# Inheritance tax, part 2

The Paper F6 (UK) syllabus requires a basic understanding of inheritance tax (IHT), and this two-part article covers those aspects that you need to know. It is relevant to candidates sitting Paper F6 (UK) in an exam in the period 1 April 2015 to 30 June 2016, and is based on tax legislation as it applies to the tax year 2014–15 (Finance Act 2014).

The first part of the article covered the scope of IHT, transfers of value, rates of tax and exemptions.

#### Tax liability on lifetime transfers

When calculating the tax liability on lifetime transfers there are three aspects that are a bit more difficult to understand, and can therefore cause problems for students.

Chargeable lifetime transfer preceded by a potentially exempt transfer that becomes chargeable
The situation where a chargeable lifetime transfer (CLT) is made before a potentially exempt transfer (PET) is fairly straightforward, and has been covered in previous examples. 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.

Example 1

• 1 August 2012 – A gift of £360,000 to his son
• 21 November 2013 – A gift of £240,000 to a trust

These figures are after deducting available exemptions.

The nil rate band for the tax years 2012–13 and 2013–14 is £325,000.

IHT liabilities are as follows:

£
1 August 2012
Potentially exempt transfer360,000
21 November 2013
Chargeable transfer240,000

• No lifetime IHT is payable as the CLT is less than the nil rate band for 2013–14.

£
1 August 2012
Potentially exempt transfer360,000

IHT liability 325,000 at nil%
35,000 at 40%
0
14,000

14,000
£

21 November 2013
Chargeable transfer240,000

IHT liability 240,000 at 40%
96,000
(Nil)

• The nil rate band for 2014–15 of £325,000 has been fully utilised by the PET made on 1 August 2012.

Grossing up
In all the examples so far concerning a CLT the trust (the donee) has paid any lifetime IHT that 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 that 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.

Example 2
On 17 June 2011 Annie made a gift of £406,000 to a trust. She paid the IHT arising from the gift.

The nil rate band for the tax year 2011–12 is £325,000.

The lifetime IHT liability is calculated as follows:

££
Value transferred 406,000
Annual exemptions
2011–12
2010–11

3,000
3,000

(6,000)
Net chargeable transfer 400,000
IHT liability
325,000 at nil%
75,000 x 20/80

0
18,750

Gross chargeable transfer 418,750

• The amount of lifetime IHT payable by Annie is £18,750. This figure can be checked by calculating the IHT on the gross chargeable transfer of £418,750:
£
IHT liability
325,000 at nil%
93,750 at 20%

0
18,750

18,750

Once the gross chargeable transfer has been calculated then 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.

Example 3
Continuing with example 2, assuming that Annie died on 12 March 2015.

17 June 2011

£
Gross chargeable transfer418,750

IHT liability
325,000 at nil%
93,750 at 40%

0
37,500

Taper relief reduction – 20%(7,500)
30,000

When an IHT question involves a CLT then make sure you know who is paying the IHT. Grossing up is not necessary if the trust (the donee) pays.

Seven-year cumulation period
As far as Paper F6 (UK) is concerned the most difficult aspect to grasp is the seven year cumulation period.

What the seven-year cumulation period means is that when calculating the IHT on a lifetime transfer (either a PET becoming chargeable or a CLT) it is necessary to take account of any CLT made within the previous seven years despite it being made more than seven years before the date of the donor’s death. Only CLTs have to be taken into account, as PETs made more than seven years before the date of death are completely exempt.

Example 4

• 1 August 2006 – A gift of £200,000 to a trust
• 1 November 2012 – A gift of £280,000 to a trust

These figures are after deducting available exemptions. In each case the trust paid any IHT arising from the gift.

The nil rate band for the tax year 2006–07 is £285,000, and for the tax year 2012–13 it is £325,000.

IHT liabilities are as follows:

1 August 2006

£
Chargeable transfer200,000

• No lifetime IHT is payable as the CLT is less than the nil rate band for 2006–07.

1 November 2012

£
Chargeable transfer280,000

IHT liability
125,000 at nil%
155,000 at 20%

0
31,000

31,000
• The CLT made on 1 August 2006 is within seven years of 1 November 2012, so it utilises £200,000 of the nil rate band for 2012–13.

1 August 2006

£
Chargeable transfer200,000

• There is no additional liability as this CLT was made more than seven years before the date of Ja’s death on 18 March 2015.

1 November 2012

£
Chargeable transfer280,000

IHT liability
125,000 at nil%
155,000 at 40%

0
62,000

• The CLT made on 1 August 2006 utilises £200,000 of the nil rate band for
2014–15 of £325,000.

Death estate

£
Chargeable estate450,000

IHT liability
45,000 at nil%
405,000 at 40%

0
162,000

162,000

• The CLT made on 1 August 2006 is not relevant when calculating the IHT on the death estate as it was made more than seven years before the date of Ja’s death on 18 March 2015.
• Therefore only the CLT made on 1 November 2012 is taken into account, and this utilises £280,000 of the nil rate band of £325,000.

Example 5

The same situation as in example 4, except that on 1 November 2012 Ja made a gift of £280,000 to her daughter rather than to a trust.

IHT liabilities are as follows:

£
1 August 2006
Chargeable transfer200,000

1 November 2012
Potentially exempt transfer280,000

£
1 August 2006
Chargeable transfer200,000

1 November 2012
Potentially exempt transfer280,000

IHT liability
125,000 at nil%
155,000 at 40%

0
62,000

62,000

Death estate
Chargeable estate450,000

IHT liability
45,000 at nil%
405,000 at 40%

0
162,000

162,000

Lifetime transfers are the easiest way for a person to reduce their potential IHT liability.

• A PET is completely exempt after seven years.
• A CLT will not incur any additional IHT liability after seven years.
• Even if the donor does not survive for seven years, taper relief will reduce the amount of IHT payable after three years.
• The value of PETs and CLTs is fixed at the time they are made, so it can be beneficial to make gifts of assets that are expected to increase in value such as property or shares.

#### Tax liability on death estate

Until now the examples have simply given a figure for the value of a person’s estate. However, it may be necessary to calculate it.

A person’s estate includes the value of everything which they own at the date of death such as property, shares, motor vehicles, cash and other investments. A person’s estate also includes the proceeds from life assurance policies even though these 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.

The following deductions are permitted:

• Funeral expenses
• Debts due by the deceased provided they can be legally enforced. Therefore gambling debts cannot be deducted, nor can debts that are unenforceable because there is no written evidence.
• Mortgages on property. This does not include endowment mortgages as these are repaid upon death by the life assurance element of the mortgage. Repayment mortgages and interest-only mortgages are deductible.

Example 6

Andy died on 31 December 2014. At the date of his death he owned the following assets:

• A main residence valued at £425,000. This had an outstanding interest-only mortgage of £180,000.
• Motor cars valued at £63,000.
• Ordinary shares in Herbert plc valued at £54,000.
• Building society deposits of £25,000.
• Investments in new individual savings accounts valued at £22,000, savings certificates from NS&I (National Savings and Investments) valued at £19,000, and government stocks (gilts) valued at £34,000.
• A life assurance policy on his own life. On 31 December 2014 the policy had an open market value of £85,000, and proceeds of £100,000 were received following Andy’s death.

On 31 December 2014 Andy owed £700 in respect of credit card debts, and he had also verbally promised to pay the £800 legal fee of a friend. The cost of his funeral amounted to £4,300.

££
Property425,000
Mortgage(180,000)
245,000
Motor cars 63,000
Ordinary shares in Herbert plc
54,000

Building society deposits
25,000

Other investments (22,000 + 19,000 + 34,000)

75,000

Proceeds of life assurance policy 100,000
562,000
Credit card debts700
Funeral expenses4,300
(5,000)
Chargeable estate 557,000
IHT liability
325,000 at nil%
232,000 at 40%

0
92,800

92,800

• The promise to pay the friend’s legal fee is not deductible as it is not legally enforceable.
• Unlike capital gains tax, there is no exemption for motor cars, new individual savings accounts, saving certificates from NS&I or for government stocks.
• The IHT liability on the life assurance policy could have easily been avoided if the policy had been written into trust for the beneficiaries of Andy’s estate. The proceeds would have then been paid direct to the beneficiaries, and not formed part of Andy’s estate. However, this aspect is not examinable at Paper F6 (UK).

#### Payment of inheritance tax

The donor is primarily responsible for any IHT that 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:

• 30 April following the end of the tax year in which the gift is made.
• Six months from the end of the month in which the gift is made.

Therefore if a CLT is made between 6 April and 30 September in a tax year then 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 then 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 that 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 additional IHT that 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 that 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, and this may be earlier than the due date.

Where part of the estate is left to a spouse then this part will be exempt and will not bear any of the IHT liability. Where a specific gift is left to a beneficiary then this gift will not normally bear any IHT. The IHT is therefore usually paid out of the non-exempt residue of the estate.

Example 7

• 20 November 2012 – A gift of £420,000 to a trust. Alfred paid the IHT arising from this gift.
• 8 August 2013 – A gift of £360,000 to his son.

These figures are after deducting available exemptions.

Alfred’s estate at 15 December 2014 was valued at £850,000. Under the terms of his will he left £250,000 to his wife, a specific legacy of £50,000 to his brother, and the residue of the estate to his children.

The nil rate band for the tax years 2012–13 and 2013–14 is £325,000.

IHT liabilities are as follows:

20 November 2012

£
Net chargeable transfer420,000
IHT liability
325,000 at nil%
95,000 x 20/80

0
23,750

Gross chargeable transfer443,750

• The due date for the IHT liability of £23,750 payable by Alfred was 31 May 2013.

8 August 2013

£
Potentially exempt transfer360,000

• The PET is initially ignored.

20 November 2012

£
Gross chargeable transfer443,750

IHT liability
325,000 at nil%
118,750 at 40%

0
47,500

• The due date for the additional IHT liability of £23,750 payable by the trust is 30 June 2015.

8 August 2013

£
Potentially exempt transfer360,000
IHT liability 360,000 at 40%144,000

• The CLT made on 20 November 2012 has fully utilised the nil rate band.
• The due date for the IHT liability of £144,000 payable by Alfred’s son is 30 June 2015.

Death estate

£
Value of estate850,000
Spouse exemption(250,000)
Chargeable estate600,000
IHT liability 600,000 at 40%240,000

• The due date for the IHT liability of £240,000 payable by the personal representatives of Alfred’s estate is 30 June 2015.
• Alfred’s wife will inherit £250,000, his brother will inherit £50,000, and the children will inherit the residue of £310,000 (850,000 – 250,000 – 50,000 – 240,000).

#### Basic inheritance tax planning

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 liability (whereas transfers on death are exempt disposals for capital gains tax 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.

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.

#### Exam standard question

The following is typical of an exam question that could be set on IHT in Section B of Paper F6 (UK).

• 3 March 2007 – A gift of £126,000 to a trust.
• 23 June 2011 – A gift of £240,000 to her daughter.
• 2 September 2011 – A gift of £300,000 to a trust.

Jing paid any IHT arising from the gifts to the trusts.

The nil rate band for the tax year 2006–07 is £285,000, and for the tax year 2011–12 it is £325,000.

Required:

Calculate the inheritance tax that will be payable as a result of Jing’s death.
(10 marks)

Jing – Inheritance tax computation

3 March 2007

£
Value transferred 126,000
Annual exemptions
2006–07
2005–06

3,000
3,000

(6,000)
Chargeable transfer 120,000

23 June 2011

£
Value transferred 240,000
Annual exemptions
2011–12
2010–11

3,000
3,000

(6,000)
Potentially exempt transfer 234,000

2 September 2011

£
Net chargeable transfer300,000

IHT liability
205,000 at nil%
95,000 x 20/80

0
23,750

Gross chargeable transfer323,750

Notes:

1. No lifetime IHT is payable in respect of the CLT made on 3 March 2007 as it is less than the nil rate band for 2006–07.
2. The PET made on 23 June 2011 utilises the annual exemptions for 2011–12 and 2010–11, therefore there is no annual exemption left to use against the CLT made on 2 September 2011.
3. The CLT made on 3 March 2007 is within seven years of the CLT made on 2 September 2011, so it utilises £120,000 of the nil rate band for 2011–12.

3 March 2007

£
Chargeable transfer120,000

23 June 2011

£
Potentially exempt transfer234,000

IHT liability
205,000 at nil%
29,000 at 40%

0
11,600

Taper relief reduction – 20%(2,320)
9,280

2 September 2011

£
Gross chargeable transfer323,750

IHT liability 323,750 at 40%129,500
Taper relief reduction – 20%(25,900)
103,600