The TX-UK syllabus requires a basic understanding of inheritance tax (IHT), and this two-part article covers those aspects which you need to know. It is relevant to those of you who are taking TX-UK in an exam in the period 1 June 2024 to 31 March 2025, and is based on tax legislation as it applies to the tax year 2023-24 (Finance Act 2023).
The Finance (No. 2) Act 2023 did not receive Royal Assent by the exam cut-off date of 31 May 2023, and is therefore not examinable as regards exams falling in the period 1 June 2024 to 31 March 2025.
IHT is paid on the value of a person’s estate when they die, but it also applies to certain lifetime transfers of assets. If IHT did not apply to lifetime transfers, it would be very easy for a person to avoid tax by giving away all of their assets just before they died.
As far as TX-UK is concerned, the terms ‘transfer’ and ‘gift’ can be taken to mean the same thing. The person making a transfer is known as the donor, whilst the person receiving the transfer is known as the donee.
Unlike capital gains tax where, for example, a private residence can be exempt, all of a person’s estate is generally chargeable to IHT.
A person who is domiciled in the UK is liable to IHT in respect of their worldwide assets. As far as TX-UK is concerned, people will always be domiciled in the UK.
For TX-UK, the only relevant chargeable person is an individual. A married couple (and a registered civil partnership) is not a chargeable person because each spouse (or civil partner) is taxed separately.
During a person’s lifetime, IHT can only arise if a transfer of value is made. A transfer of value is defined as ‘any gratuitous disposition made by a person which results in a diminution in value of that person’s estate’. There are two important terms in this definition:
Gratuitous: Poor business deals, for example, are not normally transfers of value because there is no gratuitous intent.
Diminution in value: There will normally be no difference between the diminution in value of the donor’s estate and the increase in value of the donee’s estate. However, in some cases it may be necessary to compare the value of the donor’s estate before the transfer and the value after the transfer in order to compute the diminution in value. This will usually be the case where unquoted shares are concerned. Shares forming part of a controlling shareholding will be valued higher than shares forming part of a minority shareholding.
As far as TX-UK is concerned, a transfer of value will always be a gift of assets. A gift made during a person’s lifetime may be either potentially exempt or chargeable.
Any transfer which is made to another individual is a potentially exempt transfer (PET). A PET only becomes chargeable if the donor dies within seven years of making the gift. If the donor survives for seven years, the PET becomes exempt and can be completely ignored. Hence such a transfer has the potential to be exempt.
If the donor dies within seven years of making a PET, it becomes chargeable. Tax will be charged according to the rates and allowances applicable to the tax year in which the donor dies. However, the value of a PET is fixed at the time when the gift is made.
Any transfer which is made to a trust is a chargeable lifetime transfer (CLT).
There is no legal definition of what a trust is, but essentially a trust arises where a person transfers assets to people (the trustees) to hold for the benefit of other people (the beneficiaries). For example, parents may not want to make an outright gift of assets to their young children. Instead, assets can be put into a trust with the trust being controlled by trustees until the children are older.
Unlike a PET, a CLT is immediately charged to IHT based on the rates and allowances applicable to the tax year in which the CLT is made. An additional tax liability may then arise if the donor dies within seven years of making the gift. Just as for a PET, the value of a CLT is fixed at the time when the gift is made, but the additional tax liability is calculated using the rates and allowances applicable to the tax year in which the donor dies.
Rates of tax
IHT is payable once a person’s cumulative chargeable transfers over a seven-year period exceed a nil rate band. For the tax year 2023-24, the nil rate band is £325,000, and has been the same amount since the tax year 2009-10.
The rate of IHT payable as a result of a person’s death is 40%. This is the rate which is charged on a person’s estate at death, on PETs which become chargeable as a result of death within seven years, and is also the rate used when calculating additional tax payable on CLTs made within seven years of death.
An additional nil rate band is available where a main residence is inherited on death by direct descendants (children and grandchildren). For the tax year 2023-24, the residence nil rate band is £175,000. The residence nil rate band is only relevant where an individual dies on or after 6 April 2017 and their estate includes a main residence. Any other type of property, such as a property which has been let out, does not qualify for the residence nil rate band.
The rate of IHT payable on CLTs at the time they are made is 20% (half the death rate). This is the lifetime rate.
The tax rates information which will be given in the tax rates and allowances section of the exam in the period 1 June 2024 to 31 March 2025 is:
| Nil rate band | £325,000 |
| Residence nil rate band | £175,000 |
| Rates of tax on excess – Lifetime rate – Death rate | 20% 40% |
Where earlier nil rate bands may be relevant, they will be given to you within the question.
A question will make it clear if the residence nil rate band is available. Therefore, you should assume that the residence nil rate band is not available if there is no mention of a main residence.
It is important to appreciate that the residence nil rate band does not apply to lifetime transfers becoming chargeable as a result of the donor’s death within seven years.
It would be somewhat unfair if a donor did not quite live for seven years after making a gift with the result that the gift was fully chargeable to IHT. Therefore, taper relief reduces the amount of tax payable where a donor lives for more than three years, but less than seven years, after making a gift. The reduction is as follows:
| Years before death | Percentage reduction % |
|---|---|
| More than three years but less than four years | 20 |
| More than four years but less than five years | 40 |
| More than five years but less than six years | 60 |
| More than six years but less than seven years | 80 |
Although taper relief reduces the amount of tax payable, it does not reduce the value of a gift for cumulation purposes.
The taper relief table will be given in the tax rates and allowances section of the exam.
Any unused nil rate band on a person’s death can be transferred to their surviving spouse (or registered civil partner). The nil rate band will often not be fully used on the death of the first spouse because any assets left to the surviving spouse are exempt from IHT (see the following section on transfers to spouses).
A claim for the transfer of any unused nil rate band is made by the personal representatives who are looking after the estate of the second spouse to die. The amount which can be claimed is based on the proportion of the nil rate band not used when the first spouse died. Even though the first spouse may have died several years ago when the nil rate band was much lower, the amount which can be claimed on the death of the second spouse is calculated using the current limit of £325,000.
In the same way in which any unused normal nil rate band can be transferred to a surviving spouse (or registered civil partner), the residence nil rate band is also transferable. It does not matter when the first spouse died.
Transfers to spouses
Gifts to spouses (and registered civil partners) are exempt from IHT. This exemption applies both to lifetime gifts and on death.
There are a number of other exemptions which only apply to lifetime gifts.
Small gifts exemption
Gifts up to £250 per person in any one tax year are exempt. If a gift is more than £250, the small gifts exemption cannot be used. However, it is possible to use the exemption any number of times by making gifts to different donees.
Annual exemption
Each tax year a person has an annual exemption of £3,000. If the whole of the annual exemption is not used in any tax year, the balance is carried forward to the following tax year. However, the exemption for the current tax year must be used first, and any unused brought forward exemption cannot be carried forward a second time. Therefore, the maximum amount of annual exemptions available in any tax year is £6,000 (3,000 x 2).
The annual exemption is applied on a strict chronological basis, and is therefore given against PETs even when they do not become chargeable.
Normal expenditure out of income
IHT is not intended to apply to gifts of income. Therefore, a gift is exempt if it is made as part of a person’s normal expenditure, is made out of income and that person is left with sufficient income to maintain their normal standard of living. To count as normal, gifts must be habitual. Therefore, regular annual gifts of £2,500 made by a person with an annual income of £100,000 should be exempt. A one-off gift of £70,000 made by the same person would probably not be, instead it would be a PET or a CLT.
Gifts in consideration of marriage
This exemption covers gifts made in consideration of a couple getting married or registering a civil partnership. The amount of exemption depends on the relationship of the donor to the donee (who must be one of the two persons getting married):
The second part of the article will cover the more difficult aspects of lifetime transfers, the calculation of the value of a person’s estate, the payment of IHT and basic IHT planning. It also includes a test of your understanding.
Written by a member of the TX-UK examining team