The chancellor has requested a review of the “particularly complex” UK inheritance tax regime. What is it that makes inheritance tax so complicated?
Chancellor Philip Hammond recently wrote to the independent Office of Tax Simplification (OTS) in order to call for a review of inheritance tax to make sure the system is "fit for purpose". Official figures show inheritance tax receipts stood at £4.8bn in 2016-17 and are expected to total £5.3bn by the end of this tax year. The Office for Budget Responsibility expects annual receipts to rise to more than £6bn by 2021-22.
Although inheritance tax (IHT) ends up applying to a relatively small percentage of UK residents, the total amount which is collected tends to rise every year. The chancellor has identified several aspects of the current system which would benefit from simplification; not least the exemptions and reliefs which are central to the regime. He would find no shortage of opportunities to bring greater clarity.
The nil-rate band
The standard exemption is the nil-rate band. There is normally no IHT to pay at all if the value of the estate comes in at under £325,000. Generally speaking, anything above this is taxed at 40 per cent. In light of the fact the rise in receipts reflects an increase in residential property prices, the residence nil-rate band (RNRB) was introduced last year. This currently allows £100,000 (rising to £175,000 by 2020/21) to be set against the value of the main residence.
The nil-rate band is an important one to understand fully as it has significant potential to bring down an IHT bill. Transfers between spouses are exempt and any outstanding nil-rate bands are passed to the surviving spouse on death. Importantly, it is a variable percentage rather than a fixed figure which is transferred. If a person were to leave an inheritance only worth 25 per cent of their nil-rate band to a nominee, their spouse would inherit 75 per cent of the outstanding band. This would be worth 75 per cent of whatever the nil-rate band stood at when then surviving spouse passed.
The chancellor’s letter requested a review into how the current gift rules interact with the wider system which is understandable given both how complex these rules can be and how they can be utilised over a person’s lifetime.
Gifts of up to £3,000 a year are exempt and unused allowance can be rolled over from the previous tax year to make £6,000. It is also fine to make as many gifts of up to £250 per person during a tax year.
It gets more complex when it comes to what is known as the ‘seven year rule’. Gifts in excess of the £325,000 allowance can be made without incurring inheritance tax, as long as it happens in the seven years before death, known as a potentially exempt transfer. Gifts made three to seven years before death are taxed on a sliding scale known as ‘taper relief’.
The rules are more opaque when it comes to gifts made out of income. These can be considered free of IHT but, in order to qualify, these must be made out of income, not capital, and it must not have a material impact on the person making the gift’s standard of living.
People will also be concerned with protecting assets they don’t necessarily intend to gift at all. Pensions, for example, are generally safe but this is another area where the rules can be complex and spell out problems for those unfamiliar with the system.
Charles Stanley Chartered Financial Planner, Anne McClean, says: “Pensions typically are not classed as part of a person’s taxable estate so IHT does not apply. However, if a person was to transfer their pension while in ill health or were to die within two years of doing so, the funds may be liable to IHT. This will only affect a relatively small proportion of people but it is worth being aware of it to ensure you are not caught out.”
The effects of an overly complicated system are wide-ranging but, not least, it hinders a person’s ability to piece together a homogenous long-term plan.
Charles Stanley Senior Financial Planner, David Hume, says: “Clients often delay IHT planning until they are older as they are concerned about losing access to their capital in case of the need to fund long-term care fees.
“Investments that benefit from Business Relief, such as AIM portfolios, may be a good option for clients to consider as part of their planning. The investment is accessible, but should be considered outside their estate after the two year qualifying period. Clients can also transfer their ISAs into this investment so they are totally tax-free.”
The rules surrounding IHT are undoubtedly complex. It is also true that more people are qualifying for IHT as property prices go up. The introduction of the residence nil-rate band (RNRB) provided some relief, especially considering the nil-rate band has been frozen since 2009. However, the complexities of the RNRB make it far from straightforward and puts many people at risk of missing out on this allowance altogether.
Unless the government is proposing to reduce the amount it collects, the temptation may be to make certain allowances/exemptions less generous under the guise of making it easier to understand. The irony here is that taxpayers may be better off trying to familiarise themselves with the intricacies of the system prior to any review in order to see if they are being led into a new regime that stands to leave them worse off.
The tax treatment of pensions and investments depend on individual circumstances and is subject to change in future. The rules on tax or their interpretation, as with the rates of tax applicable, may alter. You are recommended to consult a professional tax adviser on all tax matters.