What is Inheritance Tax?
Benjamin Franklin once wrote that there are only two certainties in life namely ‘death and taxes’. It can therefore be agued that all forms of death tax are the fiscal synthesise of these two unavoidable ‘certainties’ that we all face at some point in time.
The first death tax, Legacy Duty, was introduced in 1796 in order to finance the Napoleonic Wars and was initially only levied on personal property over a certain value. In its present form, Inheritance Tax (IHT) was introduced by the Thatcher government in 1986 under the Finance Act of the same year, replacing the old Capital Transfer Tax (CTT) that had been itself introduced by Harold Wilson in 1975 as a replacement of Estate Duty, which had existed since 1894.
When is it applicable?
At present, under s1 Inheritance Tax Act 1984, IHT applies to ‘transfers of value that reduces the value of the testator’s estate’ and is chargeable on the value being transferred. In other words, IHT is payable on the value of a person’s estate they pass on to their named beneficiaries. It is also levied on certain gifts made within the seven years before an individual’s death.
However, the tax, at a single rate of 40%, is only applicable to transfers of wealth on or shortly before death that exceed the current Nil Rate Band (NRB) of £325,000.00 set in 2009. In his Autumn Statement, the Chancellor had announced the current NRB would increase by 1% to £329,000 in 2015 but the Government has since decided that it will now remain frozen at its current level until 2019 to help fund the £1bn shortfall in the cost of reforming social care. If the threshold had increased with RPI, the NRB would be around £358,000 today and an estimated £420,000 in 2019.
The result of this freeze will be that a greater proportion of a person’s estate will be pushed over the 0% threshold. Moreover, as a person’s assets increase in value (such as their home), an ever larger number of estates will be subjected to IHT. It has been estimated that by 2019 an extra 5,000 estates will fall into the IHT bracket.
Unsurprisingly, IHT stirs strong public emotions as it is seen as an unfair tax. Critics argue that most people have already paid Income Tax and possibly Capital Gains Tax on the wealth that they have accumulated over the years and therefore to tax it again upon death before it can be passed on to their family amounts to double taxation.
Limiting your IHT Liability
So what can you do to limit the amount of IHT that may become due? Fortunately, there are some of exemptions that can be applied to a person’s estate.
- Spouse/Civil Partner Exemption – Transfers between married couples and civil partners from 5 December 2005 are generally exempt from IHT whether during lifetime or on death. There has been some pressure recently to extend the spouse exemption more generally to cohabitees and other individuals living together but this has so far been resisted by HMRC.
- Transferable Nil Rate Band – On 9 October 2007 the Government announced the introduction of the transferable NRB between spouses and civil partners. This allows for the transfer of any unused NRB on the death of an individual to be used against the estate of their deceased’s surviving spouse or civil partner. Prior to this, in order to maximise the amount passing free of tax on the death of the first spouse, a married couple would include NRB gifts or a discretionary trust in their Wills. In addition, and more importantly, the value of the NRB being transferred is also uplifted to that prevailing at the time of the death of the surviving spouse. This means that the first £650,000 of a surviving spouse’s estate will pass free of tax provided the first spouse had left their entire estate to them in the first place, and that their claim has been accepted by HM Revenue & Customs.
- 10% Charity Gift – Gifts to charities are already exempt from IHT, but in a recent budget statement the Chancellor announced a new IHT relief for such gifts. Provided at least 10% of a person’s estate which would otherwise be chargeable to IHT (that is, the total estate after the NRB and other exemptions and reliefs) is left to charity the rate of IHT on the remaining chargeable part of the estate is reduced to 36%, rather than 40%.
- Business Property Relief – All unlisted trading companies or trading groups, listed companies where the deceased has control and unincorporated trading businesses receive 100% relief from IHT tax provided the transferor has owned the relevant asset for 2 years prior to the transfer. However, the relief is complex and can depend to a large extent on how businesses are structured.
- Agricultural Property Relief – Farmland qualifies for relief from IHT typically at a rate of either 50% or 100% depending when the land was purchased. The relief is given on the agricultural value of the land and not its market value. Farmhouses can also qualify for relief although recent cases have shown this to be a controversial area and subject to a number of limitations.
- Woodland Relief – The value of the timber (but not the land) is excluded from your estate but if sold IHT is then due. The woodland might also qualify for agricultural relief or business relief if it is part of a working farm or business.
- Heritage Relief – IHT and CGT can be deferred indefinitely on gifts of heritage property provided they are of pre-eminent national, scientific, historic or artistic interest or land is of outstanding or architectural interest. However, again the relief is complex and is depended on the nature of the assets ion question.
In addition, you can also mitigate your potential IHT liability by utilising all or some of the following allowances during your lifetime:
- Gifts to people getting married – Up to £5,000 from each parent of the couple could be made while a payment of £2,500 from each grandparent or more remote relative could also be made to those getting married.
- Any number of gifts up to £250 to each recipient – Small gifts that are meant to cover things such as birthday and Christmas presents.
- Gifts up to £3,000 in total in each tax year – You can gift up to £3,000 free from IHT any in one tax year although this cannot be combined with a further gift of £250 to the same person. If you haven’t used your previous year’s allowance it can be rolled over and utilised in the current year, which means you could make a gift totalling £6,000 free of IHT.
- Gifts made as part of your ‘normal expenditure’ This exemption allows you make regular gifts from surplus income, providing the gift doesn’t reduce your standard of living, is not from capital and forms some pattern of regular spending.
- Potentially Exempt Transfers (PETs) – You can make gifts of any amount but as the names suggests the value of the gift is only potentially exempt from IHT provided you survive for seven years from the date of the gift. If you die within this period the value of the gift will be added back into your estate but taper relief will be applied to the gift dependent on when the gift was made.
(In the case of the last three allowances a testator would be well advised to ensure that they have sufficient funds for their own needs and the needs of their spouse before making such gifts).
Declaring the Value of the Estate
In order to determine whether any IHT is due from a person’s estate, all their assets have to be valued as at their date of death. These valuations are then included in one of two types of tax forms.
If the estate is a non-taxable estate, or where there is no tax liability because of spouse or civil partnership exemption and the estate is less then £1 million, the valuations are included in form IHT205. In the case where the executors are also claiming the transferable NRB on the death of the survivor of a married couple of a civil partnership, and the estate is less then £650K, they will also have to complete form IHT217. Both forms are then submitted to a local probate registry with an application for a Grant of Probate or Letters of Administration.
In the case where IHT is due or where the estate is over £1m but it is still tax exempt because spouse or civil partnership exemption applies, the valuations are included in form IHT400 and it supporting schedules. At present, there are over 20 different supporting schedules to cover the different types of investments that can be held. This is then submitted to the Capital Taxes Office in Nottingham along with payment of the tax due. After an initial inspection of the forms, and subject to any initial investigation, HMRC will then issue form IHT421 which allows you to apply for a Grant of Probate or Letters of Administration while they check the various valuations declared in more detail.
Once the Capital Taxes Office are happy that the value of all the deceased’s assets have been declared correctly, they will then issue a clearance letter but this is only based on the declared assets and if any further assets which had not already been disclosed come to light, they will have to be declared to HMRC on a set of amended accounts and any addition tax may then have to be paid.
Paying the IHT and Penalties
In order to prevent interest being applied to the amount that is due to HMRC the full amount of IHT has to be paid within 6 months from the end of the month in which the person died. Usually this is paid directly from the liquid funds held by the deceased in their bank account by submitting form IHT423 schedule to the relevant bank.
If there are insufficient funds to settle the IHT liability within the six month period, the executor can elect to pay the tax due by installments. However, installment payments can only be made on the tax due on the part of the amount that relates to immovable property, such as a person’s home. The tax due on the remaining assets, such as shares and funds held in a bank account, must be settled in full by the due date. Any outstanding tax liability attracts interest at the current rate of 3%.
Any incorrect/false valuations included in either of the two tax forms whether intentional or not will result in penalties being imposed either on the estate or the individual responsible for the estate, namely the executor depending on the nature of the error. This can also include a criminal investigation in serious cases.
Foreign Assets and Non-Domiciliary Status
IHT charges are based on an individual’s domiciliary status and as you would expect individuals domiciled in the UK are liable to be tax on their worldwide assets. In contrast, individuals whose domicile lies outside the UK are only liable to IHT on their assets held in the UK.
However, whilst gifts between spouses who are both domiciled in the UK are exempt from an IHT liability regardless of the amount being gifted, the allowance is limited to £55,000 in cases where one spouse is not domiciled in the UK. This amount is also a lifetime limit, meaning that once that limited has been reached, all gifts are then taxable in the same way as gifts to any other individual and they are not ‘reset’ every 7 years.
However from April 2013 the allowance will be raised to £325,000 and a Nom-Domiciliary will be able to elect to be considered domiciled here for IHT purposes if they wish. If they do their world wide assets will become liable to IHT on their death just like assets held by a UK domiciled taxpayer. Consequently, they may end up ultimately paying more in tax than they have saved by utilising the increase in the allowance.
As you can see, IHT is a complex and continually evolving issue. It varies over time according to each individual’s estate and cannot be avoided. It is therefore of crucial importance when dealing with a person’s estate that you instruct a firm like Prince Evans Solicitors LLP to ensure that all available allowances and exemptions are used when calculating the amount of IHT due, and guarantee that the correct amount of tax has bee paid.