Personal taxation

In general terms, inheritance tax is a cumulative tax which is charged on transfers of property made during an individual’s lifetime and on the estat...

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...qual to the increase in value to the donees. However, there are situations where this can differ.

You can see an example of this in the workbook.

Individuals who are domiciled in the UK are liable for inheritance tax on all their property, wherever in the world it is situated. Although we will examine the concepts of residence and domicile separately in a later chapter, an individual will be deemed domiciled in the UK if they have been resident in it for at least 15 of the previous 20 years, with residence being established according to the rules for income tax.

An individual can be deemed...

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...taken to be the latest date at which the right could have been exercised.

If an individual attempts to avoid a tax liability by carrying out a transfer as a series of steps rather than one single action, the inheritance rules will attempt to tax this as one transaction, ignoring the additional steps in the process.

 

After what period of residence in the UK will an individual be deemed domiciled?

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Inheritance tax becomes chargeable on transfers of property made by an individual during their lifetime which reduce the value of the transferor’s estate, and also on the portion of their estate after death which exceeds the nil rate band. The ...

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... their nil rate band entitlement can be transferred to their surviving spouse or civil partner. We will examine this in more detail in the transfers on death section.

 

On what is inheritance tax charged?

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In addition to the normal nil rate band, an additional residence nil rate band was introduced on 6 April 2017, with the intention of protecting a family home from IHT. The rate in 2023/24 is £175,000 and can be used against the chargeable estates of those dying after 6 April 2017.

It is only available when a home is being inherited by a direct descendant of the deceased (child, step-child, adopted or foster child)....

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...fy for the relief.  The relief is also not available if a property is left to a discretionary trust, as the trustees take on the immediate legal ownership. In contrast, the relief will be available if firstly, a property passes to a trust with an immediate post-death interest provided that the direct descendants have an interest in possession and secondly, if property passes to a trust for a disabled person or a minor.

The value of property for IHT purposes is normally taken as the price it would be expected to fetch on the open market. Where there are legal costs involved in the transfer, they are ignored in the calculations if they are paid by the donor but reduce the value if they are paid by the donee. Where a transfer of property also results in a capital gains tax liability, if the tax is paid by the donee the value of the transfer is reduced by the amount of tax paid.

Related property

Related property is property which is in the estat...

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...d is allowed as a deduction from the total premiums.

If premiums are payable on a policy for the benefit of someone other than the individual paying them, there is a transfer of value for the amount of the premium, although it may be exempt under the normal expenditure exemption. If the premium is paid net of life assurance premium relief, the value of the transfer is taken as the net amount.

Where a transfer is made of related property, what value is the donor deemed to have transferred?

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All chargeable transfers of property made by an individual over a seven-year period are added together and where the amount exceeds the nil rate band a tax liability arises. Once more than seven years have passed from the date of a transfer, it drops out of the cumulation process.

However, a transfer that has dropped out of the cumulation may st...

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... a liability for inheritance tax is calculated on lifetime transfers which reduce the value of the transferor’s estate and estates on death. However, there are different types of transfers that can be made, which impact on the amount of tax due.

On what is the inheritance tax due on death calculated?

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When an individual makes a transfer of property during their lifetime, it can be one of four types:

Exempt

A potentially exempt transfer (PET)

Chargeable but not taxable

Chargeable and taxable

Any transfer which is not exempt or potentially exempt is chargeable if this takes the seven year cumulation total over the value of the current nil rate band, with the excess  charged at the lifetime rate.

Exempt

An exempt transfer is not counted as a chargeable transfer and is therefore not taxed at the time the transfer is made or included in any future tax liability calculations. A relief reduces the value of the transfer but does not remove it from the tax regime.

Although the exemption categories are listed separately, they can work in conjunction with each other, meaning that some types of transfer may be partly exempt under one category and partly exempt under another and thus still be fully exempt from any liability for tax.

Transfers between spouses and civil partners

Transfers of property between legally married spouses and civil partners, registered under the Civil Partnership Act 2004, are exempt during lifetime and on death, even when they are not living together. This means that when married spouses or civil partners are both domiciled in the UK, the estate of the first to die can pass to the spouse or partner with no liability for IHT, regardless of the value of the estate being transferred. 

The exception to this is where the transferor is domiciled in the UK but the spouse or civil partner is not.  Here, the exemption is limited to a lifetime total value of £325,000.

James, who is UK domiciled, dies in the 2023/24 tax year and leaves his estate of £400,000 to his non-UK domiciled spouse Amanda. £325,000 of the £400,000 is exempt, leaving £75,000. James has the full 20223/24 nil rate band available and so no tax would have had to be paid.

It should, therefore, be noted that a non-domiciled spouse or civil partner who elects to be considered UK domiciled could receive an estate up to £650,000 free of any IHT liability - £325,000 exempt and £325,000 within the nil rate band.

Annual exemption

Each tax year, the annual exemption allows transfers of property...

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...or’s seven-year cumulative total over the nil rate band, tax is charged at the appropriate rate for lifetime transfers at the time. If the donor then survives for a period of 7 years, there will be no further tax to pay. If the donor dies within the following 7 years, tax at the death rates will then apply retrospectively.

The tax is recalculated using the value of the gift and the previous seven-year cumulation at the date of the transfer but using the death rates applicable at the time of death. If tax had been paid at the time of the transfer, because it was in excess of the nil rate band, then it is allowed as a credit against the death tax due. The amount of tax can also be reduced by taper relief, as for PETs, if the donor has died more than 3 years after making the transfer.

You can see an example of this in the workbook.

Where a chargeable lifetime transfer results in the donor paying tax, that is, it exceeds the nil rate band, it has to be grossed up. This is because the loss to the estate is the value of the transfer plus the tax paid on it. Tax is calculated on the value of the gift plus the tax, so the net transfer value must be grossed up. For example, a gift of £12,000 is made, which takes the donor’s cumulative total over the nil rate band, and the tax rate is 20%. The tax is £2,400, so the donee receives £9,600. If the donor wants the donee to receive £12,000, they will have to make a larger gift so that £12,000 is the net amount. It is the grossed up amount that is cumulated for future transfers. If the transferee pays the tax, there is no grossing up as the loss to the donor’s estate is only the amount of the transfer.

If a chargeable lifetime transfer and any previous cumulations are within the nil rate band there will be no tax payable on it at the time it is made. It is also likely that there would be no tax payable on death as it would still be within the available nil rate band. However, this situation can change if PETs are also involved in the calculations.

The next example in the workbook looks at a combination of a PET and a chargeable lifetime transfer.

Explain how taper relief is applied to the calculation of an inheritance tax liability.

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There can be situations where a donor gives away property but still continues to enjoy a benefit from it. This is known as a gift with reservation. Where a benefit is retained, the property is treated as still belonging to the donor for inheritance tax purposes. For example, Beth gifts a painting to her niece but keeps it in her house. In this situation, the painting and its value would still be counted as part of Beth’s estate.

The legislation relating to these gifts was introduced in the Finance Act 1986 and ap...

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...or then it may be regarded as the donor having a reservation of benefit.

An interest-free loan which is repayable on demand or at the lender’s death is not considered to be gift with reservation of benefit. The ability to demand an immediate repayment ensures that the lender’s estate is not reduced by the value of the loan.

If the donor of a gift with reservation subsequently gives up their retained interest, how will they be treated in relation to inheritance tax?

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On an individual's death, a liability for inheritance tax arises as if the deceased had made a transfer of value, equal to the value of their estate, immediately before their death.

An individual’s estate at death includes all the property to which they were beneficially entitled, which includes the proceeds of any life assurance policies. You should also remember that if they are domiciled in the UK this includes property anywhere in the world. A deduction from the total value is permitted to cover funeral expenses.

Excluded property is ignored and incudes; pension funds, property situated outside the UK where the owner is not UK domiciled, reversionary interests in trusts unless acquired for money or money’s worth and holdings in authorised Unit Trusts and shares in OEICs where the beneficial owner is not UK domiciled.

Where this total estate value and anything within the previous seven-years cumulation exceeds the currently applicable nil rate band, tax is charged at the current flat rate. From 6 April 2012, a reduced rate of IH...

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...ount or all of the nil rate band available on the first death has been used up by a transfer to a non-UK domiciled spouse or civil partner, it will not be available to be claimed on the second death. This means that where a transfer on death to a non-UK domiciled spouse or civil partner exceeds £650,000 in 2023/24 (£325,000 exemption and £325,000 nil rate band), there will be no nil rate band available for transfer on the second death.

The residence nil rate band (RNRB) can be transferred on a similar basis.

Claims for a nil rate band increase are normally made by the deceased’s personal representatives. They should be made within two years of the end of the month in which death occurred or within 3 months of beginning to act as a personal representative if that is later.  Where no claim is made by the personal representatives, anyone liable to pay tax as a result of the death can make the claim.

Who is entitled to claim to have any unused portion of a nil rate band transferred to their estate?

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There are 3 reliefs available that reduce the value of a transfer in certain circumstances. These are different from taper relief, which reduces the amount of actual tax paid. Although the reliefs do not actually remove the transfer from the tax calculation process, if the relief is 100% it effectively makes the transfer exempt.

Business relief

Business relief applies to transfers of some types of business property that has been owned for at least 2 years before the transfer. It applies to transfers during lifetime or on death.

Not all business assets qualify for the relief. Businesses that wholly or mainly deal in securities, stocks and shares, land or buildings or making or holding investments do not qualify. The relief is also not available where the business property is subject to a binding contract for s...

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...the donor dies within seven years of an agricultural property transfer that qualifies for the relief, there may be a charge to IHT. This would arise if the donee was not still the owner or the property no longer qualified for the relief.

Woodlands relief

This relief covers the growing of timber in the UK and EEA. It applies only to the timber and not the actual land (though the land may qualify for agricultural relief).

This relief only applies to transfers on death and defers the tax payable until the disposal of the timber. However, the occupation of woodlands for commercial purposes would qualify for business relief, which would give relief at 100% and be more advantageous than simply deferring the tax.

When would business relief and agricultural relief not apply?

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In general terms, a settlement is a trust for persons in succession, or subject to a contingency. Transfers of property into trusts, unless bare or for the benefit of disabled individuals, or fully exempt, are chargeable lifetime transfers.

To understand the inheritance rules for the different types of trusts it is necessary to first understand the term interest in possession. Although the term interest in possession is not defined within the Inheritance Tax Act, it is generally taken to mean a beneficiary under a trust who has a present right to present enjoyment of the trust property or the right to income generated from the trust property as it arises.

Discretionary trusts

A discretionary trust is one where no beneficiary has an interest in possession and it is up to the Trustees to decide which beneficiaries to pay any benefits to and in what amounts.

The taxation of these trusts is highly complex and beyond the scope of this chapter, but in broad terms the following conditions apply: 

Transfers into the trust are chargeable lifetime transfers with tax payable if the transfer takes the settlor’s cumulative total of CLTs in the previous seven years over the nil rate band

There may also be tax to pay if the settlor dies within seven years

If a beneficiary dies there is no transfer of value and therefore no I...

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... are therefore no longer as attractive. It should also be noted that, from 1 December 2003 and the introduction of stamp duty land tax, it became impossible to avoid the tax on the sale of the property to the trust, which also made the arrangement less attractive. Prior to this date stamp duty could be avoided by not completing the sale.

Prior to the 1986 Budget, many regular premium life assurance policies were sold under a form of flexible trust where the donor was a potential beneficiary. The changes in the budget would have meant that the premiums would have become gifts with reservation. An amendment allows the premiums not to be gifts with reservation if the policy was taken out before 18 March 1986 and not varied after that to either increase the benefits or extend the term, or have an index-linked variation made on or before 1 August 1986. Any required increase in cover should now be made through a new policy under a non-reservation trust.

These 1986 budget changes could also have affected the death benefits under pension scheme policies which are under trust, as the pension is reserved for the donor. HMRC has stated that these arrangements are not regarded as gifts with reservation.

How often might a periodic IHT charge be imposed on the trustees of discretionary trusts?

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The Government introduced an income tax charge on certain inheritance tax planning arrangements in the Finance Act 2004. Although it came into effect on 6 April 2005, it can affect arrangements that were put in place any time after 18 March 1986.

Income tax is charged on the benefit people get by having completely free or low-cost enjoyment of certain assets which they previously owned, or provided the funds to purchase. An annual cash value is stated in the rules for the benefit and this is added to their taxable income in the year in which they have the benefit.

The charge applies to all UK residents. Those fully domiciled in the UK will be liable for the tax on all their worldwide property. Those not UK domiciled or deemed domiciled are liable only on property in the UK and for those who have become domiciled or deemed domiciled the charge does not apply to assets they ce...

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...t to POAT, they can avoid the tax by electing for it to be subject to IHT on death, by completing form IHT 500. The normal deadline for making this election is 31 January following the end of the first tax year in which the income tax charge arose. The regulations prevent a double IHT charge when death occurs within seven years of the original gift. Without these special provisions, IHT would have been charged on the PET when it became chargeable and again on death due to the IHT 500 election. Although it may seem beneficial to elect for taxation on death to avoid the annual income tax charges, these annual charges may be significantly less than the IHT liability which would arise on death. Calculations need to be made carefully to ensure the most tax efficient method is chosen.

How is the income tax charge calculated on pre-owned assets?

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How inheritance tax due is actually paid depends on whether it arose on a lifetime transfer or on death.

Lifetime transfers

The liability on lifetime transfers normally rests on the donor (transferor), although it can be paid by the donee (transferee).

When a chargeable transfer is made, the donor must report this to HMRC so that the tax due can be calculated. Tax is normally due 6 months after the end of the month in which the transfer took place. However, where transfers ...

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...ecessary for the personal representatives to obtain a loan. On some property, for example, land, it is possible to pay any tax due in instalments.

Where an estate is divided between an exempt beneficiary and a non-exempt one, the property will be split before any tax due is calculated, to ensure that the exempt beneficiary does not suffer any impact from taxation.

Who is liable for any tax due on a PET where the donor dies within 7 years?

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The Finance Act 2006 changed the inheritance implications for trusts.

The creation of a trust is a transfer of value for IHT purposes, with the amount of the transfer being the loss of value to the donor’s estate. Whether or not tax is payable depends on:

Whether the settlor’s nil rate band has been exceeded

The terms of the trust

The exemptions available and the type of trust

Whether the settlor has made any other chargeable lifetime transfers in the previous seven years

Where an exemption can be claimed, for example gifting the annual exemption into a trust, there is no IHT liability.

Bare trusts

A transfer of value to a bare trust is a PET. The trust fund is the inheritance estate of the beneficiary. If the settlor survives seven years, the transfer will drop out of the cumulative calculation, but if the settlor does not survive seven years it will become chargeable (though it will benefit from taper relief). The liability will fall on the beneficiary of the trust.

Trusts for the vulnerable and disabled

A transfer into a trust for a vulnerable or disabled person is considered a PET, even when it is a discretionary trust. This type of trust can only become chargeable if the donor dies within seven years. The Finance Act of 2006 allowed individuals to settle their own property on themselves – a self-interest trust – if they could show that they had a condition that would lead to a future disability.

Interest in possession trusts

For interest in possession trusts created before 22 March 2006, the creation during the settlor’s lifetime was a PET. If the settlor died in the following seven years, there would be a tax charge with the liability falling on the tru...

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...ithin 7 years.

This treatment only applied to a trust that had been in existence for less than 25 years or where all the beneficiaries are grandchildren of a common grandparent or their widows/widowers or children.

The inheritance tax consequences of setting up the trust were the same as for absolute gifts but it gave the settlors an element of retained control over the capital and discretion on how the income was distributed.

The Finance Act 2006 ended the favourable tax treatment on 6 April 2008, if no changes had been made beforehand. The treatment is now based on the 3 options available to the trustees before 6 April 2008. These are:

If the trust was amended so that the beneficiaries became absolutely entitled at age 18, there will continue to be no periodic or exit charges

If the trust was amended to mirror an 18 to 25 trust, there will be an exit charge when capital entitlement arises but no periodic charge

If the trust has been left unaltered it is treated as a relevant property trust - like a discretionary trust - from 6 April 2008. Ten-yearly anniversaries will arise with reference to the date of the trusts creation. Up to the first ten-year anniversary after 6 April 2008, the charge will be based on the period from 6 April 2008 to the ten-year anniversary date

Additional examples from this chapter

This chapter has involved a number of complex concepts and calculations, both singularly and in combinations.

You can see further examples in the workbook along with further practice calculations.

Jerry is about to set up a trust for his grandchildren but wants to know whether this will be taxed. What factors will determine whether tax will be payable?

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Chapter revision test. Your results and 3.4 hours of estimated study time will be added to your CPD certificate on completion. If you retake the test then additional CPD time for the test will be added.

Multiple response question - select all the correct answers