Inheritance tax: Proposals for simplification

In January 2018, the Chancellor asked the Office of Tax Simplification (OTS) to conduct a review of inheritance tax (IHT).

Following a “call for evidence” in April 2018, the OTS published its first report in November 2018 which focused on the administrative aspects of IHT. On 5 July 2019, a second report, “Simplifying the design of Inheritance Tax”, was released. The report looks at various technical aspects of the IHT rules and makes a number of recommendations aimed at simplifying the operation of the tax. 

Here, we look at some of the report’s proposals which, if implemented, could have significant implications for the affairs of many private clients. 

Lifetime giving

Gift exemptions

IHT is primarily a tax on death; however, it can also arise in respect of transfers made during a person’s lifetime. Under current rules, gifts from one individual to another do not give rise to an immediate IHT bill; however, if the donor dies within seven years of making the gift, IHT will be payable unless the gift qualifies for an exemption/relief or falls within the individual’s available IHT “nil rate band” (the value of a person’s estate which is taxed to IHT at 0%).

In its report, the OTS notes that there are a large number of IHT exemptions for lifetime giving, many of which are not well known or understood by the general public. In particular, the exemption for “normal expenditure out of income” (NEOI) (under which regular gifts made out of a person’s surplus income are exempt from IHT) is criticised for its complexity and creating an administrative burden for a person’s executors after death in providing supporting evidence that the gifts were normal expenditure and that they had been made from surplus income.

Accordingly, the OTS recommends that the government should:

  • replace various existing lifetime giving exemptions (the annual gift exemption and the exemption for gifts in consideration of marriage or civil partnership) with an overall personal gifts allowance which would allow an individual to make IHT exempt gifts up to a fixed amount each year;
  • consider the level of this allowance and reconsider the level of the existing small gifts exemption (which exempts gifts from IHT of up to £250 to each recipient per annum); and
  • reform the NEOI exemption, either by limiting the amount of income covered by the exemption to a fixed percentage of a person’s annual income (thereby enabling the existing complex criteria for the gifts to be “regular” and out of “excess income” to be removed) or by replacing the exemption in its entirety with a higher personal gifts allowance. In this context, the OTS noted, using HMRC data, that an annual personal gifts allowance of £25,000 would cover the value of 55% of all NEOI claims.

If the government decides to go ahead with introducing an annual personal gifts allowance, most taxpayers are likely to welcome this simpler approach. However, individuals with a high annual income may well be adversely affected by reforms to the exemption for NEOI if they are currently relying on this exemption to, say, make substantial gifts each year to family members. Such individuals would be well advised to make the most of the current NEOI exemption while it remains in its current form (always ensuring that detailed records of annual income and the gifts are retained so that, in the event of the individual’s death, their executors will be able to prove that the payments were normal expenditure and made out of income).

Gifting period and taper relief

As mentioned above, lifetime gifts can result in an IHT bill when the donor dies within seven years of making the gift. However, in order to work out which gifts may be subject to tax after a person’s death, the executors may need to consider gifts made up to 14 years before death (this is of particular relevance where a person has made lifetime gifts into trust). Then, once it has been ascertained whether IHT is payable on the gift, “taper relief” will apply to reduce the tax bill if the donor survived for more than three years.

The report notes that these rules are complex and poorly understood. It also recognises that it can be difficult for executors to identify gifts made many years before death. In light of this, the OTS recommends that the government should:

  • reduce the seven year period to five years so that gifts to individuals made more than five years before death are exempt from IHT;
  • abolish taper relief; and
  • remove the “14-year rule” (so that only gifts made within seven years of death – or five years if the recommendation above is implemented – need to be taken into account).

The reduction of the seven year period to five years, together with the removal of the 14-year rule, are enormously welcome proposals and will significantly reduce the administrative burden for executors following an individual’s death. This, of course, does come at the cost of the abolition of taper relief. In this context, the OTS recognises that this will create a “cliff edge” as gifts made five years before death would be exempt whereas gifts made five years less one day before death could be subject to 40% IHT. However, in our view, although there would be some taxpayers adversely affected by this change, the merits of the shorter five year period would outweigh the drawbacks of creating this cliff edge.

Liability for payment and the nil rate band

Under current rules, where IHT arises in respect of a lifetime gift to an individual, the recipient (rather than the deceased’s estate) is liable to pay such tax (unless the deceased specifies otherwise in their will). In calculating whether such an IHT liability arises or whether the gift falls within the donor’s “nil rate band” amount, the nil rate band is allocated to gifts in chronological order.

The report recognises that individuals often do not realise that some of the gift might be clawed back in tax, should the donor fail to survive for seven years (resulting in the recipient spending the money before the seven year period expires). It also notes that the chronological allocation of the nil rate band can cause inequalities between gift recipients (where an earlier gift benefits from the nil rate band but a later one does not).

The OTS raises various possibilities for simplifying these rules, including changing the liability for payment of tax on lifetime gifts so that it is payable by the estate (rather than the gift recipient), and allocating the nil rate band proportionately across all relevant lifetime gifts (rather than from the earliest gift first). However, rather than coming to a firm conclusion about which possible option it would recommend, the OTS simply asks the government to explore options for simplifying these rules. Taxpayers should therefore stay alert for further developments on this as any changes to these rules could have implications both for the donor and the recipient of any lifetime gifts.

Interaction of IHT with capital gains tax

As things currently stand, when an individual dies, for capital gains tax (CGT) purposes, their heirs are treated as acquiring the assets in their estate at their market value as at the date of death. This “capital gains uplift” effectively resets the clock for CGT purposes and wipes out all previous gains. However, the uplift is not available on lifetime gifts; instead, such gifts are usually chargeable disposals for CGT purposes (or, in certain circumstances, are transferred on a “no gain, no loss” basis).

The OTS’ report notes that the difference in treatment between lifetime giving and transfers on death can provide an incentive for taxpayers to transfer assets on death rather than in life (particularly when the assets in question will qualify for an exemption from IHT). Accordingly, the OTS recommends that:

  • where a relief or exemption from IHT 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.

If implemented, this proposal would have significant implications for many individuals. We agree with the OTS’ conclusion that the current capital gains uplift can distort decision making for clients in respect of timing the transfer of assets which are exempt from IHT. The proposal would certainly deal with this concern; however, it would come at a large tax cost for many. Furthermore, given that the key aim of the OTS’ report is to simplify the design of IHT, we would be concerned that this recommendation would only create additional complexity and administrative burden. For example, it would be necessary to look back at old records to work out historic acquisition costs of assets, and it is unclear how an asset which passes to two beneficiaries on death (one of whom is exempt and the other is not) would be dealt with. The government will need to consider carefully whether the advantage of this proposal outweighs the clear disadvantages.

Businesses and farms

Two of the main reliefs from IHT are agricultural property relief (APR) and business property relief (BPR). They operate to provide relief from IHT on agricultural property or certain business assets by reducing the value of the property transferred by either 50% or 100%, the policy aim being to help prevent the break-up of farms or businesses on the death of the owner.

Prior to the report being published, there had been concerns that the OTS might recommend abolishing these reliefs. However, the report uses HMRC data to demonstrate that the extra tax raised by abolishing APR and BPR would not fund a significant reduction in the rate of IHT. It is therefore very welcome news that the OTS does not recommend getting rid of these reliefs.

However, the report does mention a number of possible options for reform. The key recommendations in respect of BPR are set out below.

Trading or investment?

Under current rules, BPR will not apply if the business in question consists “wholly or mainly” (generally understood to be greater than 50%) of holding investments. However, equivalent CGT reliefs for business assets (either gift holdover relief or entrepreneurs’ relief) do not use the “wholly or mainly” test; rather, the CGT reliefs look at whether there is “substantial” trading activity in the business (generally understood as requiring at least 80% trading, as opposed to investment, activities).

The OTS therefore recommends that the government should:

  • 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.

Whilst it would certainly be a simplification to align these tests, clearly, if this recommendation is implemented, there would be a tax cost for many individuals as some businesses which currently fall within the scope of the rules will no longer qualify for BPR. It may be necessary to reorganise some business structures if changes are made.

Also in the context of looking at the trading requirements for BPR, the report highlights a few other areas which require simplification. It recommends that the government should:

  • review the treatment of indirect non-controlling holdings in trading companies (in order to ensure that the holding structure does not inappropriately limit the application of BPR as a result of the shares being treated as an investment even though the major asset of the holding company is the shareholding in a trading company);
  • consider whether to align the IHT treatment of furnished holiday lets with that of income tax and CGT (as, in general, these are currently deemed to be trading for income tax and CGT but not for BPR purposes); and
  • review the treatment of limited liability partnerships (LLPs) to ensure they are treated appropriately for the purposes of the BPR trading requirement (since the current wording of the IHT legislation suggests that a corporate trading group that has an LLP rather than a company as its holding vehicle may not be treated as “trading” for BPR purposes).

If implemented, these recommendations would be helpful developments and may in fact bring some businesses within the scope of BPR for the first time. In the context of the recommendation regarding LLPs, we would suggest that the relevant legislation confirms the position for ordinary partnerships as well as LLPs.

AIM traded shares

Finally, it should also be noted that the report questions whether it is within the policy intent of BPR to extend the relief to third party investors in AIM traded shares (as is currently the case), in particular where they are no longer held by the family or individuals originally owning the business. The OTS does not make any formal recommendations in respect of the availability of BPR for AIM traded shares; however, it is of course possible that the government will decide to tighten up the rules in light of this comment unless it considers that one of the purposes of BPR is to encourage investment in smaller, higher risk companies. Any reform of the rules in this context could have significant implications for the large number of private clients who have invested money in “AIM portfolios” for the specific purpose of protecting such funds from IHT on their death.

Term life insurance

It is common for individuals to purchase life assurance policies known as term life cover which pay out a certain amount if the individual dies within the term of the policy. It is usually advantageous for such policies to be transferred into trust to ensure that any pay-outs from the policy following the individual’s death do not form part of their estate and so are not liable to IHT.

However, not all policies are written in trust, often because the individual in question has not been made aware of the IHT advantage. The OTS therefore recommends that the government should:

  • consider ensuring that death benefit payments from term life insurance are IHT free on the death of the life assured without the need for them to be written in trust.

This would be a welcome simplification.

Notable exceptions from the report’s recommendations

The report mentions a number of other aspects of the IHT rules but, perhaps unexpectedly in some cases, does not make any recommendations in respect of these. Of particular interest are the following points:

  • Spouse exemption: the report notes that cohabiting couples and siblings cannot make use of the spouse exemption; however, it “considers that any change to the definition of spouse to include a cohabiting partner or sibling would be far reaching” and would “form part of a wider response to social change…rather than being driven primarily by Inheritance Tax considerations”.
  • Residence nil rate band: introduced in 2017, the aim of the residence nil rate band (RNRB) was to make it easier to pass on the family home to direct descendants without IHT (although it should be noted that, since the value of the relief starts to taper in respect of estates worth more than £2 million, this regime is not relevant for most high net worth clients). The report recognises that the RNRB is overly complicated and notes various possible options (including the possibility of abolishing the relief and, instead, increasing the nil rate band); however, unfortunately, no recommendations for simplification are made on the basis that the regime is still relatively new.
  • Trusts: the OTS recognises in its report that a number of respondents to its “call for evidence” raised concerns regarding the IHT treatment of trusts. However, it also notes that HMRC published a consultation on the taxation of trusts in November 2018 and so, in light of the fact that this consultation has a wider remit than the OTS’ review on IHT, does not make any recommendations on the IHT treatment of trusts. It is disappointing that the OTS has declined to offer its views on the IHT treatment of trusts as this is a key area of complexity within the IHT regime. To date, HMRC has not given any indication as to when it will publish any findings or recommendations in respect of its consultation on the taxation of trusts.
  • Charities: since 2012, where a person leaves 10% or more of their estate to charity on their death, the IHT rate on the rest of the estate not passing to charity is reduced from 40% to 36%. The OTS notes that determining whether this reduced IHT rate applies to an estate is complicated and also reports a suggestion that there is low public awareness of the reduced rate. However, it concludes that it is still early days for the reduced rate and so more time is needed before its effectiveness can be properly evaluated. Accordingly, no recommendations are made in respect of the reduced rate or any other aspect of the IHT treatment of charitable gifts.

Next steps

The Chancellor has confirmed that the government will consider the recommendations made in the OTS’ report and will respond “in due course”. Given that the government’s attention is currently focused on Brexit and the change in its leadership, it seems unlikely that there will be any major announcements in the near future.

If implemented, some of the recommendations (for example, the proposed reduction of the seven year period for lifetime gifts to five years and the removal of the 14-year rule) would improve the IHT position for many private clients (although the downside from the abolition of taper relief must not be forgotten). However, there would also be losers from some of the other recommendations. As mentioned above, it would be sensible for individuals with a high annual income to take full advantage now of the current rules in respect of the NEOI exemption. Business owners should also consult with their advisers if they have any concerns about how the possible changes to BPR (in particular, the proposal to align the trading requirements for BPR with the requirements for gift holdover relief and entrepreneurs’ relief) will affect whether their business assets qualify for BPR.

If you would like further information or advice on the recommendations made by the OTS, please get in touch with us. In the meantime, we will be closely monitoring the position and will provide further updates on any developments.