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LAWS08130-Inheritance Tax Study Guide
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Inheritance Tax 1.1. Inheritance Tax – Introduction to and History of Inheritance Tax 1.2. Inheritance Tax – Why Tax Wealth? 1.3. Inheritance Tax – Lifetime Transfers 1.4. Inheritance Tax – Exemptions and Exclusions Inheritance Tax 5.1 Inheritance Tax – Introduction to and History of Inheritance Tax 1
The way that wealth is taxed in the United Kingdom is unusual. From a policy perspective, however, inheritance tax is not particularly effective. There are two main taxes of wealth families: Annual wealth taxes tax the stationary ownership of wealth. Typically in common-law type jurisdictions, there are transfer taxes, which only apply when wealth is transferred from one person to another – they generally tax transfers on death and within seven years of death. o Within transfer of wealth taxes, either donor or donee based taxes are possible. Donor based taxes are measured relative to the person who is transferring the wealth. Such a system is common only to the United States and the United Kingdom. Donee based taxes (e.g. Ireland’s acession tax) examine how much an individual receives. Donee based taxes would seem to make greater sense – those who are receiving the wealth should bear the burden of tax and their taxable capacity should be material. Capital Transfer Tax (CTT), the predecessor of Inheritance tax (IHT) was designed initially to be a cumulative lifetime gifts tax. The idea was that everyone had a meter which ran throughout his or her lifetime which kept tag of all non-exempt gifts made, with the estate on death forming the last transfer. o Whilst CTT had a fairly high nil rate band, once this was exceeded, the tax was progressive, with a maximum rate of 75% of the value transferred once transfers exceeded £2.5 million (1982/83). o This system was gradually diluted, and eventually, in 1986, changed completely. In 1986, the CTT Act 1984 became Inheritance Tax Act (IHTA) 1984, and the policy of taxing gifts "from the cradle to the grave" was abandoned. o Inheritance tax can now best be viewed as a tax on death, and on transfers within 7 years of death. Dealing first with transfers during lifetime, these are either exempt, potentially exempt or chargeable (the latter category is unusual). o An example of an exempt transfer is between spouses. Such transfers are not subject to Inheritance Tax. o A potentially exempt transfer (PET) deal with the problem that the tax catches gifts on death and gifts within seven years of death. Most lifetime gifts are given this status – if a person lives 7 years beyond the gift, it will become exempt. If they do not, then it is a chargeable transfer. o A lifetime chargeable transfers are chargeable when made, unlike PETs which only become chargeable as a result of death within 7 years. Lifetime chargeable transfers are charged at the rate of 20%, to the extent they, on top of earlier chargeable transfers within the immediately preceding seven years, exceed the nil rate band, (£325,000 in 2014- 15,unchanged since 2009-10). The most significant example of this is a transfer into a trust. This is an anti-avoidance device. 2 Wealth Taxes Annual Wealth Transfer Donor based Donee based
The way that shares are valued are by the amount of control which is given. A 5% shareholding is worth proportionately less than a 51% shareholding. If a person transfers away shares from 51% shareholding, their loss will be greater than the donee’s gain. o In Crossman (an estate duty case) the assets were shares in a family company. In the articles of association there were restrictions on how the shares could be sold (share preferences). Here there were share preferences – they had to be offered to family members first. The taxpayer argued that the market value of the shares was lower because the family members had first preference. The court in this case stated that assets which restricted transfer had to be valued as if from the position of someone buying the shares subject to the same restriction as the seller. 5.3 Inheritance Tax – Exemptions and Exclusions Inheritance Tax is not chargeable where: o 1. The transferor is exempt; o 2. The transfer is exempt; o 3. The property transferred is excluded property (see below); o 4. The disposition is not a transfer of value. 1. Exempted transferors include diplomatic agents (Diplomatic Privileges Act 1964), staff of international organisations (International Organisations Act 1968) consular officers – (Consular Relations Act 1968). 2. Of the exempt transfers the most significant is unlimited transfers between spouses where recipient not domiciled in UK in which case exemption restricted to a lifetime limit of the nil rate band in 2014-15). o NB: Spouse does not include an ex-spouse/CP but see (d)(ii) below - Dispositions for Maintenance of the Family. Note – The Annual Exemption – First £3,000 of transfers in a year of assessment are exempt, s 19(1). Earlier transfers receive the exemption first, even PETS (this may waste the exemption - make any CTs first in the year) except where transfers take place on the same day, in which case the a.e. is allocated pro rata (e.g. on the basis of the value of the gift) s 19(3). Carry forward of unused exemption for one year only s.19(2). Because of this latter rule, it is necessary to give the current year’s annual exemption notionally first: Eg A makes a transfer of £5,000 in year 2, having made no transfers in year 1. All the year 2 exemption is used up plus £2,000 of the exemption carried forward from year 1. There is no exemption to carry forward to year 3, as the exemption from year 1 (of which £1,000 has still not been used) cannot be carried forward for more than one year. The annual exemption has not increased for a long time – this is similar to the £ small gifts exemption. o The small gifts exemption (s.20 IHTA) applies to outright gifts to individuals provided the value of the gift to each individual does not exceed £250 per individual in a year of assessment. This cannot be added to the annual exemption. The £250 is not a limit which is always available – it does not state that the first £ is tax free; rather if £251 is given, the whole exemption is lost. o The normal expenditure out of income is another important exemption of transfer. Exempt to the extent that: (a) it was made as part of the normal expenditure of the transferor, and (b) taking one year with another, it was made out of his income, and (c) the transferor was left with sufficient income to maintain his normal standard of living. 4
This might apply e.g. to the payment of premiums to a life assurance policy. During the lifetime, the benefits of the policy are assigned to another person – on death of the policyholder, the sum will be paid to the assignee. The assignation will be a lifetime transfer, although the actual value of the life assurance policy at this stage will be low. The payment of the life assurance policy bypasses the deceased’s estate and therefore minimal tax is paid thereupon. The premiums for this policy are normal expenditure out of income, although the premiums must not reduce the normal standard of living. In Bennett v IRC there was a trust which held shares in a family company. A widow received around £300 per year from the trustees. Eventually, the trustees decided to sell the shares in the company, selling these shares to a larger company and in return received many shares in the new company and around £2 million. The widow was now entitled to £350, per year. The widow instructed the trustees to distribute the surplus to her three sons. She died around a year after she had given this direction. By the time she had died, the sons received around £180,000. HMRC challenged the claim that the £180,000 was normal expenditure out of income. Some quite interesting observations as to what ‘normal expenditure out of income’ means. ‘Normal’ does not require the payment to be the same size at all times. All that needs to be shown is a settled pattern of expenditure. Although the expenditure had not been going on for very long, the judge stated that it was necessary to show that the pattern of expenditure was intended to remain in place for more than a nominal period. Here the widow seemed to indicate that the pattern should continue for the rest of her life. The recipients did not require to be the same individuals at all times. The amount need not be fixed. However, a deathbed resolution would not constitute normal expenditure. o Gifts on consideration of marriage (s.22): Gifts to the parties of the marriage, or if in settlement, to the parties and their issue, are exempt to an extent depending on the relationship of the donor to the party - each parent - £5,000 grandparents - £2,500 other parties - £1, o Gifts to charities o Gifts to o NP o Main o Disp 3. Excluded property includes (s.6 (i) Property situated outside UK owned by an individual domiciled outside the UK, s 6(1) (ii) Certain Government Securities owned by persons neither domiciled nor ordinarily resident in UK, s 6(2) (iii) Certain savings by persons domiciled in Channel Islands or Isle of Man, s 6(3) (iv) Certain government pensions in respect of overseas service, s 153 (v) Moveable property owned by members of visiting forces, s 155. (Format) 4. If the disposition is not a transfer of value then no IHT is payable. If there is no transfer of value in disposition then there is notionally no IHT. But bad bargains are not exempt, subject to s.10, which states: "A disposition is not a transfer of value if it is shown that it was not intended [a subjective test], and was not made in a transaction intended, to confer any gratuitous benefit on any person and either – (a) that it was made in a transaction at arms length between persons not connected with each other , or 5
o 2. And would otherwise have been a chargeable transfer. Things which are exempt are therefore not PETs. (Knowing one’s exemptions is important here). [Note when looking at past exam papers, lifetime transfers into “interest in possession” trusts and to “accumulation and maintenance trusts” were PETs before 2006. No longer. These are now lifetime chargeable transfers.] The consequences of being a PET are: o 1. If the donor survives for 7 years, the transfer becomes exempt o 2. Until the contrary is proved, it is assumed the donor will survive for seven years : no tax is payable when it is made : it is excluded from the donor's running total of chargeable transfers o 3. If the donor dies within 7 years of the transfer, it becomes chargeable (see later for the computation in this event) Inheritance Tax – Transfers on Death Transfers on death are governed by s.4(1): "On the death of any person tax shall be charged as if, immediately before his death, he had made a transfer of value and the value transferred by it had been equal to the value of his estate immediately before his death." o Exemption - deaths on active service in armed forces, s 154. o Death is the final transfer. But what is the definition of estate here? Section 5 provides as follows: "A person's estate is the aggregate of all the property to which he is beneficially entitled." o Often this will simply equate to ownership. However, beneficial entitlement must be a power to dispose (s.5(2)). It will generally apply to property which is not owned (e.g. in a trust) but the disposal of which could be directed. o Beneficial entitlement includes a share of common property, of partnership property. It excludes excluded property (define) and property accruing after death – e.g. if a company dividend pays out to the executor after death. o Debts: these reduce the value of the estate if incurred for consideration in money or money’s worth (s.5(5)) as do reasonable funeral expenses (s.172) including the cost of the tombstone (SP 7/87). Unsecured debts just reduce the value of the estate, secured debts are treated as first reducing the value of the property on which they are secured s.162(4). This is a relatively complicated area of law. o Expenses of estate administration not deductible, except for foreign property (s.173). Thus, generally, the value of the property on death is taken for IHT purposes. However, changes in the value of the estate which have occurred by reason of death are taken into account as if they had occurred before the death (s.171) (e.g. a Life Insurance Policy.) o This is important in particular in relation to LI policies, which, before an individual is very old are not particularly valuable. The surrender cost of such policies is, moreover, typically very low. This is why there is such a large market in life assurance – they may be sold, instead of surrendered for a larger value. o The increase in value of an LI policy has a deleterious effect for the inheritance taxpayer and therefore policies should be assigned before death. o Some assets (e.g. goodwill) will fall in value after death. Inheritance Tax – Death Reliefs Reliefs available on death include: o 1. Quick succession relief (s.141) 7
When a recipient of a chargeable transfer (on death or inter vivos) dies within 5 years of receiving the transfer, and tax was payable on the making of the transfer, a reduction in tax payable on the second transfer is available. Relief depends on time between first transfer and death. I do not need to know how to calculate this relief. o 2. Relief for fall in value of assets after death Assets must be sold, or if not sold, cancelled or suspended, for relief to be available. 2a. Quoted shares sold within 12 months by the 'appropriate person' or cancelled or suspended within 12 months ss.178-189. Sale price can be substituted for market value at death. Aggregate value of all shares sold must be substituted. Thus if some shares are sold at a profit and others at a loss, this relief should only be claimed if the total for the sale of the shares is lower than their value at the date of death. It may be preferable to wait before sale of certain groups of shares, while selling others beforehand. The former group may also be transferred to a beneficiary in the alternative to result in a lower aggregate. This often comes up in exams. 2b. Sale of land within four years ss 190-198. Relief as above. The ‘appropriate person’ here is the executor (the individual liable to pay tax). o 3. Survivorship clauses (e.g. Will by A containing a provision "to B if she should survive me by 3 months" would avoid a double charge to IHT if B should die shortly after A. The clause itself causes a problem by creating a contingent interest in favour of B – i.e a trust.) Under s.92 as long as the clause is for a period which does not exceed 6 months, the provision in the will is taxed in light of what happened at the end of the period. Liability for IHT on death falls upon: o 1. Personal representatives (ie executors) s 200(1)(a) o 2. Beneficiaries: Liability limited to tax on property received s 200(1)(c) o 3. Vitious intromitters s 199(4)(a) o 4. Where additional tax is due or a PET becomes a CT because of death within 7 years of transfer, donee s 199(2). Thus there may be tax to pay on lifetime chargeable transfers or failed PETs. Note the person with liability to pay the IHT may not be the same as the person who bears the IHT - see later. Inheritance Tax – Gift with Reservation for Benefit Because of the seven year rule, there is a temptation to transfer ownership of property to another person but retain the benefit thereof. There is therefore a high potential for avoidance and therefore provision has been made (FA 1986 s 102 - 102C & sched 20). o The main section (s.102) applies to gifts of “property” and the same rules apply with slight modification where the gift is an interest in land The rule is triggered where there is a gift of property and either o (a) possession and enjoyment of the property is not bona fide assumed by the donee; or Say there is a painting worth £5,000,000 which is given away to children during an individual’s lifetime and loaned to a public body. There is no bona fide possession and enjoyment of the property here. o (b) at any time in the seven years before the donor's death (or the time between the gift and death if less) the donor is not entirely or virtually excluded from – 8
