welcome move for IHT purposes, particularly for those individuals who have not put their life policy into trust and do not realise that, unless they take action, the proceeds will form part of their estate. However, if a trust is not used the money won't be available until probate is granted, which often takes many months – a real issue if the purpose of the life assurance is to provide a fund to pay IHT on the individual's estate. Moreover, a trust provides flexibility for the trustees to change who the beneficiaries are, thus enabling them to accommodate people’s changing personal circumstances. For example, a trust can avoid money hitting a beneficiary's estate at a time when they have marital or financial problems. Therefore, even if this recommendation is implemented, individuals should still consider the use of a trust and seek appropriate advice.
Annual Gift Allowances
Each individual can make capital gifts totalling £3,000 in any tax year (which can be carried forward for one year if unused) without any IHT implications, in addition to 'small gifts' of £250 to any number of people they choose. The marriage allowance also enables parents to gift £5,000 to each child, grandparents/great-grandparents £2,500 to each grandchild/great-grandchild and other relatives and friends to gift £1,000 IHT free on the occasion of the recipient's marriage or civil partnership.
The OTS has suggested replacing these exemptions with a new, single personal gift allowance, but the report makes no suggestion as to what the amount of this new allowance might be. If such an amalgamation represented an overall increase to the amount that an individual can gift IHT free each year, this would clearly be welcomed (bearing in mind that the £3,000 annual gift exemption hasn't increased since it was first introduced in 1981 and had it risen in line with inflation it would now be nearly £12,000). It would, however, be a shame if the ability to carry forward the annual exemption is lost (as the report suggests) as many people don’t have the funds to make gifts every year.
Gifts out of surplus income
Many people feel that it is not fair that they have to pay income tax during their lifetime and that the same money is hit again by IHT when they die. What is known as the 'normal expenditure out of income' exemption enables individuals to make regular gifts out of their surplus income, such that the gifts are immediately free from IHT, i.e. the usual seven year rule doesn’t apply. However, in the event of the donor's death it is necessary for their executors to prove that the gifts satisfy the requirements of the exemption, as a result of which we advise clients making such gifts to keep extensive records of their income and expenditure, which can be a real burden.
For a variety of reasons the OTS suggests either abolishing this relief all together (possibly in return for a higher annual gifts allowance, which would apply to gifts of both capital and income) or limiting the amount of income that can be gifted in this way, perhaps in conjunction with removing the 'regular' requirement. A complete abolishment could materially affect high-earners and directors with large annual bonus payments/dividends and it is difficult to see how a combined income and capital allowance would equate to anywhere near the amount of surplus income that such individuals may be in the habit of gifting. Removing the 'regular' requirement would make the relief easier for individuals to understand (and for executors to claim on their death), but again this would only be welcomed if any annual income gift limit was substantial enough to still make the relief worthwhile to such high earners.
Business Property Relief (BPR) and AIM Investments
Certain business interests and assets used in a business can be gifted (in lifetime or on death) completely free of IHT if the conditions for BPR are satisfied. But for many people, including the elderly, direct investment in a business isn't practical. Currently investors can take advantage of this valuable relief by buying shares that are traded on the Alternative Investment Market (AIM), making investing in trading businesses an option for all. The OTS queries whether this was within the policy intent of the relief but notes the Government's previous commitment to supporting growth in such markets. The OTS suggests that the scope of BPR should be scrutinised and potentially restricted.
Capital gains tax (CGT)
When an individual dies, any historic gains attaching to the assets in their estate are 'washed out' and the beneficiaries of the estate take the assets at their probate value, the intention being to avoid the same assets being subject to both IHT and CGT.
The report recommends removing this CGT uplift on death in cases where an IHT relief or exemption already applies. This would be, arguably, one of the most drastic changes and would result in children inheriting a family business free of IHT, but being hit with a much larger CGT bill on selling the business in the years following their parent's death (because they are treated as acquiring the shares at their parent's original acquisition cost and not at the value at the date of their parent's death). Moreover, many people fail to keep records of their acquisitions, which could make the calculations very difficult in the years following the death.
Leading the path to reform?
We think the report is a mixed bag; we welcome some of the recommendations and others not. We are particularly disappointed that the report fails to deal with various issues which were widely commented on during the consultation process, including the treatment of trusts and the residence nil rate band (RNRB), despite the latter receiving much criticism since its introduction in April 2017. The OTS comments that 'The residence nil rate band is one of the most complex areas of Inheritance Tax and generated a large proportion of the correspondence received by the OTS'. But the OTS appears to have bottled out of dealing with it, concluding that because the RNRB 'is still relatively new, more time is needed to evaluate its effectiveness before recommendations can be made on how best to simplify it'.
So what, if anything, will happen next?
The OTS is an independent advisor to the Government and primarily offers recommendations through reports which are either commissioned by the Chancellor of the Exchequer (as with the IHT report) or initiated by the OTS itself. A report in March 2015 provided a detailed review of the extent to which the OTS's recommendations had been implemented. That review found that out of 60 'big picture' recommendations made, only 16 were accepted by the government, with only 9 fully implemented and 7 partly implemented. So an implementation rate of about 25%. As for other formal OTS recommendations, 174 of the 342 made were accepted or partly accepted with 109 fully implemented. A further review carried out in 2017 records that out of the 79 recommendations made by the OTS between 2015-2017, a total of 27 were implemented.
History therefore suggests that, generally speaking, OTS recommendations are more likely than not to be ignored by the Government and never make the statute books. With the Chancellor who commissioned the report, Philip Hammond, having been replaced by Sajid Javid, Brexit dominating much of the government agenda for the foreseeable future, and an early general election seeming ever more likely, it is possible that this will be the end of the line for these recommendations.
In a reminder of the status of OTS recommendations, the Chancellor's initial letter in reply said: 'the Government will consider the recommendations made in the report and respond in due course. Any changes to inheritance tax and the wider tax system are the prerogative of the Government and Parliament.'
Whatever the eventual outcome, the report serves as a useful reminder for individuals to regularly review their tax planning affairs and to take proper advice.
Here at Womble Bond Dickinson we have experts who can assist you with navigating the various complexities of the current IHT regime, thereby avoiding any unintended consequences and ensuring that reliefs are utilised in full.