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8 minute read
As the law stands at present, most gifts made during a person’s lifetime are potentially chargeable to Inheritance Tax, but no charge arises unless the person making the gift dies within seven years. Such gifts are therefore known as ‘Potentially Exempt Transfers’ (PETs). This is why Inheritance Tax planning generally involves giving assets away at an age when you will live for at least seven years. By doing so, no Inheritance Tax is then payable on the value of the gift.
In the current 2020-21 tax year each individual has a tax-free Inheritance Tax allowance of £325,000 known as the Nil Rate band.
Inheritance Tax is charged at a rate of 40% on the value of an individual’s estate above the available Nil Rate band on death. Other reliefs may also be available, such as, the Residence Nil Rate Band which is discussed further below.
A lifetime gift into a relevant property trust is referred to as a Chargeable Lifetime Transfer (“CLT”). Inheritance Tax is payable on CLTs at a rate of 20%. The 20% rate applies to transfers of value in excess of the available Nil Rate Band.
One concept that is very important when considering Inheritance Tax planning is the value of any gifts being made. Inheritance Tax is charged on the loss in value to the person making the gift. This may be different from the value of the asset actually given away. This is known as the ‘diminution in estate’ principle.
Example:
“Mr A owns two vases which together have a value of £1,000. One vase alone is only worth £300. If he gives one vase away, the loss in value to him is £700, and not £300. In this case, the value of the gift for Inheritance Tax purposes would be £700.”
Historically, the most tax efficient will planning strategy would have been to create a nil rate band trust. This was because if you simply left all your assets to your spouse, then you would lose the benefit of the tax-free band for Inheritance Tax purposes.
Legislation was introduced in 2007 so that if the surviving spouse dies on or after 9 October 2007 it is possible to transfer any unused Nil Rate band from the first spouses’ death across in calculating any Inheritance Tax due on the estate of the second.
The amount of unused Nil Rate band transferred is calculated by looking at the value of unused nil rate value at the time of the first spouse’s death in percentage terms.
For example, if [first spouse] died in October 2002, when the Nil rate band was £250,000 and left chargeable legacies of £100,000, there would have been an unused amount of £150,000 at their death. The percentage of this unused value is 60% (£150,000/ £250,000 x 100).
Where in the past this amount would have been lost, we are now able to aggregate the remaining unused band from the first spouse, to the second. This means that if [second spouse] were to die in 2020/2021 when the nil rate band is £325,000, the total aggregated nil rate band that could be
used is £520,000 being [second spouse] band of £325,000 and an additional 60% of £325,000 which has been transferred over.
An additional Nil Rate Band was introduced from 6 April 2017 where a property that has been a person’s residence is passed on to direct descendants (children, grandchildren etc.) on death.
This Residential Nil Rate Band (RNRB) was worth £100,000 in 2017/18 increasing by £25,000 per year to £175,000 in 2020/21. The RNRB is available in full if your Estate is worth less than £2 million but is reduced by £1 for every £2 over £2 million.
The RNRB may also be available if you downsize or sell a residence and leave assets of an equivalent value to direct descendants on death.
Unlike the Nil Rate Band, the RNRB is not affected by gifts made by an individual in the 7 years prior to their death.
Like the Nil Rate Band, the percentage of the unused RNRB on the death of the first spouse can be transferred to the surviving spouse.
This means that a married couple may be entitled to a total Inheritance Tax exemption of £1million based on current rules (being 2 x Nil Rate Band and 2 x RNRB).
The value on which Inheritance Tax is payable on death can be broken down into three categories:
(i) The value of any lifetime gifts made during the seven years prior to death,
(ii) The value of your estate on death and,
(iii) The value of any assets held in a trust which was created before 22 March 2006 from which you were absolutely entitled to receive the income.
Any tax payable under (i) is reduced by a percentage if the gift occurred more than 3 years before death. This is known as ‘taper relief’. The longer a person survives after making the gift, the greater the amount of relief. The reduction and effective rates of tax are as follows:
It is worth noting that taper relief only applies if there is a tax charge resulting from the gift. It does not have the effect of reducing the value of the gift when determining the nil rate band which is available on death. Instead it reduces the tax which would otherwise be payable on a gift
coming into charge as a result of death.
There are other reliefs such as the Agricultural Property Relief and Business Property Relief.
Gifts out of income
Gifts which meet the qualifying conditions will be exempt from Inheritance Tax and will not affect the aggregate level of gifts when determining the available nil rate band. Since income normally takes the form of cash, cash gifts are the most obvious format for these exempt gifts to take. The
main conditions include:
• Gift must be made from surplus income;
• Gift must form part of normal expenditure of the donor; and
• Must not affect your normal standard of living.
A regular pattern of gifts is required, with your intentions being initially important. It will be necessary to be able to show that the exemption conditions have been met so it will be important to document and retain information which demonstrates the level of surplus income, the regular gift pattern in operation and your intentions when the gifts were made. If the exemption is claimed on death the executors will need a significant amount of information, showing all sources of income, all items of expenditure, the surplus net income remaining and gifts made out of that surplus, for the seven preceding years. We would recommend that you seek professional advice if planning to use this exemption to ensure that this is correctly documented and effective.
After you have started to make regular gifts, you can stop them if your circumstances change, or vary the amounts you are giving away, either up or down. In addition, you could review the position each year and make a catch-up payment if you find that you still have surplus income after the regular monthly gifts. If you do follow this route, we would recommend further documentary evidence to defend any argument from HMRC.
Annual exemption
You can give away gifts’ worth up to a total of £3,000 in each tax year and these gifts will be exempt from Inheritance Tax. Any unused part of the £3,000 exemption can be carried forward for one year only and used to relieve against gifts in the subsequent year. The order that the annual exemption is set against the gifts made in a tax year is earliest first. You cannot choose which gifts have the benefit of the annual exemption.
The Small Gifts Exemption
You can give away up to £250 per Tax Year to any person completely free of Inheritance Tax and to as many different people as you wish. This is in addition to the Annual Exemption above.
Gifts in Consideration of Marriage
A parent can give up to £5,000 to their child and a grandparent can give up to £2,500 as a marriage gift. A gift to anyone else on their marriage of up to £1,000 can also be given without suffering any Inheritance Tax.
Other Exempt Gifts
There are several bodies to whom gifts can be made and which are completely exempt from Inheritance Tax. These include:
• Gifts to Charities
• Gifts for National Purposes, e.g. National Heritage.
• Gifts to Housing Associations
• Gifts to Political Parties
A further relief is available where you gift more than 10% of your net estate to charity on your death. In this situation, as well as the amounts left to charity being exempt from Inheritance Tax, the rate of Inheritance Tax payable on the remainder of your estate reduces from 40% to 36%.
