The Government will soon consult on the inheritance tax position of a UK-domiciled individual married to a foreign-domiciled spouse.
While it is generally true that foreign domicile is a gateway to IHT savings, this is one situation where it can be a serious drawback. Throughout this piece, the terms “marriage” and “spouse” also refer to civil partnerships, while “UK-domiciled” includes “deemed UK-domiciled”.
Generally, transfers between spouses, made either during life or upon death are exempt from IHT – without monetary limit. This, together with the ability to transfer the nil-rate band of the first to die to the surviving spouse, means that couples can leave everything to each other free of tax and without any other negative implications.
Where a UK-domiciled spouse transfers assets to a non-UK domiciled spouse, however, the inter-spouse exemption is restricted to £55,000. This restriction does not apply the other way round, that is, where the transferor spouse is non-domiciled and the recipient spouse is UK-domiciled or where both are non-UK-domiciled.
This £55,000 exemption is a cumulative limit applying to all transfers made at any time during life and/or on death. If used – or part-used – during life, then there will be none – or only part – available on death. Where a transfer occurs on death, any part of the £55,000 exemption available is deducted, with the remainder subject to IHT after application of the nil-rate band.
A simple example can demonstrate the potential tax implications of marriage to a foreign domiciliary. Assume H has an estate of £650,000 and wishes to leave all to W on death. To keep it simple, let’s assume that W has no assets, the IHT nil-rate band remains frozen and there have been no lifetime gifts.
Where H and W are both UK-domiciled, there will be no tax on first death or on death of the survivor. The £650,000 transfers to W on the death of H under the limitless interspousal exemption. H’s unused nil-rate band of £325,000 is transferred to W. On the subsequent death of W, both nil-rate bands amount to £650,000, so the estate is tax-free.
Now assume H is UK-domiciled and W is not. As £650,000 passes on the death of H, the £55,000 exemption applies. This creates a balance of £595,000 upon which H’s nil-rate band of £325,000 is applied. The taxable estate amounts to £270,000, which, at 40 per cent, creates tax on first death of £108,000. It should be apparent that if the estate is not in liquid assets serious difficulties could arise.
W, who inherited £542,000 net of tax, then dies some time later. H’s nil-rate band was exhausted on his death, so W’s nil-rate band only can apply. Deducting the £325,000 from £542,000 produces a taxable estate of £217,000, which, at 40 per cent, creates further tax on second death of £86,800.
The difference is self-evident. The UK-domiciled couple paid no tax. However, where money moved from the UK domiciliary to the foreign domiciliary the fate of marriage carried a tax burden of £194,800, with over half payable on first death.
In addition to increasing the IHT-exempt amount, the Government also intends to allow individuals not domiciled in the UK and who have a UK-domiciled spouse to elect to be treated as UK-domiciled for IHT. In effect, allowing them to elect to be treated the same as a UK couple.
Paul Kennedy is head of FundsNetwork Tax Planning