The Office of Tax Simplification’s review of UK inheritance tax

The government asked the Office of Tax Simplification (OTS) to review the inheritance tax system and make recommendations on how it can be simplified. Last month the OTS published its report and we caught up with Nick Mendoza, Senior Associate of Howard Kennedy LLP, who explained about the report, the current inheritance tax system and the recommended changes. It is widely agreed that Inheritance Tax (IHT) is one of the most complex areas of UK taxation. Whilst many people may understand the basics of how IHT is levied, there are a vast array of reliefs, exemptions and allowances available. Trying to understand how and when these apply can be challenging, even for professionals working in the financial industry. The Office of Tax Simplification’s report runs to 107 pages and covers a large number of areas, including how trading businesses, furnished holiday lets, and farms are taxed on death, and how IHT is levied on pensions and life assurance policies. Whilst the recommendations in these areas were reported in the press, the recommendations that grabbed the most attention related to how lifetime gifts are taxed on death. At the moment an outright gift does not give rise to any immediate IHT charge. Instead, to the extent that an outright gift exceeds an individual's annual gifting allowance of £3,000 it is known as a “potentially exempt transfer” (PET). A potentially exempt transfer will be entirely outside of the IHT net if the person making the gift survives that gift by seven years. If they fail to survive the full seven years then the gift will be brought into account when calculating the value of the individual's estate on death. IHT will be payable on the gift if the value of the gift exceeds the IHT Nil Rate Band (currently £325,000). However, if the individual who made the gift fails to survive the full seven years but survive more than three years then after three years the rate of tax on the gift will begin to taper down. Taper relief applies as follows:

Years between gift and death	Percentage of full tax rate applied
3 to 4	80%
4 to 5	60%
5 to 6	40%
6 to 7	20%

This method of taxing lifetime gifts is not easy to understand. In my brief explanation above I have referred to three allowances/reliefs that must be factored in so as to work out the how a gift is taxed; (1) the annual gifting allowance of £3,000 (2) the Nil Rate Band and (3) Taper Relief. Given that it is often bereaved family members who are tasked with resolving the lifetime gift position it is no wonder that confusion and mistakes can arise. Another area of where there is a general lack of understanding is around the normal expenditure out of income exemption. At the moment lifetime gifts are entirely exempt for IHT purposes if they form part of a person's normal expenditure out of their unused income. In order to be able to claim the normal exemption out of income exemption, it is necessary for executors to demonstrate a pattern of giving by the deceased individual and that the deceased individual had sufficient excess income to make the gifts and maintain their usual standard of living. In their report, the OTS noted that the large number of reliefs and exemptions are not well known or understood by the general public. It also noted that it can be difficult for executors to establish gifts going back seven years. Accordingly, the OTS recommended the following:

The various different lifetime giving exemptions should be scrapped and replaced with one overall personal gifts allowance. This would allow individuals to make gifts up to a fixed amount each year and those gifts would be exempt from IHT.
The normal expenditure out of income exemption should be reformed, either by limiting the amount of income covered by the exemption to a fixed percentage of a person’s annual income, or by replacing the exemption in its entirety with a higher personal gifts allowance.
The seven-year period should be reduced to five years, meaning that gifts to individuals made more than five years before death are exempt from IHT.
Taper relief should be abolished.

These proposals, if implemented, will undoubtedly simplify how lifetime gifts are taxed and should make the process of establishing the tax position on death much easier. However, the proposals have not been universally welcomed. Critics have pointed out that the proposed changes to the normal expenditure out of income exemption will mean that individuals with high incomes will find their ability to make tax free gifts substantially curtailed. Moreover, the abolition of Taper Relief will result in a “cliff edge” scenario, meaning that gifts made five years before death will be entirely exempt from IHT, whereas a gift made five years less one day before death could be subject to IHT at the rate of 40%. The OTS can only make recommendations and has no legislative powers and so we will wait and see the extent to which this government (or the next) seek to implement the recommendations. Nick Mendoza, Senior Associate at Howard Kennedy LLP