The Office of Tax Simplification (OTS) published its second report earlier this month which provides recommendations to the Treasury on the simplification of Inheritance Tax (IHT). Although the remit of the report was to simplify existing policy, rather than to propose different policy, the recommendations would lead to a significant change in existing tax planning strategies. The report highlights that the inconsistencies and complexity of the existing rules lead to a difference in tax paid between individuals who seek specialist advice and the large number of people who do not seek advice. The OTS anticipates that this difference would be narrowed if the recommendations were implemented.
The recommendations would leave the nil rate band and residence nil rate band untouched so that on the death of a surviving spouse after 6 April 2020, assets to the maximum value of £1m can pass free of IHT so long as certain criteria are met. The residence nil rate band only applies in certain circumstances and the legislation is widely criticised for being fiendishly complicated. The residence nil rate band was introduced in 2017 and was considered too new to be addressed in the OTS’ report.
In addition to the OTS’ report, HMRC are currently carrying out a review on the taxation of trusts. The consultation period closed earlier this year and HMRC are collating the responses. Mindful of the ongoing consultation, the OTS’ report specifically excludes trusts, but the recommendations are likely to be considered by HMRC in relation to reviewing the IHT regime for trusts.
The combination of the OTS’ report and HMRC trust consultation, if implemented, will lead to significant changes in the current IHT rules. Although it is the OTS’ objective to simplify the current rules so that less professional guidance is required to navigate the tax rules, it will be important for individuals to review their existing estate planning arrangements once any changes are confirmed to see how they fit within a new IHT framework.
A summary of the OTS’ key recommendations is as follows:-
1. Gift Exemptions
- Replace the annual gift exemption (currently £3,000) and exemption for gifts in consideration of marriage or civil partnership (currently £5,000 by a parent) with an overall personal gift allowance; and
- Reform the exemption which allows individuals to gift their excess income free of IHT or replace it with a higher personal gift allowance. The removal or cap of the gift out of excess income exemption would remove a significant tax planning opportunity.
2. Gifting Period and Taper
- Reduce the current 7 year period to 5 years so that gifts to individuals made more than 5 years before death would be exempt from IHT; and
- Abolish taper relief which currently reduces the IHT payable on lifetime gifts made more than three years prior to death.
3. Liability for Payment and the Nil Rate Band
- The OTS comment that it is not widely known that a recipient of a lifetime gift is liable for any IHT payable on that gift and an individual’s nil rate band is allocated to lifetime gifts in the order in which they are made. The OTS’ recommendation is that any IHT payable on lifetime gifts should be met from the estate and the nil rate band should be allocated on death proportionately across the total value of lifetime gifts which are brought into charge.
4. Interaction with Capital Gains Tax (CGT)
- Under the existing rules, for CGT purposes, the person inheriting an asset is treated as acquiring it at market value on the date of death. Where an asset is exempted or relieved from IHT, the CGT uplift on death means that the asset can be sold or gifted shortly after death without IHT or CGT being payable. For example, if a wife inherits assets from her husband’s estate, the inherited assets benefit from spousal exemption so that no IHT is payable and she can gift the assets to her children free of CGT. If the wife survives for seven years, the assets are received by the children free of IHT and CGT. The OTS comments that the existing interaction between CGT and IHT complicates the decision-making process of passing assets to the next generation.
- The OTS recommends that where a relief or exemption from IHT applies, the CGT uplift on death should be removed so that the recipient is treated as acquiring the assets at the historic base cost of the person who died. Using the example above, a CGT liability could be triggered if the surviving wife were to gift assets received from her husband’s estate to her children. If implemented, this change would encourage cyclical gifting so that donor’s annual CGT exemptions are fully utilised.
5. Businesses and Farms (BPR/APR)
- The OTS recommend that the trading test for business property relief (BPR) should be brought in line with the CGT trading test.
- Under the existing rules, in order to benefit from BPR, a business must be “wholly or mainly” trading. The “wholly or mainly” test is generally considered to be a greater than 50% test. The test looks at the main activities of the business, and its assets and sources of income and profits. For CGT purposes, in order to qualify for relief, a business must have “substantial” trading activity. HMRC guidance suggests that this generally requires an 80:20 split of trading vs investment with several indicators to look at including assets, income, expenses, time spent by employees and the history of the business. If this change is implemented, individuals would need to review their business interests to establish whether they are likely to qualify for IHT relief and whether any restructuring could be carried out within the business in order to improve the likelihood of qualifying for relief.
- Under the existing rules, shares that are traded on the Alternative Investment Market (AIM) can benefit from BPR if they have been held for a minimum of two years. There is a suggestion that as the role of BPR is to keep businesses intact, it may not be appropriate for BPR to continue to be available on AIM shares. If BPR is removed from AIM shares it would encourage people to review their investment strategy as AIM shares are historically volatile.
6. Other Areas
- The OTS recommends 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 change would simplify the trust reporting regime for life policies.
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