The Office of Tax Simplification (OTS) recently published its second set of recommendations for the simplification of inheritance tax (IHT), following an initial report in autumn 2018.
Whilst the first report dealt with administrative simplification and gave recommendations for improving the ‘user experience’ for those needing to interact with the IHT systems, this second report looks at the potential for more substantive change to the IHT legislation itself.
The report makes 11 recommendations, split across three key areas of IHT – lifetime gifting, the interaction of the IHT and capital gains tax (CGT) regimes, and businesses and farms.
If adopted, some of the recommendations could result in substantial changes to the current IHT position. However, as with all OTS reports, these are only recommendations, not confirmed government policy. It remains to be seen whether the government will take any or all of them forward. Even if it does, changes to the IHT rules may not, in the current environment, be seen as a political priority.
A package of recommendations has been made in relation to the IHT exemptions for lifetime gifts. This starts with a proposal that the current allowances (both the annual gift allowance and the exemption for gifts in contemplation of marriage) should be replaced with a single personal annual gift allowance.
This would run alongside a review of the current exemption for regular gifts out of surplus income. It is suggested that the revised relief should reflect an annual percentage of the taxpayer’s income, or alternatively that the exemption be abolished, and the proposed single personal gift allowance be increased to compensate for the change.
The second recommendation is that only gifts made in the five years prior to death (rather than the current seven) should be charged to IHT. At the same time, the taper relief that reduces the tax rate due on lifetime gifts, and the ’14-year rule’ (which requires taxpayers to consider gifts made outside the normal seven-year period in some circumstances) would be abolished.
As well as achieving administrative simplification, this change could have a real benefit for settlors of lifetime trusts, who may be able to gift up to their nil rate band into trust every five years instead of having to wait seven years.
The final recommendation in this area is that the government explore options for simplifying and clarifying the rules around liability for tax on lifetime gifts – an issue which can cause significant practical difficulties for executors.
Interaction with capital gains tax
CGT and IHT work hand in hand, and for lifetime gifts one can never plan for one tax without considering the other.
The current position for a death estate is that there is a CGT-free uplift on assets held at death in almost all cases. In effect, the increase in value of the asset from acquisition is cancelled out. Where there is also IHT relief, whether that be a spousal exemption, Agricultural Property Relief (APR) or Business Property Relief (BPR), there is also no IHT charge. As a result, the asset is passed on with no tax charge. Because the base cost is higher, the beneficiary of the estate is immediately able to sell or onward gift assets with no CGT implications.
The OTS has recommended that where assets in the estate benefit from one of the IHT reliefs set out above, there should be no corresponding uplift in base cost for CGT purposes. There would be no immediate charge to CGT, but the beneficiary would inherit the original cost of the asset and the latent gain.
If brought in, individuals would need to revisit their overall gifting strategies to take account of the impact of this recommendation: the removal of the CGT uplift may create an increased incentive for lifetime giving.
BPR is currently available for most businesses, provided their activity is not ‘wholly or mainly’ related to the holding and management of investments. In practice this means that qualifying businesses need to be more than 50% trading.
The CGT rules for business reliefs have a higher threshold of 80% trading, and the OTS’s recommendation is that the government should review whether it is appropriate for the BPR threshold to remain at the current lower level.
The tax treatment of Furnished Holiday Let (FHL) businesses is also inconsistent: the business is treated as a trade for income tax and CGT, but generally as an investment business for BPR purposes. Here the OTS has recommended that the IHT treatment is aligned with the income tax and CGT position, which could remove many second homes from the scope of IHT.
There are helpful recommendations to review the IHT treatment of corporate and Limited Liability Partnership (LLP) joint venture structures to ensure that BPR is available consistently where there is a genuine trading business, and this may help to iron out some of the wrinkles in the legislation.
Farms and Agricultural Property Relief
This relief had been considered to be at risk of attention, but the final report does not recommend major change.
It does suggest a review of HM Revenue & Customs’ (HMRC’s) current approach of seeking to remove APR on a farmhouse when the farmer needs medical treatment or goes into care. This would be a welcome softening of approach and preserve relief at what is a difficult time for a family.
The same applies to the recommendation that HMRC should clarify in its guidance when a formal or estimated valuation of an estate or farm is required where BPR or APR is accepted. If implemented, this will remove an administrative headache for executors.
We would recommend that individuals use this opportunity to re-examine their IHT position and consider the impact, if any, the proposed changes could have. Depending on timing and – with ongoing Brexit concerns – content, we may find out in this autumn’s Budget whether or not the government does intend to take the recommendations forward.
Senior Manager, Tax Advisory