UK Office of Tax Simplification Takes Aim at Inheritance Tax
Death duties were first introduced, in their modern form, back in 1894 when the government introduced estate duty, a tax on the capital value of land. Estate duty was eventually replaced by Capital Transfer Tax in 1975, which introduced the concept of tax on lifetime gifts, and subsequently, by Inheritance Tax (“IHT”) in 1986 which, in turn, introduced potentially exempt transfers (“PETs”) for lifetime gifts.
Despite the fact that the vast majority of UK estates are not subject to IHT (the Office of Budget Responsibility’s figures for 2017/18 suggest that only 3.8 percent of estates were liable to pay the tax), it has long been the subject of much heated political debate, which continues to persist today. Earlier this year, Chancellor Philip Hammond described the existing IHT arrangements as “particularly complex”, and in a letter to the Office for Tax Simplification (“OTS”) he requested that it undertake a review “to ensure that the system is fit for purpose and makes the experience of those who interact with it as smooth as possible.”
Beyond administrative and technical issues, the review will examine the processes for submitting returns, disclosure, estate planning, payment and the plurality of available reliefs.
In outlining its objectives for the review, the OTS confirmed that it is hoping for “genuine, substantive simplification”, rather than “a bonfire of taxpayer reliefs and exemptions”. Nevertheless, there are several areas where the current legislation looks ripe for reform.
The variety of lifetime exemptions and reliefs from IHT is frequently identified as an area of particular complexity. Among these exemptions are the annual exemption, the PET regime and the exemptions for small gifts, gifts on marriage and gifts made out of normal expenditure from income. There are also reliefs for business and agricultural property, including Business Property Relief (“BPR”) and Agricultural Property Relief (“APR”).
Alongside these exemptions is the Nil Rate Band (“NRB”) within which assets are taxed at zero percent. Transferable between the estates of spouses, the NRB has remained static at £325,000 for nearly a decade and is due to stay at that level until at least 2021.
Announced in the budget of March 2016, the Residence Nil Rate Band Allowance (“RNRB”) has added yet another layer of complexity. An additional tax-free sum that can be claimed by estates where a “residence” is “closely inherited” by “lineal descendants”, the RNRB is currently set at £125,000 and will increase incrementally by £25,000 in each of the following two tax years, resulting in the availability of an additional IHT allowance of £175,000 by 2020/21. If the above criteria are satisfied, the RNRB will potentially offer individuals the opportunity to pass on £500,000 of assets free of IHT (from 2020/21 onwards) when combined with the basic NRB (i.e. £1m between a married couple).
The situation is further complicated by the fact that the relief is subject to a tapered withdrawal where an estate exceeds £2m and is lost entirely when it exceeds £2.35m. This creates a genuine tax planning headache, especially for couples whose individual assets fall below the upper threshold of £2.35m, but whose combined assets (on the second of their deaths) may well exceed it.
In short, the RNRB has been an overly complex means of increasing the threshold at which assets can be passed free of IHT. It has been poorly received, as it discriminates against individuals who have neither children nor property, and has also been under-utilised, with only one in six estates claiming the relief. Ironically, although designed to reduce the numbers of estates caught by the IHT net as a result of rising property prices, IHT receipts nevertheless hit a record high of £5.2bn in 2017–18.
It is unsurprising then that there are calls for the law to be reformed. The great unknown is how radical that reform might prove to be. It may be that some of the more under-utilised lifetime IHT exemptions are removed, such as those for small gifts or gifts on marriage. Simultaneously, the annual exemption may be increased, a step long overdue given that the annual exemption has remained stuck at £3,000 per annum since 1981.
The Chancellor might also make changes to the RNRB, either cosmetically, by increasing the definition of “lineal descendants” to include nieces/nephews (“lineal descendants” currently only includes children/grandchildren), or more radically, by scrapping it entirely and increasing the basic NRB. This idea is not entirely fanciful given the wording of the OTS’ Call for Evidence, the final question of which asks whether some IHT exemptions should be removed to fund “a lower or graduated rate or higher NRB”. Unfortunately, this may be reading into things a little too much, given that the RNRB was only introduced last year and is mentioned specifically only once in the Call for Evidence, in a question regarding “other areas of complexity.”
An area which the Call for Evidence does place a lot of emphasis on is the IHT treatment of businesses. This is in line with a separate OTS publication of earlier this year entitled “Simplifying the taxation of key events in the life of a business,” which featured a significant discussion of BPR and its interplay with capital gains tax (“CGT”) reliefs relating to businesses, including CGT hold-over relief and Entrepreneurs Relief. Of slight concern is the OTS’ questioning of the extent to which these generous reliefs “distort decision making,” as well as its reference to “inconsistent definitions or approaches within IHT and across IHT and CGT which cause complexity.”
The inconsistent definitions referenced in the Call for Evidence include those for trading companies, which differ across BPR, CGT hold-over relief and Entrepreneurs Relief. This is unsurprising, as in its publication of earlier this year, “Simplifying the taxation of key events in the life of a business”, the OTS noted that “the OTS have been told on several occasions that aligning [these] definitions would represent a significant simplification.” While this may be true, if such a simplification were to consist of increasing the level of trading activity required for a business to qualify for relief, from the current 50 percent threshold for BPR, to the 80 per cent threshold required for Entrepreneurs Relief and CGT hold-over relief, then this would represent a significant loss of relief for many UK taxpayers.
As has been the case since the inception of the RNRB, clients should review their existing Wills and consider the extent to which their estates might benefit from the additional tax-free sum. Couples, whose individual assets fall below the upper threshold of £2.35m, but whose combined assets (on the second death) are likely to exceed it, may wish to consider leaving a “residence” or an interest in a “residence” to one of their children/grandchildren on the first of their deaths, in order to utilise the relief and reduce the value inherited by the surviving spouse. Alternatively, they might consider making lifetime gifts to ensure that both estates qualify for the relief. Nevertheless, careful planning is required and overzealous clients should be warned against letting the tax tail wag the proverbial dog.
More generally, clients would be well advised to monitor any changes that are made to the IHT reliefs as a result of the consultation, since any such changes may have a significant impact on existing estate planning, and, potentially, create new tax planning opportunities.
Alternatively, and radically, the Chancellor could decide to scrap IHT altogether, defining death as a “disposal” for CGT, or instead institute a form of gift tax, whereby the recipients of lifetime gifts, or those who inherit assets are taxed, rather than the estate of the deceased (however unlikely this might be). We await the OTS recommendations with interest.
John Sweeney, Associate
This article was originally published in International Accountant and can be read online here.