The Office for Tax Simplification (OTS) has presented its second report to Parliament, which makes recommendations on simplifying inheritance tax (IHT), making it easier for people to understand and more intuitive.
Following a brief from the Chancellor in January 2018, the OTS set about reviewing a wide range of administrative and technical aspects of IHT. Its first report was published in the Autumn of 2018, and this dealt with administration, the awkwardness of the system and recommendations for improving the user experience.
Now, in July 2019, the second report and proposed recommendations on the technical impact of IHT has been presented to Parliament.
It is important to remember this is not draft legislation and given the current political turmoil, it is not known which recommendations will be taken forward and which will not.
The report specifically sets out that any changes would need to be legislated ahead of coming into operation and that it would be preferable for the changes to take effect for deaths on or after a certain date, rather than there being a transitional period. This may provide a window of opportunity to get matters in order ahead of a change in law.
Some topics, such as charitable gifts reducing the rate of IHT charged on a death estate, and the mechanics of the residence nil rate band were put into the ‘too difficult’ pile. Trusts were broached and then passed back to HMRC to deal with through a separate consultation. The detrimental impact of inflation on the nil rate band was referred to, with no recommendation to increase the limit.
That said, the report makes 11 recommendations and the key points are summarised below.
A package of recommendations is made in relation to IHT exemptions available for lifetime giving. This starts with the proposal that the current allowances should be replaced with a single personal annual gift allowance. The level of that allowance should be considered carefully by the government given that the current allowances have not kept pace with inflation.
This would run alongside a review of the current exemption for regular gifts out of excess income, which is a very generous but administratively burdensome relief in that the executors have to prove there was excess income available. Suggestions are that the revised relief should reflect an annual percentage of the taxpayer’s income or, alternatively, the personal gift allowance could be increased to reflect gifts out of income, with the current exemption being abolished.
HMRC’s data shows that a personal gift allowance of £25,000 per annum would cover the value of 55% of all regular gifts out of excess income claims – but clearly setting a personal gift allowance at this level would create winners (administratively) and losers (those who currently gift large sums under the exemption each year).
The press has picked up on one particular recommendation that only gifts made in the five years prior to death should be charged to IHT, which is a reduction from the current seven years. At the same time, the taper relief that reduces the tax rate due on lifetime gifts should be abolished.
Reducing the number of years in this way broadly offsets removing the taper relief. However, having reviewed life insurance premiums, a policy over five years is cheaper overall than a seven year policy benefitting from taper relief. The real benefit though is that settlors of lifetime trusts may be able to gift up to their nil rate band into trust every five years instead of having to wait seven years. Cumulatively, this adds up to passing on more wealth, quicker.
Who pays the tax?
Working out who pays the tax is complex, and the broad position is that gifts made first benefit from the nil rate band and as a result, later gifts and the death estate are taxable. Any tax due on lifetime gifts is due by the recipient, and this is often overlooked and no money is left to pay the IHT charge. Legally, this can be a nightmare for executors, as the estate can become jointly liable for any tax unpaid by the recipient of the lifetime transfers.
To counter this difficulty, the recommendation is that the government should explore options for simplifying and clarifying the rules.
Whilst the current rules are difficult, the proposed changes are for the nil rate band to be shared between the lifetime gifts made, for the estate to pay the tax due both on lifetime gifts and the death estate and for the liability of executors to be limited. Practically, these suggestions raise as many new concerns as the problems they seek to solve – and this is acknowledged in the report. For this recommendation at least, it is a case of waiting to see if the government can come up with any suitable alternatives. In the meantime, wills should be reviewed to make sure that they take into account lifetime gifts and the potential tax burden thereon when balancing up the distribution of an estate.
The interaction of capital gains tax
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 recommendation is that where assets in the estate benefit from one of the reliefs set out above, there should be no corresponding uplift in base cost for CGT purposes. This means there is no immediate charge to CGT, but the beneficiary inherits the original cost of the asset and the latent gain. This creates a practical difficulty in working out the inherited base cost, and the position for assets that partly benefit from relief and are partly chargeable to IHT would need to be worked through.
If brought in, big picture gifting strategies will need to be revisited to mitigate the impact of this recommendation. This is likely to involve focus being shifted to lifetime giving and the report notes that this may be beneficial commercially for businesses, where the tax advice to date has been to retain the assets until death to benefit from the CGT uplift, perhaps to the detriment of the business.
Business Property Relief
BPR is a vitally important relief that prevents the need for businesses, estates and farms to be broken up and sold to pay IHT on the death of the business owner. This rationale is clearly stated in the OTS report.
BPR is currently available for businesses where the business is not one of “wholly or mainly” investment business, such as rental, and in practice this means businesses need to be more than 50% trading. This is in line with the principles established through the Farmer and Balfour cases, and for many landed estates even the 50% trading test can be challenging where there has been diversification and, for example, rental income received from renewable projects that can tip the balance.
The CGT rules for business reliefs have a higher threshold of 80% trade, and the recommendation is that the government should review whether it is appropriate for the trading threshold for BPR to remain at 50% rather than 80%, in line with the CGT reliefs.
This impacts all businesses, with a sharp focus on diversified landed estates and farms, and unfortunately the change would be simple to implement legislatively. Whilst the outcome of a government review is unknown, it would be wise to review current structuring of diversified businesses now.
The tax treatment of Furnished Holiday Let (FHL) businesses is also inconsistent; the business is treated as trade for income tax and CGT, but generally as an investment business for BPR purposes. This is notwithstanding recent successes in the courts in BPR claims where the holiday let owners provided exceptionally high levels of services in addition to the holiday home. The recommendation is that the IHT treatment is aligned with the income tax and CGT position, which could remove many second homes from the scope of IHT. This would also bolster BPR claims for diversified landed estates, and provide encouragement to move from long-term letting to holiday letting. The government has increased tax on second home ownership in recent years, so whilst this recommendation is welcome, it may meet with resistance from the Treasury.
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.
Finally, whilst not specifically flagged as a recommendation, there is commentary on certain AIM listed shares qualifying for BPR and the question is left hanging whether companies that are no longer family companies (ie founders have sold out), should qualify for BPR.
Farms and Agricultural Property Relief
This relief was considered to be most at risk of attention, but no reference is made in the OTS report to the availability of APR on let land, other than to specify when the rate is 50% or when it is 100%.
Interestingly, the report suggests a review of HM Revenue & Customs’ (HMRC’s) current treatment to seek to remove APR on a farmhouse when the farmer needs medical treatment or goes into care. This is a welcome softening of approach.
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.
Life insurance policies
Current best practice is to write all insurance policies into trust so that the proceeds paid on death are administered separately from the estate and the value is not amalgamated with the death estate of the deceased, and so charged to IHT.
The recommendation to remove the requirement for a trust to access these benefits is welcome, particularly in light of the impending requirement under new legislation for all trusts to register with HMRC, including those that hold nothing other than a life insurance policy.
If you would like to discuss any of the OTS’ proposed changes, please contact your usual Saffery Champness partner, or speak to Jamie Younger.