Inheritance tax is set to change, now that the Office of Tax Simplification (OTS) has conducted a wide-ranging review into what is often seen as an unpopular tax.
In theory, inheritance tax is charged at 40% on the value of an estate, once it is over the £325,000 inheritance tax allowance.
In practice, however, many of the country’s wealthier people do not pay inheritance tax, due to careful financial planning.
On the other hand, the exponential rise in UK property prices has meant more people are finding they have to pay inheritance tax.
People who are often already dealing with the difficulties of bereavement are having to navigate their way through a complex set of rules and regulations, even if, ultimately, it may mean they do not need to pay the tax.
It is no wonder then, that the so-called death tax is so unpopular.
The OTS review into inheritance tax makes recommendations for reforming the rules around inheritance tax. The Government will have to respond to them.
If you need to pay inheritance tax in the future, or if you are planning for your own legacy, you will need to know how these proposed changes might affect you.
Here, we look at these recommendations, and what their implications are for the future of inheritance tax.
A Shorter Time Limit for Taxable Gifts
Currently, if you decide to give away your money to your relatives while you are still living, there is a seven year limit.
What this means is that if you die within seven years of giving the gift, then the person receiving it may still have to pay some inheritance tax, depending on the circumstances.
Under the present rules, this form of potentially exempt transfer, or PET, is an effective way of reducing your inheritance tax bill, but it comes with the “potential” caveat – if the giver dies within the seven year period, there could be a chargeable amount of inheritance tax.
The OTS has recommended shortening the seven year period down to five years.
There is still a possible downside. Under the current regulations, the amount the gift recipient might have to pay goes down based on the number of years since receiving the gift, known as taper relief. The review recommends abolishing this.
This means that if the giver dies within the allowed period, any tax payable would be at the same rate, with no tapered reduction.
Inheritance Tax on Gifts: Who Pays?
The inheritance tax allowance is allocated to gifts first. Currently it stands at £325,000. This means most people would not normally have to pay tax on a gift, even within seven years of the giver’s death.
If the total value of gifts is higher than the allowance, then the recipient must pay the inheritance tax bill.
The OTS is recommending that instead of the recipient being liable for tax on gifts, the estate should be liable instead.
A further recommendation is that the nil-rate band is allocated across all gifts proportionately, rather than under the current rules, where oldest gifts benefit from the nil rate first.
Changing the Single Gift Allowance
Lifetime gifts are where you can give up to £3,000 a year from your estate without this counting towards tax.
Under the current regulations, you can also give up to £5,000 if a child is getting married; and make smaller gifts of up to £250, providing these are all to different individuals.
In its report, the OTS says that the current arrangements are confusing and could lead to misunderstandings, especially as the different gift limits are calculated in different ways.
One example is the £3,000 limit, which is a cumulative figure, whereas the £250 gift exemptions per person do not come under an overall total, but cannot be combined.
Most of these gift allowances are at levels frozen since the 1980s. The OTS has not recommended a new limit, but it has highlighted the fact that if the £3,000 limit had risen with inflation, it would currently stand at £11,900.
What the OTS does recommend is that there should just simply be a single, personal gift allowance per person.
Some wealthier families might lose out, if they routinely expected to give individual £250 gifts, which would exceed the new annual allowance.
Other Proposed Gifting Changes
At present, an individual can give away unlimited gifts of money from their income which are not then subject to inheritance tax, provided they are made on a regular basis, and do not affect the standard of living of the giver.
For cash-rich individuals, this has meant they can reduce their inheritance tax liability by passing down wealth to their loved ones over time, during their lifetime.
The OTS has looked at the difficulties surrounding this exemption, where claiming it has depended on detailed record-keeping, and where in some cases it has been used to exempt gifts exceeding £1m a year.
Currently there is no legally binding definition of what normal expenditure or expenditure out of income would be.
The proposed solution for gifts out of existing income is either to introduce a fixed percentage of it that individuals are allowed to give; or to get rid of the exemption rule completely and instead provide a higher annual gift allowance.
Removal of the Capital Gains Uplift
The capital gains uplift works like this: when someone inherits assets, under current regulations, they can acquire it under the market value at the time of death, rather than the amount originally paid for it.
It is like resetting the clock, which then means the recipient can sell the asset without incurring capital gains tax (CGT).
However, because CGT is not charged at death, in some situations where there have also been an inheritance tax exemption, this could mean someone paying no tax at all.
Consequently, the OTS has recommended changing the capital gains rules to close this loophole.
It proposes that assets are instead valued at their original price to simplify the system.
This could mean someone inheriting assets will have to pay CGT, but it could also encourage more people to make transfers of assets during their lifetime. The view is that the current system acts as an incentive for people to hold onto assets until death, even if they would really prefer to sell them.
Of course, any CGT liability that has existed at the time of death will still be liable for payment to HMRC.
Businesses and Farms
The OTS has looked at the treatment of businesses and farms under the present rules.
At things currently stand, businesses and farms can come under several exemptions, which allow them to be passed on as inheritance without being sold or broken up.
These exemptions come in the form of business property relief and agricultural property relief.
The OTS recommends certain changes. It questions whether business trading activity should continue to be set at a lower threshold than other business tax reliefs to qualify for property relief.
It also wants to review the treatment of indirect, non-controlling holdings in trading companies and of limited liability partnerships.
It is considering whether to align the inheritance tax rule for furnished holiday lets with those for income tax and capital gains tax.
The OTS is also looking at the approach to agricultural property relief in circumstances where a farmer must leave their farmhouse due to medical treatment or other care.
What Will Happen in the Future?
First, the Treasury must respond to the OTS recommendations. Next, should it accept any of the proposals, these will then be subject to a consultation period, before becoming law.
There may, therefore, be an announcement about proposed reforms in the Chancellor’s Autumn Statement.
In the longer term, a Labour Party-commissioned report has proposed a more radical overhaul to inheritance tax. The Land for the Many report suggests replacing it with a lifetime gift tax, which would be levied on recipients of assets over £125,000.
There are other, less drastic views about changing inheritance tax, including replacing it with capital gains tax charged on estates.
As things stand, inheritance tax is an imperfect, uneven system, and therefore there will be changes to it to some degree in the near future.
What Should You Do About Inheritance Tax?
Regardless of what changes are coming and when, you should be planning for your estate and looking at how best to manage your wealth.
There are various strategies you may consider for reducing your inheritance tax bill.
These include: reducing your assets through gifts; freezing them through a loan; converting them into assets which will, currently, qualify for some sort of relief; and taking out life assurance to help your dependents meet any inheritance tax liability.
With the current complexities of the system, and with changes likely at some point, the first thing to do is seek professional advice about writing your will, or dealing with the affairs of someone who has died.