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Case Study: Calculating IHT on failed PETs

Potentially exempt transfers are IHT-free only if death occurs after seven years.

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The problem: My dad has just died, leaving his estate of £325,000 to me. He was divorced, so only had one nil-rate band available. I thought that there would be no inheritance tax payable but the executors of the estate tell me that not only will there be £80,000 to pay, but also there will be another £6,000 for me to pay in respect of a cash gift of £200,000 that he made to me nearly seven years ago. How is that possible?

The solution: Your dad’s gift of £200,000 was a potentially exempt transfer. The potential for this to be fully exempt would have been realised had he survived for seven years. Unfortunately, as he died within this seven-year period, the potential was not realised and it became a failed PET; in other words, a chargeable transfer. This meant that the nil-rate band available to his estate had to be reduced by £200,000, meaning that £200,000 of the estate was chargeable to IHT at 40 per cent, resulting in a liability of £80,000:

IHT on estate:

Estate:                         £325,000

Nil-rate band:               £325,000

Minus failed PET        (£200,000)

                                   (£125,000)

Taxable @ 40%           £200,000

IHT payable                   £80,000

In addition it seems that your dad created a discretionary trust for his grandchildren nearly seven years before the PET to you. The £200,000 that he paid into the trust would have been a chargeable lifetime transfer but, since it was within the nil-rate band at that time, no IHT was payable.  However, although this was made more than seven years before he died, it still has to be taken into account in calculating the liability on the failed PET, since the CLT was made within seven years of the PET.

IHT on failed PET:

Failed PET                     £200,000

Nil-rate band                  £325,000

Minus CLT                    (£200,000)

                                     (£125,000)

Taxable @ 40%               £75,000

IHT                                   £30,000

Less 80% taper relief      (£24,000)

IHT payable                     £6,000

When calculating the liability on a deceased client’s estate, it is necessary to go back seven years from the date of death in order to take into account any failed PETs or CLTs made within that seven-year period. In addition, however, when calculating the IHT on any failed PETs, it is necessary to go back seven years from the date of the failed PETs, even if that means going back more than seven years from the date of death.

Paul Thompson is tax & estate planning consultant at Canada Life

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