Inheritance tax, part 2

The TX-UK syllabus requires a basic understanding of inheritance tax (IHT), and this two-part article covers those aspects that you need to know. This article is relevant to candidates sitting the TX-UK exam in the period 1 June 2021 to 31 March 2022, and is based on tax legislation as it applies to the tax year 2020–21 (Finance Act 2020).

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 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.

EXAMPLE 18
Ali died on 3 March 2021. He had made the following lifetime gifts:

• 1 August 2018 – A gift of £360,000 to his son.
• 21 November 2019 – A gift of £240,000 to a trust.

These figures are after deducting available exemptions.

The nil rate band for the tax years 2018–19 and 2019–20 is £325,000.

IHT liabilities are:

Lifetime transfers

No lifetime IHT is payable because the CLT is less than the nil rate band for 2019–20.

Additional liabilities arising on death

The nil rate band for 2020–21 of £325,000 has been fully utilised by the PET made on 1 August 2018.

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.

EXAMPLE 19
On 17 June 2017, Annie made a gift of £406,000 to a trust. She paid the IHT arising from the gift.

Annie has not made any other gifts since 6 April 2016.

The nil rate band for the tax year 2017–18 is £325,000.

The lifetime IHT liability is calculated as:

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:

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 20
Continuing with example 19, Annie died on 12 March 2021.

Additional liability arising on death

17 June 2017

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 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.

EXAMPLE 21
Ja died on 18 March 2021 leaving an estate valued at £450,000 (the residence nil rate band is not available). She had made the following lifetime gifts:

• 1 August 2012 – A gift of £200,000 to a trust.
• 1 November 2018 – 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 years 2012-13 and 2018-19 is £325,000.

IHT liabilities are:

Lifetime transfers
CLT on 1 August 2012

No lifetime IHT is payable because the CLT is less than the nil rate band for 2012–13.

CLT on 1 November 2018

The CLT made on 1 August 2012 is within seven years of 1 November 2018, so it utilises £200,000 of the nil rate band for 2018-19.

Additional liabilities arising on death
CLT on 1 August 2012

There is no additional liability because this CLT was made more than seven years before the date of Ja’s death on 18 March 2021.

CLT  on 1 November 2018

The CLT made on 1 August 2012 utilises £200,000 of the nil rate band for 2020–21 of £325,000.

Death estate

• The CLT made on 1 August 2012 is not relevant when calculating the IHT on the death estate because it was made more than seven years before the date of Ja’s death on 18 March 2021.
• Therefore, only the CLT made on 1 November 2018 is taken into account, and this utilises £280,000 of the nil rate band of £325,000.

EXAMPLE 22
The same situation as in example 21, except that on 1 November 2018 Ja made a gift of £280,000 to her daughter rather than to a trust.

IHT liabilities are:

Lifetime transfers

Additional liabilities arising on death

Advantages of lifetime transfers

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 which 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 the value.

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 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:

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

EXAMPLE 23
Andy died on 31 December 2020. 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 individual savings accounts valued at £22,000, savings certificates from NS&I (National Savings and Investments) valued at £19,000 and government securities (gilts) valued at £34,000.
• A life assurance policy on his own life. On 31 December 2020, the policy had an open market value of £85,000 and proceeds of £100,000 were received following Andy’s death.

During his lifetime, Andy had contributed into a personal pension scheme. The pension fund was valued at £167,000 at the time of his death.

On 31 December 2020, 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.

The residence nil rate band is not available.

The IHT liability is:

Death estate

• The promise to pay the friend’s legal fee is not deductible because it is not legally enforceable.
• Unlike capital gains tax, there is no exemption for motor cars, individual savings accounts, saving certificates from NS&I or for government securities.
• 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 TX-UK.
• The pension fund of £167,000 is outside of Andy’s estate.  

Residence nil rate band

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, then the residence nil rate band is reduced to the value of the residence.

EXAMPLE 24
Una died on 10 July 2020 leaving an estate valued at £625,000. Under the terms of her will, Una’s estate was left to her children. The estate included a main residence valued at £225,000 on which there was an outstanding interest-only mortgage of £130,000.

The IHT liability is:

Death estate

The value of Una’s main residence is £95,000 (225,000 – 130,000), so the residence nil rate band is restricted to this amount.

Payment of inheritance tax

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:

• 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 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, 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 25
Alfred died on 15 December 2020. He had made the following lifetime gifts:

• 20 November 2018 – A gift of £420,000 to a trust. Alfred paid the IHT arising from this gift.
• 8 August 2019 – A gift of £360,000 to his son.

These figures are after deducting available exemptions.

Alfred’s estate at 15 December 2020 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 residence nil rate band is not available).

The nil rate band for the tax years 2018–19 and 2019–20 is £325,000.

IHT liabilities are:

Lifetime transfers
CLT on 20 November 2018

The due date for the IHT liability of £23,750 payable by Alfred was 31 May 2019.

PET on 8 August 2019

The PET is initially ignored.

Additional liabilities arising on death
20 November 2018

The due date for the additional IHT liability of £23,750 payable by the trust is 30 June 2021.

PET on 8 August 2019

• The CLT made on 20 November 2018 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 2021.

Death estate

• The due date for the IHT liability of £240,000 payable by the personal representatives of Alfred’s estate is 30 June 2021.
• Alfred’s wife will inherit £250,000, his brother will inherit £50,000 and the children will inherit the residue of the estate of £310,000 (850,000 – 250,000 – 50,000 – 240,000).

Basic inheritance tax planning

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 liability (whereas transfers on death are exempt disposals).

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.

EXAMPLE 26
Victor has an estate valued at £1,400,000, including a main residence valued at £550,000. He has not made any lifetime gifts. Victor’s wife died on 17 May 2010 and all of her estate was left to Victor. Under the terms of his will, Victor has left his main residence to his brother, with the residue of the estate left to his children.

Currently, Victor’s estate will benefit from a nil rate band of £650,000 (325,000 + 325,000). The residence nil rate band is not available because the main residence will not be inherited by a direct descendant.

Victor could amend the terms of his will so that his brother inherited £550,000 of other assets, with the main residence being included within the residue. A residence nil rate band of £350,000 (175,000 + 175,000) would then be available, saving IHT of £140,000 (350,000 at 40%).

There is no reason why Victor’s brother could not purchase the main residence from the children following Victor’s death.

Capital gains tax (CGT)

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 that 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. CGT is not an issue if a cash gift is made.

EXAMPLE 27
On 20 June 2020, Craig made a gift to his grandson of a residential property valued at £250,000. The gift of the property resulted in a chargeable gain of £145,000.

The value of the property is expected to increase to £300,000 by 31 December 2022, and to £340,000 by 31 December 2027.

Craig is an additional rate taxpayer. He will not make any other disposals during the tax year 2020–21, and he has not made any previous lifetime gifts. Craig has an estate valued in excess of £2,000,000 for IHT purposes.

CGT liability
Craig’s CGT liability for 2020–21 is:

Craig dies on 31 December 2027
The gift of the property is a PET. If Craig lives until 31 December 2027, then the PET will be exempt because he will have survived for seven years. The IHT saving will be £136,000 (£340,000 at 40%), so a lifetime gift would appear to be beneficial despite the immediate CGT cost of £37,156.

Craig dies on 31 December 2022
If Craig were to die on 31 December 2022, the IHT saving (ignoring annual exemptions) would be:

Note that although there will be no IHT liability in respect of the PET, the PET will reduce the amount of nil rate band available against Craig’s death estate.

The lifetime gift no longer appears to be beneficial because the immediate CGT cost of £37,156 outweighs the IHT saving of £20,000.

Written by a member of the TX-UK examining team