Inheritance tax (IHT) is clearly one of the most pressing concerns among advisers. Here, Francesca Gandolfi and Kim Jarvis of Canada Life International list the most common queries from advisers, including crucial information on exemptions, periodic charges, and the 14-year shadow
1. Transferable nil rate bands.
If, on first death, everything is left to the surviving spouse/civil partner, does the survivor now have a lifetime gift threshold of £650,000?
Unfortunately the answer is no, as any available transferable nil rate band (TNRB) can only be used against the IHT arising on the death of the surviving spouse - it is not eligible to be used by the surviving spouse/civil partner for lifetime gifting.
There is also a lot of confusion around transferring the residence nil rate band (RNRB), which was introduced in April 2017. The RNRB is transferable between spouses/civil partners on death, much like the standard nil rate band (NRB). It is the unused percentage of the RNRB from the estate of the first to die which can be claimed on the second death. If the first death occurred before April 2017, on the survivor's death there will be a 100% RNRB available irrespective of whether the first death owned residential property. However, if the first death's estate was greater than £2m, then the RNRB would be tapered.
Remember that nil rate bands transfer as percentages not amounts, ensuring that the NRB at the time of the second death is increased by the proportion of the NRB unused on the first death. For example, Janet died in 2008/09 when the NRB was £312,000. She left £156,000 to the children and everything else to her husband John who subsequently died in 2018, when the NRB was £325,000. As 50% of Janet's NRB was unused John's personal representatives can increase his NRB by 50% to £487,500. John's personal representatives would also be able to claim 100% of Janet's RNRB as her estate was less than £2m.
2. Periodic Charges.
What should be included at the tenth anniversary and what nil rate band needs to be used?
The answer depends on the type of trust. Calculating the value of a trust is relatively straightforward if you are dealing with a discretionary gift trust, however it is a little more complicated for gift and loan trusts and discounted gift trusts.
Under a gift and loan trust, any outstanding loan due back to the settlor needs to be deducted from the value of the trust as the trustees have an outstanding liability that needs to be taken into account when calculating the net value of the trust.
For a discounted gift trust, if the settlor is still alive, the trustees have an obligation to provide the regular payments to them and the actuarial value of this commitment should be deducted from the value of the trust.
When looking at what distributions need to be factored into the periodic charge calculation, these refer to the distributions to beneficiaries.
If the trust allows reversions back to the settlor and these are correctly carved-out in the trust at outset, they will not be treated as distributions (for example, discounted gift trusts and flexible reversionary trusts). Likewise, neither will any loan repayments made to a settlor under a gift and loan trust be treated as a distribution.
Whether a ten-yearly anniversary IHT charge is payable or not, the reporting requirements apply where the value of the trust is over 80% of the available NRB (currently £260,000). The trustees may therefore have an obligation to report the trust to HMRC even though no tax charge arises.
The trustees then need to consider the NRB available to the trust. The amount available will be the NRB at the tenth anniversary less any chargeable transfers made by the settlor in the seven years before this trust was created. From this you can see that the trustees will need to be aware of previous transfers made by the settlor and that these gifts can have an impact for the lifetime of the trust.
Let us consider an example:
- In January 2013 Lisa made a gift of £400,000 to her daughter. As this is a potentially exempt transfer (PET) no tax is payable.
- In January 2017 Lisa sets up a discretionary trust with a gift of £200,000. Lisa regularly used her £3,000 annual gift exemption. This is a chargeable lifetime transfer (CLT).
- As the CLT is below the available nil rate band no tax is payable.
- Lisa sadly dies in January 2019.
- In January 2027 the trustees must calculate whether a periodic charge is due. The trust value has grown to £250,000 and the NRB has increased to £350,000.
- As Lisa died within seven years of the PET, the PET failed and became chargeable. As the failed PET was £400,000 the available NRB at the ten-yearly anniversary (2027) is zero.
- Therefore a periodic charge will be payable in 2027 on the trust of 6% x £250,000 = £15,000.
As more discretionary trusts approach their tenth anniversary, questions around how the periodic charge is calculated have increased.
3. 14 year shadow.
When does the shadow take effect?
The 14 year shadow is only an issue if, on death, the total of the CLTs and PETs made in the previous seven years exceeds the available nil rate band, meaning that tax is payable.
For those considering making a PET and a CLT at or around the same time, it is logical to make the CLT before the PET as this can impact the periodic charges. However, when making a PET the donor should also be wary of any CLTs made in the previous seven years, and this is where professional advice is paramount.
Let's consider two clients, Bert and Eric. Both die on 6 April 2022, when the NRB is £370,000, with estates valued at £500,000 each. Both had made gifts in the previous seven years:
- Bert made a £200,000 outright gift to his daughter on 6 April 2015 and then a £200,000 gift into a discretionary trust on 6 April 2018.
- Eric also made the same gifts but he settled the £200,000 into the discretionary trust on the 6 April 2015, with the outright gift to his daughter on the 6 April 2018.
- Both are divorced so when calculating the tax payable on the estates they have one NRB. Bert and Eric's 2015 gifts can be ignored as they survived seven years, but the 2018 gifts need to be considered. Both use up the NRB first, meaning that the estate has a NRB of £170,000 (£370,000 - £200,000). This results in £330,000 being taxable at 40%, giving an IHT liability on both estates of £132,000.
But if both estates have the same tax liability where does the 14 year shadow come in?
Now we need to consider the tax on Eric's 2018 failed PET. In considering the tax on the estate, we have to look back at the history of gifts in the seven years before death. However, when looking at the tax on a failed PET, we have to go back seven years from the date of the PET; and Eric had made a CLT within this seven year period.
Even though it was made more than seven years before death, the CLT now needs to be taken into account in calculating the tax on the failed PET. Consequently, the failed PET has to be placed on top of the previous CLT, meaning that there is an extra liability of £7,200 ((£200,000 + £200,000) - £370,000 x 40% x 60%).
Although, taper relief is available here, the point is that CLTs made in the seven years before PETs can continue to have an impact.
4. What is the difference in domicile and residence?
Domicile should not be confused with residence. It is, in simple terms, the country in which you have your permanent home. If you leave the UK, you do not automatically change your domicile and you will still be treated as UK domiciled for the next three calendar years for the purposes of IHT.
If you are from a foreign country and have come to live in the UK, you are treated as ‘deemed domiciled' and charged to IHT once you have been resident here for at least 15 out of the last 20 tax years.
If you are not domiciled, or deemed domicile, in the UK, IHT will only be levied on your UK assets if their value exceeds the nil rate band threshold.
5. What exemptions and reliefs are available?
There are a number of exemptions and reliefs available to individuals bother during their lifetime, and on their death, including:
- Transferable nil rate band - if all assets pass from one spouse/civil partner to another on death, any unused portion of the nil rate band of the first to die also transfers, leaving the surviving spouse/civil partner a potential £650,000 nil rate band.
- Spouse or civil partner exemption - assets passed between spouses/civil partners during their lifetime are not counted as gifts when valuing an estate.
- £3,000 annual exemption - a person can give away £3,000 in any one tax year free from IHT. This can be carried forward but only by one year, and only where the full allowance is used for the current year.
- Charity exemption - donations to registered charities are not counted as gifts when valuing an estate.
- Small gift exemption - a person can make outright gifts of up to £250 in total, to each of any number of people in one year, and these will be exempt from IHT. The total of any one person's allowance cannot form part of any larger gift.
- Other exempt gifts include cash or gifts for weddings or civil partnership ceremonies. On these occasions parents can each make gifts worth £5,000, grandparents £2,500 and anyone else £1,000 and these will be exempt from IHT.
- Regular gifts out of income may also be exempt from IHT.
- Business and agricultural property relief - if an individual own shares in a trading company, company property (provided they are a majority shareholder) or agricultural property, this relief may reduce their inheritance tax liability.
Francesca Gandolfi and Kim Jarvis are Technical Managers at Canada Life International.