Since coming on for Gordon Brown just over a year ago, he has radically simplified capital gains tax, cut the knots enmeshing the taxation of UK-resident non-domiciles and assuaged concerns over the increasing burden of inheritance tax by introducing a transferable inheritance tax nil-rate band.
The transferable nil-rate band was introduced to address a widely held concern – everyone has a nil-rate band for inheritance tax purposes but not everyone can effectively use it.
Where most or all of an estate passed to a surviving spouse or civil partner, the value transferred was (and still is) gener- ally exempt from IHT. However, this meant that the nil-rate band available on the first death was not used or not fully used.
The reforms mean that the unused nil-rate band can be transferred to the survivor of the marriage or civil partnership to proportionately increase the value of the nil-rate band avail- able on the survivor’s death.
Inheritance tax impacts on expats because it is domicile-based rather than residence-based. Unlike income tax, leaving the UK does not necessarily reduce exposure to inheritance tax.
The territorial scope of IHT can be simply expressed:
l Individuals domiciled in the UK are liable to IHT on the value of their worldwide assets.
l Individuals not domiciled in the UK are liable to IHT on the value of assets situated in the UK.
Additionally, for IHT purposes only, individuals who are not domiciled in the UK are treated as being UK-domiciled in two situations:
l An individual is deemed to remain UK-domiciled for three years following the acquisition of a non-UK domicile of choice;
l An individual is deemed to acquire a UK domicile if he/she is tax-resident in the UK for at least 17 out of the last 20 tax years.
Every individual, whether UK-domiciled or not, is entitled to a full inheritance tax nil-rate band but the availability of spouse/civil partner exemption is restricted to £55,000 where the recipient spouse is not UK-domiciled. The Government believes this restriction is necessary to prevent avoidance of tax by simply passing assets to those outside the inheritance tax net.
The availability of a transferable nil-rate band on the estate of the first to die of a non-domiciled spouse or civil partner is calculated only by reference to property that is potentially subject to an UK charge, that is, UK assets. Assets held outside the UK, by a person not domiciled, or not deemed domiciled in the UK, are not taken into account when calculating the available unused nil-rate band.
Where the survivor dies in the UK and the spouse or civil partner, who held no UK assets, died abroad leaving all overseas assets to their children, none of the nil-rate band will have been used on the first death and thus 100 per cent is transferable to the survivorRenate, who was German-domiciled, died in June 2008. Her husband John, who was UK-domiciled, died in February 2003 with assets of £450,000, all of which passed to Renate. The nil-rate band in February 2003 was £250,000.
The IHT position on John’s death was: assets £450,000, spouse exemption (£55,000), chargeable amount for IHT £395,000
As the amount chargeable exceeded the nil-rate band, there is no “unused” nil-rate band to transfer.
This transferable nil-rate band will only be of benefit:
a: If the survivor remained domiciled outside the UK but had UK assets in excess of the nil-rate band, orb: If the survivor became domiciled or deemed domiciled in the UK.
Ghislaine, who was France-domiciled, died in July 2008. Her only UK asset was a flat in London valued at £900,000. Her husband James, who was UK domiciled, died in March 2003 with assets of £200,000, all of which passed to Ghislaine. The nil-rate band in March 2003 was £250,000.
The IHT position on John’s death was: assets £200,000, spouse exemption (£55,000), chargeable amount for IHT £145,000
There was “unused” nil-rate band of £105,000 (£250,000 – £145,000). The unused proportion was 42 per cent (105,000/250,000 x 100) On Ghislaine’s death, the nil-rate band available will be uplifted by 42 per cent to £443,040.
Where a marriage ceremony has been conducted abroad, it must meet the requirements of the law in the country in which the marriage was celebrated if the parties to the marriage are to be regarded as “spouses” for the purposes of this legislation.
Although the transferable nil-rate band is of use to tax planners, its importance should not be overestimated and it should not be regarded as a substitute for a comprehensive planning strategy.Since the Budget this year, there has been a lot of discussion about the merits of different types of investments, in partic- ular, investment bonds and collective investment schemes. This has mainly focused on the tax comparisons but tax should never be the sole driver behind choosing a particular investment.
Going back to basics can be the simplest way to add value. We will consider one of the flexibilities offered by an investment bond over a collective – deficiency relief. This was introduced in the Income and Corporation Taxes Act 1988 as a method of ensuring only the true profit on an investment bond (onshore or offshore) is taxed.
Consider, for example, Peter who invests £200,000 in an offshore bond. In year four of the policy, Peter takes a part surrender of £100,000, which incurs a large chargeable-event gain (£100,000 minus (4x 5 per cent allowance of £200,000) = £60,000 x 40 per cent). In year six, Peter fully surrenders the policy, now worth £120,000. Using the calculation below, the figures are: £120,000 + £100,000 less £200,000 + £60,000 = £40,000 loss.
As Peter’s adviser, you might consider the deficiency relief provisions. A deficiency occurs where (i) the proceeds from start to finish are less than (ii) the premium paid plus any previous gains. The deficiency is defined as the difference between (i) and (ii).
Deficiency relief provisions can only be used on a final-event calculation. For example, when a policy is fully surrendered or reaches maturity and a loss has occurred. To identify whether such a loss has occurred we need to do a final-event calculation which is as follows:
Proceeds from bond + previous part surrenders & previous part assignments for consideration
Premiums paid + previous excess gains = chargeable-event gain/loss
It is possible to use the £40,000 loss to offset against any of Peter’s income which falls within the higher-rate tax bracket for that tax year. For earned income and savings income, this would be income charged at 40 per cent and for dividend income this would be income charged at 32.5 per cent. Where only earned and savings income apply for the tax year, the deficiency may be applied by extending the basic-rate tax band by the amount of the deficiency.
Deficiency relief is available to reduce the higher-rate tax liability in the following order, (1) earned income, (2) savings income and (3) dividend.
If we assume that Peter’s earned income has pushed him into the higher-rate tax bracket by £20,000 and he has savings income in the form of interest on bank accounts to the value of £5,000 and a further £3,000 in UK dividend income.
The deficiency of £40,000 reduces Peter’s income tax liability as follows:
For earned income, the marginal rate is reduced from 40 per cent to 20 per cent on the £20,000 (a saving of £4,000 in tax).
For savings income, the marginal rate is reduced from 40 per cent to 20 per cent on the £5,000 bank interest, which has had tax deducted at source, so no further tax is payable.
For dividend income, the liability to pay income tax at 32.5 per cent on the £3,000 UK dividend income is removed but the tax credit of 10 per cent cannot be reclaimed, giving an effective rate of tax of 20 per cent.
The remaining £12,000 of the deficiency relief cannot be used in another tax year or carried back to a previous tax year and will therefore be lost.
There are a number of restrictions which are placed on the use of deficiency relief, the first being that this planning opportunity is only available to individuals. The amount of deficiency relief which can be used by an individual is limited to their higher-rate income tax liability, regardless of whether the investment bond is onshore or offshore.
The relief is also limited to the amount of any of the previous excess gains on the same bond. For example, Jane has two bonds both which have excess gains of £30,000 for the first bond and £10,000 for the second bond. If Jane decides to surrender bond 1, she creates a loss of £40,000. Only £30,000 deficiency relief is available – as that is the excess gain created by that bond – so Jane would not be able to claim the full amount of her loss.
However, tax has to be paid on the excess gain, so if the client has been non-UK-tax-resident at the time the tax liability was due on the large part surrender, he would still be able to utilise the deficiency provisions without suffering the big tax bill on the large part surrender.