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.
The first part of the article covered the scope of IHT, transfers of value, rates of tax and exemptions.
When calculating the tax liability on lifetime transfers, there are three aspects which are a bit more difficult to understand and can therefore cause problems for students.
Chargeable lifetime transfer preceded by a potentially exempt transfer which becomes chargeable
The situation where a chargeable lifetime transfer (CLT) is made before a potentially exempt transfer (PET) is fairly straightforward, and was covered in the first part of the article. However, where the sequence of gifts is reversed, the IHT calculations are more complicated because the PET will use some or all of the nil rate band previously given to the CLT.
Grossing up
So far, in all of the examples concerning a CLT, the trust (the donee) has paid any lifetime IHT which has arisen. The loss to the donor’s estate is therefore just the amount of the gift. However, the donor is primarily responsible for any lifetime IHT which arises on a CLT. In this case, the loss to the donor’s estate is both the amount of the gift and the related tax liability. To correctly calculate the amount of IHT payable it is therefore necessary to gross up the net gift.
Any available annual exemptions are deducted prior to grossing up, and it is only necessary to gross up the amount in excess of the nil rate band.
Once the gross chargeable transfer has been calculated, this figure is used in all subsequent calculations. CLTs are never re-grossed up on death, even if the nil rate band is reallocated as a result of a PET becoming chargeable.
When an IHT question involves a CLT, make sure to check who is paying the IHT. Grossing up is not necessary if the trust (the donee) pays.
Seven-year cumulation period
As far as TX-UK is concerned, the most difficult aspect to grasp is the seven-year cumulation period.
When calculating the IHT on a lifetime transfer (either a PET becoming chargeable on death or a CLT), it is necessary to take account of any CLT made within the previous seven years despite this CLT being made more than seven years before the date of the donor’s death. Only CLTs have to be taken into account in this way, because PETs made more than seven years before the date of death are completely exempt.
Lifetime transfers are the easiest way for a person to reduce their potential IHT liability.
Until now, the examples have simply given a figure for the value of a person’s estate. However, it may be necessary to calculate the value.
A person’s estate includes the value of everything which they own at the date of death such as property, shares, vehicles, cash and other investments. A person’s estate also includes the proceeds from life assurance policies even though the proceeds will not be received until after the date of death. The actual market value of a life assurance policy at the date of death is irrelevant.
Funds which have been invested in (and not withdrawn from) a pension fund are outside of a person’s estate. Investing in a pension fund can therefore be a good approach to reducing a person’s liability to IHT. However, it is possible to withdraw 25% of a pension fund as a tax-free lump sum, and any such withdrawal will fall back into the estate.
The following deductions are permitted:
For residence nil rate band purposes, the value of the main residence is after deducting any repayment mortgage or interest-only mortgage secured on that property.
If a main residence is valued at less than the available residence nil rate band, the residence nil rate band is reduced to the value of the residence.
Chargeable lifetime transfers
The donor is primarily responsible for any IHT which has to be paid in respect of a CLT. However, a question may state that the donee is to instead pay the IHT. Remember that grossing up is only necessary where the donor pays the tax.
The due date is the later of:
Therefore, if a CLT is made between 6 April and 30 September in a tax year, any IHT will be due on the following 30 April. If a CLT is made between 1 October and 5 April in a tax year, any IHT will be due six months from the end of the month in which the gift is made.
The donee is always responsible for any additional IHT which becomes payable as a result of the death of the donor within seven years of making a CLT. The due date is six months after the end of the month in which the donor died.
Potentially exempt transfers
The donee is always responsible for any IHT which becomes payable as a result of the death of the donor within seven years of making a PET. The due date is six months after the end of the month in which the donor died.
Death estate
The personal representatives of the deceased’s estate are responsible for any IHT which is payable. The due date is six months after the end of the month in which death occurred. However, the personal representatives are required to pay the IHT when they deliver their account of the estate assets to HM Revenue and Customs (HMRC), and this may be earlier than the due date.
Where part of the estate is left to a spouse, this part will be exempt and will not bear any of the IHT liability. Where a specific gift is left to a beneficiary, this gift will not normally bear any IHT. The IHT is therefore usually paid out of the non-exempt residue of the estate.
Make gifts early in life
Gifts should be made as early in life as possible so that there is a greater chance of the donor surviving for seven years.
Gifts made just before death will be of little or no IHT benefit, and may result in a capital gains tax (CGT) liability (whereas transfers on death are exempt disposals for CGT purposes).
Make use of the nil rate band
Gifts can be made to trusts up to the amount of the nil rate band every seven years without incurring any immediate charge to IHT.
Gifts to trusts within seven years of each other will be subject to the seven-year cumulation period, whilst an immediate charge to IHT will arise if a gift exceeds the nil rate band.
However, as far as TX-UK is concerned, there is no advantage to making gifts to a trust on death. This will not save any IHT.
Skip a generation
When making gifts either during lifetime or on death, it can be beneficial to skip a generation so that gifts are made to grandchildren rather than children. This avoids a further charge to IHT when the children die. Gifts will then only be taxed once before being inherited by the grandchildren, rather than twice.
Of course, such planning depends on the children already having sufficient assets for their financial needs.
Residence nil rate band
Given that the residence nil rate band is only available where inheritance is by direct descendants, rearranging the terms of a will can save IHT.
Although the interaction of IHT and CGT is not examinable at TX-UK, the two taxes could be examined within the same question and the information given could be relevant to both taxes.
For a lifetime gift of unquoted shares, the IHT transfer of value will be based on the diminution in value of the donor’s estate. In contrast, for CGT purposes the valuation will be based on the market value of the shares gifted.
As far as tax planning is concerned, a lifetime gift can avoid or reduce the IHT which would arise if assets were retained until death. However, the potential IHT saving must be weighed against any immediate CGT cost. There are no CGT implications if assets are retained until death, because transfers on death are exempt disposals for CGT purposes. CGT is of course not an issue if a cash gift is made.
Written by a member of the TX-UK examining team