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 2023 to 31 March 2024, and is based on tax legislation as it applies to the tax year 2022–23 (Finance Act 2022).
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.
EXAMPLE 1
On 4 May 2022, Daniel made a gift to his son of 15,000 £1 ordinary shares in ABC Ltd, an unquoted investment company. Before the transfer, Daniel owned 60,000 shares out of ABC Ltd’s issued share capital of 100,000 £1 ordinary shares. ABC Ltd’s shares are worth £18 each for a holding of 60%, £10 each for a holding of 45% and £8 each for a holding of 15%.
Although Daniel’s son received a 15% shareholding valued at £120,000 (15,000 x £8), Daniel’s transfer of value is calculated as follows:
| £ |
|
|---|---|
| Value of shares held before the transfer 60,000 x £18 | 1,080,000 |
| Value of shares held after the transfer 45,000 x £10 | 450,000 |
| Value transferred | 630,000 |
In contrast, for capital gains tax purposes the valuation will be based on the market value of the shares gifted, which is £120,000.
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.
EXAMPLE 2
Sophie died on 23 January 2023. She had made the following lifetime gifts:
The gift to Sophie’s son on 8 November 2015 is a PET for £450,000. Because the PET was made more than seven years before the date of Sophie’s death, it is exempt from IHT.
The gift to Sophie’s daughter on 12 August 2020 is a PET for £610,000 and is initially ignored. It becomes chargeable as a result of Sophie dying within seven years of making the gift, and the transfer of £610,000 will be charged to IHT based on the rates and allowances for 2022–23. Note that the increase in the value of the house is not relevant when considering this PET on Sophie’s death.
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.
EXAMPLE 3
Lim died on 4 December 2022. She had made the following lifetime gifts:
The gift to the trust on 2 November 2015 is a CLT for £420,000, and will be immediately charged to IHT based on the rates and allowances for 2015-16. There will be no additional tax liability as the gift was made more than seven years before the date of Lim’s death.
The gift to the trust on 21 August 2020 is a CLT for £615,000, and will be immediately charged to IHT based on the rates and allowances for 2020-21. Lim has died within seven years of making the gift, so an additional tax liability may arise based on the rates and allowances for 2022–23. Note that the increase in the value of the house is not relevant when considering this CLT on Lim’s death.
IHT is payable once a person’s cumulative chargeable transfers over a seven-year period exceed a nil rate band. For the tax year 2022–23, 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 2022–23, 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 2023 to 31 March 2024 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.
EXAMPLE 4
Sophie died on 26 May 2022 leaving an estate valued at £850,000. Under the terms of her will, Sophie’s estate was left to her children (the residence nil rate band is not available).
The IHT liability is:
Death estate
| £ | |
|---|---|
| Chargeable estate | 850,000 |
| IHT liability 325,000 at nil% 525,000 at 40% | 0 210,000 |
| 210,000 |
EXAMPLE 5
Continuing with example 4, assume that Sophie’s estate included a main residence valued at £325,000.
The IHT liability will then be:
Death estate
| £ | |
|---|---|
| Chargeable estate | 850,000 |
| IHT liability 175,000 at nil% 325,000 at nil% 350,000 at 40% | 0 0 140,000 |
| 140,000 |
The residence nil rate band of £175,000 is available because Sophie’s estate included a main residence and this was left to her direct descendants.
EXAMPLE 6
Ming died on 22 April 2022 leaving an estate valued at £300,000 (the residence nil rate band is not available).
On 30 April 2020, she had made a gift of £240,000 to her son. This figure is after deducting available exemptions.
IHT liabilities are:
Lifetime transfer – 30 April 2020
| £ | |
|---|---|
| Potentially exempt transfer | 240,000 |
The PET is initially ignored when made on 30 April 2020.
Additional liability arising on death – 30 April 2020
| £ | |
|---|---|
| Potentially exempt transfer | 240,000 |
The PET utilises £240,000 of the nil rate band of £325,000 for 2022–23. No IHT is payable on Ming’s death in respect of the PET.
Death estate
| £ | |
|---|---|
| Chargeable estate | 300,000 |
| IHT liability 85,000 at nil% 215,000 at 40% | 0 86,000 |
| 86,000 |
Only £85,000 (325,000 – 240,000) of the nil rate band is available against the death estate.
EXAMPLE 7
Joe died on 13 October 2022 leaving an estate valued at £750,000 (the residence nil rate band is not available).
On 12 November 2019, he had made a gift of £400,000 to a trust. This figure is after deducting available exemptions. The trust paid the IHT arising from the gift.
The nil rate band for the tax year 2019-20 is £325,000.
IHT liabilities are:
Lifetime transfer – CLT on 12 November 2019
| £ | |
|---|---|
| Chargeable transfer | 400,000 |
| IHT liability 325,000 at nil% 75,000 at 20% | 0 15,000 |
| 15,000 |
The gift to a trust is a CLT. The lifetime IHT liability is calculated using the nil rate band for 2019-20.
Additional liability arising on death – CLT on 12 November 2019
| £ | |
|---|---|
| Chargeable transfer | 400,000 |
| IHT liability 325,000 at nil% 75,000 at 40% | 0 30,000 |
| IHT already paid | (15,000) |
| Additional liability | 15,000 |
The additional liability arising on death is calculated using the nil rate band for 2022–23.
Death estate
| £ | |
|---|---|
| Chargeable estate | 750,000 |
| IHT liability 750,000 at 40% | 300,000 |
The CLT made on 12 November 2019 has fully utilised the nil rate band of £325,000.
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.
EXAMPLE 8
Tony died on 16 August 2022 leaving an estate valued at £775,000. Under the terms of his will, Tony’s estate was left to his grandchildren. The estate included a main residence valued at £435,000.
On 30 April 2020, Tony had made a PET of £400,000 to his son.
IHT liabilities are:
Lifetime transfer – PET on 30 April 2020
| £ | |
|---|---|
| Potentially exempt transfer The PET is initially ignored | 400,000 |
Additional liability arising on death – PET on 30 April 2020
| £ | |
|---|---|
| Potentially exempt transfer | 400,000 |
| IHT liability 325,000 at nil% 75,000 at 40% | 0 30,000 |
| 30,000 |
Death estate
| £ | |
|---|---|
| Chargeable estate | 775,000 |
| IHT liability 175,000 at nil% 600,000 at 40% | 0 240,000 |
| 240,000 |
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.
EXAMPLE 9
Winnie died on 9 January 2023. She had made the following lifetime gifts:
These figures are after deducting available exemptions.
The nil rate band for the tax years 2015-16 and 2019-20 is £325,000.
IHT liabilities are:
| Lifetime transfers | £ |
|---|---|
| 2 February 2016 | |
| Chargeable transfer | 460,000 |
| IHT liability 325,000 at nil% 135,000 at 20% | 0 27,000 |
| 27,000 | |
| 16 August 2019 | |
| Potentially exempt transfer The PET is initially ignored | 320,000 |
| Additional liabilities arising on death | |
| CLT on 2 February 2016 | |
| Chargeable transfer | 460,000 |
| IHT liability 325,000 at nil% 135,000 at 40% | 0 54,000 |
| Taper relief reduction – 80% | (43,200) |
| 10,800 | |
| IHT already paid | (27,000) |
| Additional liability | 0 |
PET on 16 August 2019
| £ | |
|---|---|
| Potentially exempt transfer | 320,000 |
| IHT liability 320,000 at 40% | 128,000 |
| Taper relief reduction – 20% | (25,600) |
| 102,400 |
The taper relief reduction is 20% because the gift to the son was made between three and four years of the date of Winnie’s death.
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.
EXAMPLE 10
Nun died on 29 March 2023.
None of her husband’s nil rate band was used when he died on 5 May 2012.
When calculating the IHT on Nun’s estate, a nil rate band of £650,000 (325,000 + 325,000) can be used because a claim can be made to transfer 100% of her husband’s nil rate band.
EXAMPLE 11
Win died on 24 February 2023 leaving an estate valued at £800,000 (the residence nil rate band is not available). Only 60% of his wife’s nil rate band was used when she died on 12 May 2013.
On 10 May 2020, Win had made a gift of £200,000 to his son. This figure is after deducting available exemptions.
The nil rate band for the tax year 2020-21 is £325,000.
IHT liabilities are:
Lifetime transfer – PET on 10 May 2020
| £ | |
|---|---|
| Potentially exempt transfer The PET is initially ignored | 200,000 |
Additional liability arising on death – PET on 10 May 2020
| £ | |
|---|---|
| Potentially exempt transfer | 200,000 |
No IHT is payable because the transfer is within the nil rate band.
Death estate
| £ |
|
|---|---|
| Chargeable estate | 800,000 |
| IHT liability 255,000 at nil% 545,000 at 40% | 0 218,000 |
| 218,000 |
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.
EXAMPLE 12
Timothy died on 19 June 2022 leaving an estate valued at £850,000. Under the terms of his will, Timothy’s estate was left to his children. The estate included a main residence valued at £450,000.
Timothy’s civil partner died on 5 May 2011. He used all of his nil rate band of £325,000.
Timothy’s IHT liability is:
Death estate
| £ |
|
|---|---|
| Chargeable estate | 850,000 |
| IHT liability 350,000 at nil% 325,000 at nil% 175,000 at 40% | 0 0 70,000 |
| 70,000 |
Transfers to spouses
Gifts to spouses (and registered civil partners) are exempt from IHT. This exemption applies both to lifetime gifts and on death.
EXAMPLE 13
Sophie died on 25 June 2022.
On 12 April 2018, she had made a gift of £400,000 to her husband.
Sophie’s estate on 25 June 2022 was valued at £900,000. Under the terms of her will, Sophie divided her estate equally between her husband and her daughter (the residence nil rate band is not available).
The nil rate band for the tax year 2018-19 is £325,000.
IHT liabilities are:
Lifetime transfers
The gift on 12 April 2018 is exempt as it is to Sophie’s husband.
Death estate
| £ |
|
|---|---|
| Value of estate | 900,000 |
| Spouse exemption (900,000/2) | (450,000) |
| Chargeable estate | 450,000 |
| IHT liability 325,000 at nil% 125,000 at 40% | 0 50,000 |
| 50,000 |
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.
EXAMPLE 14
During the tax year 2022–23, Peter made the following gifts:
The gifts on 18 May 2022 and 20 March 2023 are both exempt because they do not exceed £250.
The gift on 5 October 2022 for £400 does not qualify for the small gifts exemption because it is more than £250. It will instead be covered by Peter’s annual exemption for 2022–23 (see the following section).
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).
EXAMPLE 15
Simone made the following gifts:
The gift on 10 May 2021 utilises £1,400 of Simone’s annual exemption for 2021–22. The balance of £1,600 (3,000 – 1,400) is carried forward to 2022–23.
The gift on 25 October 2022 utilises all of the £3,000 annual exemption for 2022–23 and £1,000 (4,000 – 3,000) of the balance brought forward of £1,600. Because the annual exemption for 2022–23 must be used first, the unused balance brought forward of £600 (1,600 – 1,000) is lost.
The annual exemption is applied on a strict chronological basis, and is therefore given against PETs even when they do not become chargeable.
EXAMPLE 16
Nigel made the following gifts:
The gift on 17 May 2021 utilises Nigel’s annual exemptions for 2021–22 and 2020–21. The value of the PET is £54,000 (60,000 – 3,000 – 3,000).
The gift on 25 June 2022 utilises Nigel’s annual exemption for 2022–23. The value of the CLT is £97,000 (100,000 – 3,000). No lifetime IHT liability is payable because this is within the nil rate band for 2022–23.
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):
EXAMPLE 17
On 19 September 2022, William made a gift of £20,000 to his daughter when she got married. He has not made any other gifts since 6 April 2021.
The gift is a PET, but £5,000 will be exempt as a gift in consideration of marriage and William’s annual exemptions for 2022–23 and 2021–22 are also available. The value of the PET is therefore £9,000 (20,000 – 5,000 – 3,000 – 3,000).
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