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Inheritance tax: All change?

There is a feeling amongst many practitioners and taxpayers that IHT is too complicated to properly understand and administer.

In November 2018, the Office of Tax Simplification (OTS) published its first IHT review, covering the administration of IHT.

Subsequently, on 5 July 2019, the OTS published its second IHT report ‘Simplifying the design of Inheritance Tax’ (tinyurl.com/OTS-IHT-Review2). It is a comprehensive (103 pages) and well-written report, which covers a complex regime in a relatively straightforward and easy to understand manner.

Key areas and recommendations

The second OTS report on IHT comprises 12 chapters, which are divided into three areas:

1. Lifetime gifts;

2. Interaction with CGT; and

3. Businesses and farms

The OTS makes a total of 11 recommendations for change in the above areas. These are reproduced in the Table below.

Table: Summary of OTS recommendations

‘Key area 1: Lifetime gifts

Gift exemptions package
1 The government should, as a package:
• replace the annual gift exemption and the exemption for gifts in consideration of marriage or civil partnership with an overall personal gifts allowance
• consider the level of this allowance and reconsider the level of the small gifts exemption
• reform the exemption for normal expenditure out of income or replace it with a higher personal gift allowance

Gifting period and taper package
2 The government should, as a package:
• reduce the 7 year period to 5 years, so that gifts to individuals made more than 5 years before death are exempt from Inheritance Tax, and
• abolish taper relief

3 The government should remove the need to take account of gifts made outside of the 7 year period when calculating the Inheritance Tax due (under what is known as the ’14 year rule’).

Liability for payment and the nil rate band
4 The government should explore options for simplifying and clarifying the rules on liability for the payment of tax on lifetime gifts to individuals and the allocation of the nil rate band.

Key area 2: Interactions with Capital Gains Tax
5 Where a relief or exemption from Inheritance Tax applies, the government should consider removing the capital gains uplift and instead provide that the recipient is treated as acquiring the assets at the historic base cost of the person who has died.

Key area 3: Businesses and Farms APR/BPR
6 The government should, as a package:
• consider whether it continues to be appropriate for the level of trading activity for BPR to be set at a lower level than that for gift holdover relief or entrepreneurs’ relief
• review the treatment of indirect non-controlling holdings in trading companies, and
• consider whether to align the Inheritance Tax treatment of furnished holiday lets with that of Income Tax and Capital Gains Tax, where they are treated as trading providing that certain conditions are met

7 The government should review the treatment of limited liability partnerships to ensure that they are treated appropriately for the purposes of the BPR trading requirement.

8 HMRC should review their current approach around the eligibility of farmhouses for APR in sensitive cases, such as where a famer needs to leave the farmhouse for medical treatment or go into care.

9 HMRC should be clearer in their guidance as to when a valuation of a business or farm is required and, if it is required, whether this needs to be a formal valuation or an estimate.

Other areas of Inheritance Tax
10 The government should consider ensuring that death benefit payments from term life insurance are Inheritance Tax free on the death of the life assured without the need for them to be written in trust.

11 The government should review the POAT rules and their interaction with other Inheritance Tax anti-avoidance legislation to consider whether they function as intended and whether they are still necessary.’

Headline grabbers

The government is under no obligation to implement any of the OTS recommendations. However, some of the recommendations, if they were implemented, would surely grab the headlines. The main ones would appear to be:

(a) Annual gift allowance

The OTS proposes an annual gift allowance of £25,000, to replace certain gift exemptions (see Recommendation 1).

The OTS report points out that the IHT annual exemption of £3,000, if increased to reflect inflation, would amount to £11,900 (for 2019/20). Similarly, the small gifts exemption of £250 would increase to £1,010.

However, there is no upper limit to the normal expenditure out of income exemption; it is only limited to the extent of gifts out of the donor’s surplus income that satisfies the exemption conditions. The OTS points out that a personal gift allowance of £25,000 would cover the value of 55% of all normal expenditure out of income claims.

However, it must be remembered that the normal expenditure out of income exemption relates to gifts of income, not capital. The introduction of an annual gift allowance would therefore be somewhat controversial.

(b) Potentially exempt transfers

Reducing the period after which potentially exempt transfers (PETs) become exempt (ie from seven years to five years) is obviously good news for those wishing to make lifetime gifts which are not immediately chargeable (e.g. a gift from one individual to another). The removal of the 14 year ‘backward shadow’ (ie broadly where an immediately chargeable lifetime transfer made within seven years of a PET is taken into account in the IHT calculation of a PET which becomes chargeable as a result of the donor’s death within seven years of making it) would also be a welcome simplification measure.

However, the abolition of taper relief, whilst also a simplification measure, would be rather less welcome for some donors.

(c) Removal of the CGT uplift on death

It seems rather odd that a report on IHT simplification should include a recommendation that the CGT-free uplift on death (TCGA 1992, s 62) be removed in some cases. However, as the OTS report points out, there is a high degree of overlap between CGT and IHT. For example, without the CGT-free uplift, many assets on which CGT is chargeable would also attract IHT on death.

The OTS concludes that the CGT-free uplift on death is an ‘imperfect’ way of eliminating double taxation, and can lead to zero taxation: ‘The key times where zero taxation occurs are where a relief or exemption from Inheritance Tax, such as the spouse exemption, [business property relief] or [agricultural property relief], applies. In these cases, neither Capital Gains Tax nor Inheritance Tax is payable on death. The policy rationale for this is not clear.’

The scope of the OTS review on IHT simplification is to ‘…consider how key aspects of the current IHT system work and whether and how they might be simplified.’ However, OTS Recommendation 5 is outside the scope of the review.

Missed opportunities?

It will come as a disappointment to some practitioners that the OTS has not recommended any simplification measures in certain areas of IHT, most notably in respect of trusts, and additionally the residence nil rate band (RNRB).

It had been hoped by some commentators that the OTS would propose the abolition of the RNRB and replace it with a corresponding increase in the nil rate band. However, the OTS states that scrapping the RNRB and using the cost savings to increase the nil rate band for all estates would only increase the nil rate band by around £51,000 to £376,000. Alternatively, if the RNRB was abolished and the nil rate band increased to £500,000, by 2023-24 an estimated 34,400 fewer estates would have paid IHT than would otherwise be the case. However, this would cost the Exchequer around £7.5 billion during the same period. The latter course of action is therefore extremely unlikely to happen.

In any event, the OTS concluded that the RNRB is still ‘very new’, and that more time was needed to evaluate its effectiveness before recommendations could be made on how to simplify it.

The OTS reached a similar conclusion in respect of the reduced IHT rate of 36% where 10% or more of a person’s net estate is given to a charity (or to a community amateur sports club): ‘The OTS…considers that it is still very early days for the reduced rate. More time is needed before it will be possible to evaluate its effectiveness and therefore no recommendations on it are made in this report.’

Simplification or policy change?

The OTS review is to be commended in terms of recommending various potential IHT simplification measures. However, some parts of the report arguably stray outside its remit.

For example, as indicated above Recommendation 5 is not an IHT simplification measure as such but deals with a perceived issue in respect of the interaction between CGT and IHT.

In addition, the report points out that business property relief (BPR) can be claimed on some shares traded on the alternative investment market (AIM). It questions whether the policy intent of BPR was to extend the relief to AIM traded shares in the hands of third-party investors. Once again, this is not a simplification issue as such.

Nevertheless, in my view the OTS report is very well thought out and helpfully constructed.

Forthcoming attractions?

In general, taxes are something of a political football. It therefore remains to be seen which, if any, of the OTS recommendations the government will implement.

Given that the Chancellor of the Exchequer originally commissioned the OTS review of the IHT regime, it seems likely (barring a general election) that the OTS recommendations will be seriously considered, and that at least some of them will be implemented.

Practitioners who advise clients on IHT matters may therefore wish to consider whether to suggest any IHT planning to their clients, in anticipation of future changes.

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