By Kim Jarvis
Even though inheritance tax (IHT) is based on a simple concept – whatever you own at the date of your death will potentially be subject to tax – people’s preconception, for very good reasons, is that it is complex.
Take the introduction of the residence nil rate band (RNRB), effective from April 2017, which provides an additional nil rate band, on death, if certain conditions are satisfied. The RNRB is only available if the deceased owned a property, which has been their residence, and that property is passed to direct descendants. In general, the transfer must be outright but transfers into some types of trust, for example a bare trust, are acceptable but this excludes discretionary will trusts.
Even if a deceased is leaving their residence to direct descendants the RNRB may still not be available if the deceased had an estate valued at more than £2 million, as the RNRB is progressively reduced £1 for every £2 that the value of the estate exceeds the threshold.
Whilst the introduction of the RNRB fulfilled the government’s 2007 manifesto to give married couples (or civil partners) a £1 million nil rate band with effect from 2020, it is complex.
Then there is the complexity of how lifetime gifting is taxed on death. A chargeable lifetime transfer (CLT) made within 14 years of death may not itself create an IHT liability on death, nevertheless, it could reduce the nil rate band available to offset against a subsequent potentially exempt transfer(PET) where death occurs within seven years of that PET and 14 years of the initial CLT. Let’s look at an example:
• On 6 January 2013 Alex sets up a discretionary trust, for his grandchildren, with a gift of £200,000
• On 6 January 2018 Alex made an outright gift of £300,000 to his daughter, Kate. As this is a PET no tax is payable when the gift is made
• Alex, sadly, dies on 10 January 2020.
At first glance, you may think that the CLT, having occurred more than seven years before death, can be ignored, and yes, when calculating the tax payable on the estate it can be. But when calculating the tax payable on a failed PET, the legislation states that it is necessary to consider gifts that occurred in the seven years preceding the PET. So, even though the failed PET is under the nil rate band you cannot assume that no tax will arise on the failed PET.
To calculate the nil rate band available to offset against the failed PET, it is necessary to look back seven years from the date of the PET. Even though there is no IHT liability on the CLT (as Alex survived seven years from making the gift), it nevertheless reduces the available nil rate band which can be used against the failed PET.
So, in the above example, when calculating the IHT position of the failed PET, the nil rate band is reduced by the 2013 CLT (£200,000), meaning that there is only £125,000 available of his nil rate band to offset against the failed PET. Giving an IHT liability of £70,000 (40% x (£300,000 – £125,000)). No taper relief is available as Alex died within three years of making the gift. Kate, being the recipient of the gift, would be liable to the IHT.
Most people believe, on death, their estate will simply pass to their surviving spouse. They may be surprised that this is not the case especially where you have children or you are co-habiting. If a person dies without a valid will, it means they have died “intestate.” When this happens, the intestacy laws of the country in which they reside will determine how their property is distributed upon their death.
Let’s look at an example: Victoria and Edward are married with 2 children, aged 5 and 7 and have a combined estate of £2,265,000 which consists of their jointly owned home valued at £500,000. Victoria holds £450,000 cash in her sole name, an own life whole life policy, not in trust, with a death benefit of £540,000 and £180,000 in ISAs. Her total sole estate equals £1,170,000.
On Victoria’s death Edward, as joint owner, automatically inherits the home. However, under the intestacy rules in England and Wales, he is only entitled to the first £250,000 of Victoria’s sole estate plus all the personal effects.
The balance of Victoria’s sole estate (£920,000) would then be divided one half for Edward (£460,000) and one half divided equally between her 2 children. As the children are minors their share of their mother’s estate would be held on statutory trusts until they are 18 years old.
Under current rules, the gifts to Edward will be covered by the spouse exemption, however, of the £460,000, which is being divided between the children, £325,000 (the current nil rate band) is taxed at zero with the remaining balance, £135,000, being taxed at 40%. Meaning that inheritance tax of £54,000 is payable on first death.
By executing wills Victoria and Edward can ensure that their estates are left to their chosen beneficiaries and not in accordance with the intestacy rules.
Now let’s consider the situation where Victoria is UK domiciled but Edward is non-domiciled. Both have executed wills leaving everything to each other and then on second death to the children. On Victoria’s death everything goes to Edward and is covered by the inter-spousal exemption. Unfortunately this is a misconception – as Edward is domiciled outside the UK the inter-spousal exemption is limited to £325,000. So, on Victoria’s death:
• As joint owner Edward automatically inherits Victoria’s £250,000 share of the home, meaning that there is £75,000 inter-spousal exemption available to use against the rest of her estate. £1,170,000- £75,000 =£1,095,000.
• From this figure the £325,000 nil rate band can be deducted giving a taxable estate of £770,000
• IHT liability is £308,000 (£770,000 x 40%).
Edward could elect to be treated as UK domiciled in order to take advantage of the unlimited inter-spousal exemption. But this would mean that all of his worldwide assets would be subject to IHT, so before making this election Edward should seek professional advice.
If you asked the man in the street whether “IHT is only payable by wealthy people” most would probably say yes. However, figures released from the Office of Tax Simplification suggest otherwise. The average effective tax rate on higher value estates is lower than the medium to higher value estates. Estates with a net value below the nil rate band do not pay inheritance tax and therefore have an average effective tax rate of 0%. For estates valued at more than the NRB but below £5million the average effective tax rate increases steadily however, for estates over £5million this tapers out and then starts to reduce for estates over £10million. Why?
Lower value estates mostly consist of cash and residential property which do not commonly attract relief from IHT. Higher value estates have proportionately less cash and residential property but more securities and other assets, which attract relief from inheritance tax. With lower value estates potentially paying a higher effective tax rate, and the nil rate band remaining at £325,000 at least until April 2020, it is essential that professional advice is sought.
While it’s clear that IHT is simple in conception, it’s also clear that the reality is complex. IHT legislation has changed over the years, and will continue to do so. Ultimately, it often requires careful planning with a financial adviser in order to create a comprehensive estate plan.
Find out more about Canada Life’s estate planning solutions.
Kim Jarvis is a Technical Manager at Canada Life. She has worked in the life industry arena for over 20 years, with experience in trusts and their taxation, product development, the impact of new legislation on the industry and delivering training. She is an affiliate of the Society of Trusts and Estate Practitioners and a Chartered Insurer.