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UK inheritance tax introduction

Inheritance tax is often labelled as the most hated tax in Britain. This is because taxpayers work all their lives to accumulate assets that are bought from taxed income only for their assets to be taxed again upon death.

The old saying goes, the simplest way to avoid inheritance tax is to be too poor to fall within the scope of the tax and based on this notion, donors can look to give away their assets during their lifetime, and ideally the donor will live for further seven years, so those assets escape inheritance tax upon death.

This strategy is simple and has merits for avoiding inheritance tax however, many donors will need to retain a sufficient amount of wealth to maintain a standard of living they’ve become accustomed to.

Gifting assets donors no longer require is sensible as this will not compromise the donors standard of living however, gifting assets that provide value to a donor (such as their home) will often require the donor to see out their days in a less comfortable setting, which may outweigh the tax benefit.

In this article, we will discuss strategies a donor can explore to prepare for, reduce or completely eliminate your inheritance tax bill.

Overview of UK inheritance tax

What is inheritance tax?

Most of us think of inheritance tax as a death tax which is true however, inheritance tax may also be levied when an donor makes a lifetime gift.

To summarise, inheritance tax is levied when a chargeable transfer is made which is either a lifetime gift or a transfer on death.

Who pays inheritance tax?

Donors who are UK domiciled are liable to inheritance tax on their worldwide estate.

Donors who are non-domiciled are liable to inheritance tax on their UK estate only.

How is inheritance tax calculated?

Inheritance tax is calculated by quantifying the loss to the donors estate as a result of the transfer. Note that what the donor loses is not always the same as what the donee receives.

Are there any tax free allowances?

Donors are entitled to a Nil Rate Band or ‘NRB’ of £325,000 which renews or re-sets after 7 years on an ongoing basis. This means an individual can fully use their NRB in a 7 year period, and upon entering the 8^th year, the NRB will be reset.

Donors are also entitled to a £3,000 annual exempt amount per annum, a £250 small transfer allowance per donee, a marriage allowance depending on their relationship to the bride/groom and a Residence Nil Rate Band ‘RNRB’ depending on how their property is distributed upon death.

Lifetime gifts to an individual

Outright gifts to individuals (other than spouses or civil partners) are classified as Potentially Exempt Transfers or ‘PETs’ which only become chargeable if the donors death occurs within seven years of the gift.

In the event the donors death occurs within seven years of the gift, the PET becomes chargeable and the donee will have an inheritance tax bill to settle. Note that the inheritance tax charge is reduced once donor lives beyond three years after making the gift.

As tax will be borne by the donee, it is possible to take out a decreasing term life insurance policy which pays out if the donor dies within seven years, to cover the inheritance tax bill.

Lifetime gifts to a trust

Outright gifts to a trust are classified as Chargeable Lifetime Transfers or ‘CLTs’ and transfers in excess of the NRB and exemptions will be immediately chargeable to inheritance tax at the lifetime rate of 20%.

As the £325,000 NRB is renewed after seven years, a donor can transfer assets of up to £325,000 into a trust, on repeat, every seven years and no inheritance tax will be levied.

In the event the donors death occurs within seven years of the gift, the CLT becomes chargeable as part of the death estate. However, the inheritance tax charge is reduced if the donor lives beyond three years after making the gift and the lifetime tax already settled will be deducted from the final tax bill.

Capital gains and lifetime gifts

Capital gains tax must be kept on the radar when gifts are being considered. Gifts of cash and gilts are exempt from CGT however gifts of assets such as land, property or shares will likely have CGT consequences.

For inheritance planning purposes, gifting assets which are appreciating or have the potential to appreciate such as land development has the effect of ‘freezing’ the value and will move any further increase outside the scope of inheritance tax, even if the donor dies within seven years. Whereas assets that are falling in value should be retained as they’ll generate a lower inheritance tax bill upon death.

Capital gains tax can be exempted whereby a transfer is immediately chargeable to inheritance tax or in other words, when there is a CLT. Note that inheritance tax does not need to be payable, the transfer must simply be chargeable to inheritance tax. Therefore, CLTs covered by NRB will still qualify for the capital gains exemption.

Income expenditure exemption

This exemption is the most valuable as there is no monetary limit on the amount that can be transferred. A transfer will be fully exempt providing that:

a) it is made as part of normal expenditure of the donor;
b) it is made out of the income of the donor;
c) it leaves the donor with sufficient income to maintain their normal standard of living.

‘Normal’ means the donor must establish a pattern of giving and demonstrate that they have made a commitment to that pattern.  Note that HMRC may require evidence that the donor initiated a habit which is intended to continue indefinitely. Therefore, the exemption cannot be used for a donor who begins to gift income following a terminal illness diagnosis as this is an indication that the gifts were never intended to continue from the offset.

The lack of monetary ceiling makes this exemption extremely valuable to high net worth individuals whose annual income levels are high but necessary expenditure to maintain their standard of living is modest.

In terms of real-life application, this exemption can be used to make a large gift on death by means of life insurance. For example, donor A wants to make a provision on their death for B. Donor A takes out a life insurance policy on their own life, the policy is written in trust with express wishes that B benefits from the policy upon donor As death.

The premiums will fall within the normal income expenditure exemption and when A dies, the life insurance proceeds will be paid to B and will be outside of As estate as the policy is written in trust.

Another real-life example involves a parent/grandparent contributing to their child/grandchild pension scheme. The pension fund will grow tax free and coupled with years of compound interest, will likely provide a substantial fund upon retirement.

Spousal exemption

The spousal exemption enables assets to be transferred between spouses or civil partners free of inheritance tax. The exemption applies for as long as the couple of legally married or in other words, until the date of divorce.

Therefore, a deceased spouse may opt to leave their entire estate to their surviving spouse who can continue to make PETs or CLTs within the NRB which will be more efficient than distributing assets to heirs upon death.

There is a monetary ceiling where transfers are made by a UK domiciled spouse (donor) to a non-domiciled spouse (donee). The ceiling is £325,000. To manage this, it is possible for the non-domiciled spouse to elect to be treated as UK domiciled for inheritance tax purposes however, this is with the caveat that their worldwide estate will come within the scope of inheritance tax. The election can be revoked once the spouse has been non-resident for four tax years.

Therefore, the surviving spouse can elect to be treated as UK domiciled, the deceased spouse can leave their entire estate to the surviving spouse free of inheritance tax and the surviving spouse must then leave the UK for four years to revoke the UK domiciled status.

How can GTC help?

GTC can assess your exposure to inheritance tax and provide strategies that you can employ to mitigate inheritance tax through gifting assets or explore provisions that you can employ to cover your pending inheritance tax bill such as life insurance.

Become a GTC client

Book a free discovery call with our team. We will collect background information to develop a greater understanding of the necessary steps to take to optimise your taxes.

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