Taxing the estates of deceased individuals may be one of the most unpopular forms of taxation, yet this has not prevented its longevity. In the UK for example, the modern system of inheritance tax – levied on the value of the individual’s estate upon death – was introduced in 1894 in the form of Estate Duty, to help pay off a £4 million government deficit.
The times may have changed, and the size of government deficits certainly have changed, but the perception that we require death duties to balance the country’s books has not. On the contrary, there are those who have suggested that now is the time for capital taxes to be put to more ambitious use – not only in terms of generating revenue for public spending, but also in encouraging what they would claim to be a more equitable society.
The OECD made such a suggestion in its recent report on inheritance taxation. The report analysed the distribution of household wealth and inheritances across the OECD member states, and finds they are, in general, characterised by high wealth inequality and unevenly distributed wealth transfers, which are expected to increase in number and value over the coming years. Without remedial action, the report warns that these unequal wealth transfers have the potential to reinforce unequal concentrations of wealth.
Taking aside these general conclusions for a moment, there are specific findings in the report that bear closer examination:
- Inheritance taxes have generally been found to generate lower efficiency/ administrative costs than other taxes on wealth. This is largely because inheritance tax, generally speaking, is collected only once in a person’s lifetime, as opposed to annually like other taxes on net wealth or gains and income. While the picture across the OECD may be different, many families in the UK who have experience with the inheritance tax (IHT) system may disagree with this conclusion – with all the exemptions, reliefs, and other complexities – and the Office of Tax Simplification (OTS) itself has called for simplification.
- Low tax revenues are partly due to narrow tax bases. Among the 24 OECD members, inheritance, estate, and gift taxes account for a very small proportion – just over 0.5% – of overall tax revenue. This is put down to the narrowness of the tax bases. The report finds that this is a result of the number of exemptions available, particularly for transfers to close relatives such as a spouse or and in some instances to children.
- The design of inheritance, estate and gift taxes reduces the effective tax rates, in some cases more so for the largest estates. The most striking example of this is the UK, where someone with an estate valued over £10 million has a substantially lower effective IHT rate than someone with an estate worth £1-£2 million. In fact, the data suggests the effective rate paid by estates of £10 million or more is less than half that paid by estates valued at £5-£7 million. This trend is accounted for in the report by the fact that the largest estates comprise more assets benefitting from tax reliefs, such as business assets or agricultural land.
Based on their findings, the report then offers a series of recommendations for reforming inheritance, estate and gift taxes, so that they generate a higher tax yield, better address perceived wealth inequalities, and function more efficiently.
These recommendations include:
- IHT should be levied on the beneficiary of the wealth rather than the estate of the deceased;
- It should apply to all gifts and bequests received over the individual’s lifetime (excluding a tax-free lifetime allowance);
- Exemptions and reliefs should be scaled back for certain assets, such as private pensions savings and life insurance pay-outs;
- Taxing rights in respect to cross-border inheritances should be better aligned with other jurisdictions, and double taxation relief should also be provided;
- Assets should not be ‘stepped-up’ to fair market value at the time of the bequest, meaning the beneficiary is potentially liable for any capital gains accrued should they choose to sell;
- Allowing for short and long-term tax payment extensions where certain conditions are met, to help taxpayers avoid liquidity issues;
- Reporting requirements strengthened and tax administrations encouraged to collect more data (including from third parties).
High net worth individuals (HNWI)
The findings of the OECD report demonstrate that HNWIs and ultra-HNWIs are a key constituent of the IHT base. The exemptions and reliefs available in most jurisdictions mean that the majority of less-wealthy households won’t incur IHT liabilities – and the OECD’s recommendations do not seek to change this. For this reason, a well-functioning IHT system is one that accommodates the often complex affairs of HNWIs and can adapt to particular circumstances.
To illustrate the role that ultra-HNWIs play in generating IHT revenue, let us take a high-profile example. In April, the family of the late owner of the Samsung technology empire, Lee Kun-hee, announced it was to hand over $11 billion in one of the largest-ever inheritance tax bills. The late businessman’s estate was large, complex, and contained many assets that are generally eligible for reliefs and exemptions, such as shares and smaller companies.
The family announced their $11 billion bill would be paid in instalments (six over five years) – a facility recommended by the OECD and not currently available in the UK or US, however very useful for HNWIs whose liquidity relies on dividends from shareholdings. Alongside the inheritance tax payment, the family pledged billions of dollars in philanthropic donations to healthcare and the arts, including the donation of Lee’s collection of 23,000 artworks and antiques to museums in South Korea.
If there is to be reform of the UK’s IHT system to increase flexibility for HNWIs, it will be important to first identify the biggest issues they are contending with, and which may cause challenges for their businesses or families. For example, in the UK this would likely include:
- The rules governing domicile status. An individual’s domicile status is key to determining how much of their estate is exposed to UK IHT, however the rules governing domicile status are not always easy to apply. For this reason, the OECD’s recommendation for greater alignment of taxing rights and adequate double taxation relief would likely be welcomed by HNWIs, at least in principle.
- The rules governing Business Property Relief (BPR). Access to BPR is dependent on the trading profile of a business and needs to pass a 50:50 trading/non-trading activity test, which can create ambiguity and uncertainty. The OTS has suggested this test should actually be 80:20, in line with CGT reliefs (read more about these suggestions here). An alternative view, alluded to in the OECD report, would be to provide a preferential low IHT rate on businesses to facilitate succession and also to allow payment over a longer period.
- The rules governing IHT-free pension and life insurance policies. The report highlights that the justification for exempting life insurance pay-outs appears limited, as life insurance policies are effectively tax efficient investment vehicles and primarily benefit wealthy households. The same principle applies to private pension savings. One of the OECD’s recommendations is that, if reliefs are not removed, caps are applied to some reliefs.
- The rules governing wealth transfers on a lifetime basis. Inequality was a key concern of the report and a shift to taxing the recipient, alongside a lifetime limit, would potentially facilitate the earlier passing on of wealth and would limit the importance of timing gifts and inheritances. There is some evidence that small inheritances have an equalising effect and they reduce relative inequality, which would justify exempting them to unlock some of the current inequality.
If you have any questions about the OECD proposals, or about inheritance tax planning in general, please contact your usual Saffery Champness partner or Zena Hanks.
A longer version of this article was first published by Bloomberg Tax in June 2021.