Inheritance tax: what does the future hold?
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Often described as Britain’s “most hated tax”, inheritance tax seems uniquely able to enrage all sorts of people. Theoretically charged at 40 per cent on the value of an individual’s estate above £325,000, it is perceived as unfair for many different reasons.
“Inheritance tax is a wholly voluntary tax,” reads the most recommended comment underneath last week’s FT article on proposed IHT reforms. “Ask any specialist tax lawyer or accountant. The UK’s annual £5bn IHT bill is only paid by the wealthier middle classes, who have less ability to avoid it through planning. Virtually none is paid by the very wealthy in the UK.”
Tax laws surrounding inheritance are also extremely complicated, baffling families and executors at a time when they may be struggling with a bereavement.
Meanwhile, rising property prices in many parts of the country, coupled with an IHT threshold that has been frozen for a decade, mean more people are being caught by the tax. Government receipts for 2018-19 were the highest on record.
And although only 5 per cent of estates have duties to pay, 10 times as many have to complete and submit lengthy tax forms.
Against this restive background, the chancellor asked the Office of Tax Simplification (OTS), an independent statutory body, to review the tax 18 months ago.
Its strict remit meant it could only focus on how to simplify IHT from a “technical and administrative” perspective. It therefore did not consider policy questions, such as whether the tax should be abolished. Nevertheless, if enacted, recommendations made last week would represent a major shake-up of the way assets are passed on in the UK — rewriting rules which have not changed for at least four decades.
FT Money looks at the main proposals, their implications — and what chance they have of becoming reality.
‘Seven-year rule’ to be shortened
Any wealth manager will tell you that the best way of reducing IHT bills is giving money away while you are still alive. In tax-speak, such generosity is called a “potentially exempt transfer” or PET. Regardless of the size of your gift, there will be no IHT to pay if it is made seven years before your death.
Gifts are only “potentially” exempt, as if the giver dies before the seven years is up, IHT could be charged — although in some cases the amount can be tapered down after three years.
The most striking simplification recommended by the OTS is reducing the seven years to five. It also suggested scrapping the taper allowance, which it found was widely misunderstood. In practice, the taper is rarely used, as it is applies only to people who make very large lifetime gifts totalling more than the £325,000 IHT threshold. The OTS also advocates scrapping a quirk known as the “14-year rule” that affects those who have used trusts.
It found that executors struggled to prove if gifts were exempt, noting that bank statements are often only available for the past six years.
However, the proposal is controversial because it benefits people who can afford to give away large chunks of their assets to reduce IHT bills. Three years ago, the then prime minister David Cameron came under fire after it emerged he had received a £200,000 PET from his mother.
Bill Dodwell, OTS tax director, acknowledges that the move will be a “giveaway” for some. However, data from HM Revenue & Customs show that only £7m of IHT paid in 2015-16 came from gifts made two years before the clock stopped.
“In the context of a tax that raised £5bn last year, we concluded it wouldn’t move the dial very far and it would help a lot of executors, as well as HMRC [with administration],” he says.
Michael Martin, private client manager at Seven Investment Management, says the reduction would be a “good news story for middle England”.
“I can’t see why a [Conservative] government wouldn’t adopt this change, especially as doing so wouldn’t cost them very much money,” he adds.
Yet other advisers fear that scrapping the taper allowance could create an unfair IHT tax cliff edge.
“Those passing away after four years and 364 days that could be hit with the full 40 per cent tax on that gift, whereas those living one day longer pay nothing,” says Jo Douglas, financial planner at Brewin Dolphin.
Experts say this “all or nothing” outcome might lead more people to take out insurance to protect against the possibility they do not live past five years. Meanwhile, individuals who have insurance policies that move in line with the current tapering rules, called “Gift Inter Vivos” policies, would need to review these if the rules changed.
Single gift allowance
The OTS has also proposed big changes to the rules surrounding lifetime gifts. It suggests simplifying the myriad IHT-free gift allowances by replacing them with just one allowance per person.
The OTS found gifting allowances — including a £5,000 tax free sum that a parent can bestow on a child who is getting married — were confusing and poorly understood, especially as the limits are calculated in different ways and cannot be combined. For instance, the £3,000 annual gift exemption is a cumulative total, whereas the £250 small gifts exemption is per person.
While the OTS did not suggest a level, most gifting allowances have been frozen since the 1980s. It pointed out the £3,000 annual limit would now be £11,900 had it risen in line with inflation.
“[These] gifting proposals are very welcome and long overdue,” says Sarah Coles, personal finance analyst at Hargreaves Lansdown. “An overall personal gifts allowance is a great idea.”
But for wealthy families, a fixed gifts allowance — even if it was significantly higher than £11,900 — could mean paying more IHT, says Lynne Rowland, tax partner at accountancy firm Kingston Smith.
“It’s quite tough to get on to the housing ladder these days and often the only way families have to accelerate that [for younger generations] is to give them lifetime gifts. If there’s an absolute limit on how much they can give, I suspect they will limit their support as they will be hit with more tax.”
Gifts out of existing income
Wealthy families would also be hit by a separate proposal to simplify gifting under the proposals.
Currently, individuals can give away unlimited amounts of money from their income IHT-free if the gift is made on a “regular” basis and does not affect the giver’s standard of living. This is called the normal expenditure out of income exemption, and the seven-year rule does not apply.
It has allowed cash-rich individuals, such as very high earners or pensioners with generous final salary schemes and low living costs, to pass down wealth to loved ones during their lifetime, reducing their estate’s IHT liability at the same time.
The OTS found this exemption was hard to claim because it requires extensive record-keeping. There is no statutory definition of what constitutes “normal expenditure” or “expenditure out of income”. The OTS said it had heard of examples where the rule had been used to exempt gifts of more than £1m per year.
Figures provided by HMRC for the 2015-16 tax year found that 579 estates claimed the exemption that year, and that 14 per cent of claims were for £100,000 or more.
It has proposed two solutions — either introduce a fixed percentage of income that people are allowed to gift and remove the need for this to be regular, or scrap the exemption rule altogether and replace it with a higher annual personal gift allowance. This allowance could in turn be used to make gifts either from capital or income.
However, both proposals drew criticisms from experts. Laura Suter, personal finance analyst at AJ Bell, says: “There have never been clear guidelines on exactly how much you can gift under this rule [but] removing it entirely would take away a very lucrative tax break.”
Rupert Wilkinson, partner at Wilsons, a law firm, says: “The proposal to reform or scrap gifts out of income could allow HMRC to tax the same earnings twice. The idea that a gift out of income is ‘tax free’ is wrong. In the case of a high earner, much of that money may already have been subject to 45 per cent income tax in the same tax year.”
However, Mr Martin anticipates that some change to the rule is likely as it “has always seemed a little bit too good to be true”. Meanwhile, Sue Moore, technical manager at the Institute of Chartered Accountants in England and Wales, thinks wealthy families will benefit from the increased certainty the proposals would create as the rule is currently so difficult to claim for.
“There would clearly be winners and losers from such a change,” the OTS report acknowledges. “The very small number of people currently using the exemption in relation to large gifts could pay more inheritance tax.”
Remove the capital gains uplift
Another important change the OTS has suggested is removing the capital gains uplift that currently applies when someone inherits assets. The measure, which has been a part of the UK tax system since the 1970s, allows the person inheriting an asset to acquire it at the market value on the date of death, rather than the amount originally paid for it.
The rule exists because capital gains tax (CGT) is not charged on death; the thinking being that inheritance tax will apply instead on the portion of estates above the £325,000 threshold. However, the OTS report concluded that the system is operating in an “imperfect manner”. It discovered it was possible for some beneficiaries to be hit by both CGT and IHT on the same estate, while others paid neither.
One way a beneficiary could legitimately pay no CGT or IHT on an inherited asset is if the asset has benefited from an inheritance tax relief. For example, the spousal exemption means spouses can pass on assets to each other IHT-free. Meanwhile, farmland and farmhouses attract agricultural property relief (APR) of up to 100 per cent of IHT and businesses and certain Aim shares attract business property relief (BPR), also up to 100 per cent.
A beneficiary who received such an asset may choose to sell it soon after the date of death. “In these cases, neither capital gains tax nor inheritance tax is payable on death,” the OTS report said, adding: “The policy rationale for this is not clear.”
Robert Palmer, director of Tax Justice UK, a campaign group, says: “This is civil service language for ‘Why do we have this? It’s bonkers!’”
He describes the uplift as a “big loophole” which is “hard to justify”.
The OTS also found evidence that the uplift is distorting people’s decision making. Farmers and business owners are incentivised to hold these assets until death due to the tax benefits of doing so, even if they would rather sell during their lifetime.
But experts warn removing the uplift will lead to higher CGT bills and make it harder for individuals to plan for divestment.
“Say a husband were to die and leave a buy-to-let flat to his wife. [Under the current rules] there is no inheritance tax due to the spousal exemption,” says James Ward, head of private client at Kingsley Napley.
The current CGT uplift rules allow the wife to sell the property using the date of death value as the base cost. Under the OTS proposals, there would be a capital gains tax bill based on the husband’s original acquisition costs.
“This takes out a particular strong area of planning and would make it harder for people to sell property without a substantial capital gains tax bill,” he adds.
Ms Rowland says if enacted, the measure would affect a lot of UK businesses — both small and large. “It’s a pretty draconian and significant change,” she says. “I can see the current rules are preventing people from moving assets down the generations during their lifetime but [this proposal] would be a pretty huge change in passing assets on.”
‘Missed opportunities’ for reform
The most hated part of the UK’s most hated tax is the residence nil rate band, which the OTS said attracted by far the most comments in its wider consultation.
Introduced in 2017, the policy aims to allow married couples to pass on a family home worth up to £1m to direct descendants, such as children and grandchildren, completely free of IHT by 2020.
Individuals have a £325,000 IHT-free threshold (known as the nil rate band), the level of which has been frozen since 2009. Couples can pool this allowance and top it up with the new residential nil rate band (RNRB) which will rise to £175,000 per person by 2020. For estates worth more than £2m, the RNRB will be reduced by £1 for every £2 above that amount.
Sean McCann, chartered financial adviser at NFU Mutual, says the current RNRB rules are both “fiendishly complex” and unfair, as those who do not have children do not benefit from an increased allowance.
The OTS acknowledged the topic was very complicated, noting that some solicitors felt unable to advise on the law around it. However, it concluded that as the rules were still relatively new, more time was needed to assess the policy.
This buck passing has angered many experts, who regard it as a missed opportunity for reform.
“It’s disappointing to see the OTS choose to leave the residence nil rate band untouched, as it causes great confusion among people planning their estates,” says Mr Wilkinson. “It would be much simpler to ditch the relief entirely. The government should instead consider raising the IHT threshold from £325,000 — which has not moved in more than a decade — to £475,000 to match the total current nil rate band.”
IHT relief on Aim shares
In a move that will worry some investors, the OTS also questioned how business property relief — designed to ease the IHT burden of passing down family businesses — is routinely being used to avoid IHT on investments in certain Aim-listed companies. These can be passed on tax-free if held for two years or more.
Since the rules changed in 2013, a booming market has sprung up touting the IHT savings available on ready-made Aim Isa portfolios. Some £435m flowed into IHT Isas offered by the 15 main providers in the 2017-18 tax year.
However, the OTS report said the popularity of such funds “raises a question about whether it is within the policy intent of BPR to extend the relief to such shares, in particular where they are no longer held by the family or individuals originally owning the business.”
Although the OTS did not recommend further action, Mr Dodwell adds: “We think Aim is the only market in the world where investors can receive an inheritance tax benefit. Supporting a market in this way is a different policy objective from supporting passing a business down the generations.”
Nevertheless, product providers have been swift to react. “[The government] has been clear on numerous occasions that it still sees BPR as playing an important role in supporting growth investment in Aim,” says Paul Latham, head of tax products at Octopus Investments.
“Since it was established, Aim has provided more than £100bn in growth capital and the government has consistently highlighted its critical importance for UK smaller companies.”
What next for inheritance tax?
The Treasury will respond to the OTS report in due course, but even if the government accepts any of the recommendations, it would take some time for the proposals to be consulted on and become law.
Experts say those who believe the proposed changes could affect them — either positively or negatively — should not take rash action. In any case, the OTS proposals are quite minor compared with what a change of government could bring about.
“If we see a Corbyn-led Labour government, this well-thought-out paper may find itself quickly looking like moving deckchairs around the Titanic,” says Mr Ward.
A recent report commissioned by Labour entitled “Land for the Many” has been giving wealth managers nightmares. It makes a case for abolishing IHT in favour of a new lifetime gift tax levied on the recipients of assets worth over £125,000, claiming this would raise more money, more progressively.
Mr Ward says such a “punitive” charge would “stall intergenerational gifting, which has become so vital for the younger generation.”
The Resolution Foundation, a left-leaning think-tank, has previously estimated that levying income tax on inherited wealth could raise £15bn a year — some £10bn more than the current IHT system.
Others experts favour replacing IHT with charging capital gains tax (CGT) on estates — an option the OTS report raised, although it was beyond the remit of its review.
“Inheritance tax is broken,” concludes Mr Palmer of Tax Justice UK. “The public dislike it, and the very wealthy can get away with not paying it. This review has pointed to a number of features of the tax which are hard to justify. However, we need a more ambitious reform agenda to make inheritance tax work properly.”