Chapter 4: Inheritance Tax Flashcards
What is inheritance tax (‘IHT’)?
Inheritance tax (‘IHT’) is a tax that is primarily paid on the estate of a deceased person. It applies to the UK assets of UK resident taxpayers and the worldwide assets of UK-domiciled taxpayers.
when someone dies, you may not be aware that there are other events during a person’s lifetime which can give rise to an IHT charge. The rates of tax differ depending on the nature of the IHT trigger event.
What is inheritance tax (‘IHT’)?
The scope of the Inheritance Tax Act 1984 (‘IHTA’) is very broad, in order to prevent people avoiding IHT by reducing the value of their estate during their lifetime.
It is important to know what kinds of transfers could trigger IHT, the rates at which tax is payable on those transfers and what, if any, exemption or reliefs are available to reduce or eliminate any resulting tax.
Rates of tax
The rates of IHT are set annually by the budget for the tax year.
The tax year runs from 6 April one year to 5 April the following year. For the current tax year, the following rates of IHT apply:
Nil rate band
0%
Lifetime rate
20%
Death rate
40%
You will be required to apply tax rates in this topic. You will find it helpful to have a calculator to hand as you work through the topic.
IHT trigger events
There are three kinds of IHT trigger event that you need to be aware of when advising a client in relation to wills and estates:
Potentially exempt transfers (‘PET’) – Lifetime transfers of value which could become chargeable to IHT depending on whether the transferor survives for seven years after the transfer. Only failed PETs (i.e. those where the transferor does not survive for seven years) are chargeable.
IHT trigger events
Lifetime Chargeable Transfers (‘LCT’) – Lifetime transfers of value which are immediately chargeable to IHT at the lifetime rate.These are also reassessed if the transferor dies within seven years.
Death – When a person dies there is a deemed transfer of all the assets that they own (s 4 IHTA). IHT is chargeable on this transfer of value.
Transfers of value
IHT is payable on the value transferred by a ‘chargeable transfer’ (s 1 IHTA).
- A chargeable transfer is a ‘transfer of value’ made by an individual which is not an “exempt transfer” (s 2(1) IHTA).
- A “transfer of value” is a ‘disposition’ which results in an immediate decrease in the value of the individual’s estate (s 3(1) IHTA).
Transfers of value
Broadly, this means gifts but it can also include transactions at an undervalue (e.g. selling your house to a family member for less than it is worth – The difference in value counts as a gift). It applies to gifts of all forms of property (i.e. anything with a monetary value).
The ‘value’ of a transfer of value depends on the trigger event.
- For lifetime transfers, it is assessed by reference to the loss in value to the donor.
- For the death estate, the value is calculated by reference to the market value of items in the estate on the date of death (s 160 IHTA).
Nil rate bands
Individuals have a basic nil rate band of £325,000 (‘NRB’). This means they can make £325,000 of chargeable transfers at a rate of 0% (i.e. no tax is due).
An individual’s surviving spouse or civil partner can inherit the unused proportion of their basic NRB. This is known as the ‘transferable nil rate band’ (‘TNRB’).
Nil rate bands
There is an additional nil rate band (currently £175,000) for individuals who die on or after 6 April 2017 if they leave their family home to direct descendants. This is known as the ‘residence nil rate band’ (‘RNRB’)
An individual’s surviving spouse or civil partner can inherit the unused portion of their RNRB similarly to with the basic NRB.
Potentially Exempt Transfer (‘PET’)
A PET is a lifetime transfer of value to another individual. If the individual doesn’t survive for 7 years after making the transfer, it becomes chargeable alongside their death estate. The rationale behind PETs is to prevent individuals avoiding IHT by giving away property shortly before their death.
Gifts to companies and gifts made by closed companies have different rules which are beyond the scope of this module.
The tax treatment of a PET is as follows:
- The transfer is not chargeable at the point it is made. No IHT is payable yet.
- It becomes fully exempt if the transferor survives seven years from the date of the PET.
- If the transferor dies within seven years of making the PET, the PET ‘fails’ and becomes a chargeable transfer and thus subject to IHT.
Lifetime Chargeable Transfer (‘LCT’)
All lifetime transfers of value made by a person into a trust on or after 22 March 2006 will give rise to an LCT. The tax treatment is as follows:
- An LCT is a chargeable transfer when it is made. IHT is payable on the chargeable value of the LCT at the lifetime rate of 20%.
- If the transferor survives 7 years following the LCT there is no further charge to tax.
- If the transferor dies within 7 years, the LCT will be reassessed to tax at the death rate of 40%, using the NRB at the date of death.
- Practice Alert: There are different rules for trusts set up for disabled people provided that statutory requirements are met. These rules are outside the scope of this module.
Death
When a person dies there is a deemed transfer of all the assets that they own at the date of their death (s 4 IHTA).
It is this deemed transfer that gives rise to the IHT charge on death.
Property in the taxable estate is valued at the price it might reasonably be expected to fetch if sold on the open market immediately before the death (s 160 IHTA).
Death
It is important to note that the taxable death estate is not the same as the succession estate so a separate calculation of the value of the estate for IHT purposes will be needed.
IHT is payable on a person’s death estate at the death rate of 40% of the value of the estate above the available NRB.
In addition to the IHT for the death estate, any PETs or LCTs made in the 7 years before death must be re-assessed to IHT as well.
Comparing lifetime and death
An LCT with a chargeable value of £500,000 would be taxed when it was made at the lifetime rate as follows:£0 to £325,000 (nil rate band):
£325,000 x 0% = 0
£325,000 to £500,000
(lifetime rate):
£175,000 x 20% = £35,000
A death estate with a chargeable value of £500,000 would be taxed when it was made at the death rate as follows:
0 to £325,000
(nil rate band):
£325,000 x 0% = 0
£325,000 to £500,000
(death rate):
£175,000 x 40% = £70,000
Cumulation
Cumulation is used to prevent individuals reducing their IHT liability by making a series of separate dispositions.
Instead of viewing each IHT chargeable transfer (i.e. failed PET, LCT, death) in isolation, H M Revenue & Customs (HMRC) consider any other IHT transfers made in the 7 years prior to the current transfer being taxed.
The effect of the cumulative total is to reduce the NRB available for the current transfer. It is therefore necessary to calculate what is known as the ‘cumulative total’ before deducting this from the NRB available for a particular transfer.
Cumulative total = Total chargeable value of all the chargeable transfers made in the previous 7 years.
Cumulation example
A man died last month having made two lifetime gifts within the last seven years
Last year he gifted cash with a chargeable value of £50,000 (a PET)
Two years ago he gifted shares with a chargeable value of £100,000 (a PET)
His cumulative total on death is £150,000
His NRB is reduced accordingly (£325,000 - £150,000)
The NRB available on death is £175,000
Please note that this is a simplified example which doesn’t consider the availability of exemptions or reliefs.
Exemptions and reliefs
There are a number of different exemptions and reliefs which can be used to reduce or eliminate IHT. Exemptions and reliefs work in slightly different ways:
- Gifts to certain individuals or other entitles are exempt from IHT. This means that they can be made completely free from IHT and do not use up the NRB.
- Gifts of particular assets benefit from reliefs. This means that, where the conditions of the relief are met, the amount of IHT payable is reduced (sometimes by 100%).
Some exemptions and reliefs only apply to PETs and LCTs. Others apply only to the death estate. Some apply to both.
Calculating IHT
To calculate the amount of IHT which must be paid in relation to a particular transfer you will be expected to apply the relevant formula.
There is a formula to follow in relation to the following lifetime transfers: * Failed PET * LCT (when made) * LCT (when reassessed following transferor’s death) A different formula applies for the taxation of the death estate.
The formulas are set out on the following pages for completeness and are repeated later in the module when required for a calculation.
Calculating IHT on lifetime transfers
In order to calculate the IHT due on a failed PET or LCT the following formula should be used:
Step A
Identify value transferred
Step B
Apply exemptions & reliefs
Step C
Identify chargeable value
Step D
Calculate and apply NRB
Step E
Apply rates of tax
Calculating IHT on death estate
In order to calculate the IHT due when someone dies it is necessary to follow this 7 step process:
In order to calculate the IHT due when someone dies it is necessary to follow this 7 step process:
Step 1
Calculate cumulative total
Step 2
Identify assets included in the taxable estate
Step 3
Value the taxable estate
Step 4
Deduct debts/expenses
Step 5
Apply exemptions & reliefs
Step 6
Apply RNRB
Step 7
Apply basic NRB and calculate tax
Key terminology used in topic
You may find it helpful to familiarise yourself with the following terminology:
- ‘HMRC’ is short for ‘His Majesty’s Revenue & Customs’, the UK tax authority.
- ‘IHT’ is used as shorthand for ‘inheritance tax’.
- ‘LCT’ is used as shorthand for ‘lifetime chargeable transfer’
- ‘NRB’ is used as shorthand for ‘nil rate band’.
Key terminology used in topic
- ‘PET’ is used shorthand for ‘potentially exempt transfer’ and ‘failed PET’ refers to a situation where an individual does not survive for seven years after making a PET.
- References to a ‘spouse’ or ‘marriage’ should be taken to include ‘civil partner’ or ‘civil partnership’ (unless the context requires otherwise).
- ‘Taxable estate’ and ‘death estate’ may be used interchangeably.
- ‘Transferor’ / ‘transferee’ may be used interchangeably with ‘donor’ / ‘donee’.
Summary
IHT is a tax that is primarily paid on the estate of a deceased person at a rate of 40% but there are also lifetime trigger events.
A PET is a lifetime gift to another individual. It is exempt unless the transferor dies within 7 years, in which case it is charged at the death rate of 40%.
An LCT is a lifetime gift into a trust. It is an immediately chargeable transfer. An LCT is taxed at the lifetime rate of 20% but reassessed and charged at the death rate if the transferor dies within 7 years.
Summary
There is a nil rate band of £325,000. Individuals also have an additional nil rate band if they dispose of their family home to direct descendants. The unused portions of both nil rate bands are transferable to the deceased’s surviving spouse.
When calculating IHT it is necessary to take into account the cumulative total of chargeable transfers made in the last 7 years to determine the value of the NRB.
Exemptions and reliefs may be available to reduce an IHT liability.
Nil rate bands
All individuals have a nil rate band (‘NRB’) for IHT purposes. The basic nil rate band is £325,000.
This means that the first £325,000 of a transfer subject to IHT is taxed at 0%.
An individual’s surviving spouse or civil partner can inherit the unused portion of their basic NRB. This is known as the ‘transferable nil rate band’ (‘TNRB’).
Nil rate bands
There is an additional nil rate band (currently £175,000) for individuals who leave their family home to direct descendants. This is known as the ‘residence nil rate band’ (‘RNRB’). The RNRB can also be transferred to an individual’s surviving spouse or civil partner.
In this element we cover the NRB, TNRB and RNRB in more detail. We also look at the concept of cumulation.
NRB & Cumulation
Cumulation is used to prevent individuals reducing or avoiding an IHT liability by making a series of separate dispositions. Instead of viewing each chargeable transfer (i.e. failed PET, LCT, death) in isolation, HMRC consider other chargeable transfers made in the 7 years prior to the transfer being taxed. The combined value of these transfer is called the cumulative total.
Cumulative total = total chargeable value of all the chargeable transfers made in the previous 7 years.
The effect of the cumulative total is to reduce the NRB available for the transfer under consideration. It is therefore necessary to calculate the ‘cumulative total’ on the relevant date to determine the NRB amount for a particular transfer.
Available NRB = Full NRB less cumulative total
Example: Cumulation
A man died last month having made two lifetime gifts within the last seven years.
· Last year he gifted cash with a chargeable value of £50,000 (a PET).
· Two years ago he gifted shares with a chargeable value of £100,000 (a PET).
As these PETs were made in the 7 years prior to the man’s death they have failed and are chargeable transfers.
His cumulative total on death is £150,000.
His NRB is reduced accordingly (£325,000 - £150,000).
The NRB available on death is £175,000.
Please note that this is a simplified example which doesn’t consider the availability of exemptions or reliefs.
Transfer of basic nil rate band (‘TNRB’)
Before 9 October 2007 the basic NRB would be wasted when a deceased passed their estate entirely to their surviving spouse (because spouse exemption applied to so there was no use for the NRB).
Individuals would often try to make the most of both NRBs by leaving a portion of their estate to other family members or setting up trusts known as ‘nil rate band trusts’. These are discretionary trusts which cover the amount of the NRB and include the surviving spouse as a potential beneficiary. This allows them to benefit without the trust property forming part of their estate for IHT purposes.
Transfer of basic nil rate band (‘TNRB’)
Where one spouse held the bulk of the couple’s assets, they would often be advised to try and equalize their estates, to ensure both had enough assets to make the most of their own NRB.
Such tax planning tends only to be useful for wealthier individuals. In any case, it has become less common since the introduction of the TNRB in the Finance Act 2008.
The TNRB allows a surviving spouse to take advantage of the unused portion of the deceased’s basic NRB.
How the TNRB works
If a married individual dies and some or all of their NRB remains unused, the PRs of the surviving spouse can claim an increase in the survivor’s NRB equal to the unused percentage of the first spouse’s NRB - the TNRB.
The amount of the TNRB is equal to a % of the NRB sum on the date the survivor dies. It is not simply the unused amount carried forwards. This operates in favour of the taxpayer because the estate of the surviving spouse will benefit from any increase in the NRB threshold which occurs after the first death. For example, if the NRB was £312,000 when the first spouse died but had increased to £325,000 by the time the second spouse died, the amount of the TNRB would be calculated with reference to £325,000 not the lower figure of £312,000. Therefore, if the first spouse to die had used 50% of their NRB, when the second spouse died the transferable amount is £162,500.
NB: if the NRB amount has not changed between the date of the first and second death, the unused amount and unused % will be the same.
Outliving multiple spouses
The TNRB is only available after the surviving spouse dies. Therefore, it cannot be claimed in respect of a chargeable lifetime transfer when it is made by the survivor.
The date of the first spouse’s death doesn’t matter i.e. it can pre-date the introduction of the TNRB. The TNRB can apply provided the survivor’s death occurred after the introduction of the TNRB.
Outliving multiple spouses
Individuals who have survived more than one spouse can claim the TNRB in respect of all of them, subject to a cap of 100% of a full nil rate band being transferred.
Individuals who would be entitled to claim a TNRB with regards a previous marriage/civil partnership can also pass this on to any subsequent spouse they have (again capped at 100% of a full NRB).
On the next page, we consider examples involving multiple marriages in more detail.
Examples: Outliving multiple spouses
· A and B were married. B later died. Following B’s death, 20% of his NRB was used (leaving 80% unused).
· A then married C. C later died. Following C’s death, 50% of his NRB was used (leaving 50% unused).
· A has just died.
A’s PRs can claim a TNRB from both B and C (80% from B and 50% from C). However, the total is capped at 100% (one full NRB of £325,000).
A’s PRs can claim A’s own NRB plus 100% TNRB (from B/C), thus increasing A’s NRB from £325,000 to £650,000.
Examples: Outliving multiple spouses
· D and E were married. E later died. Following E’s death, 90% of her NRB was used (leaving 10% unused).
· D then married F. F died later. Following F’s death, 70% of her NRB was used (leaving 30% unused).
· D has just died.
D’s PRs can claim a TNRB from both E and F (10% from E and 30% from F).
D’s PRs can claim D’s own NRB plus 40% TNRB (from E and F), thus increasing A’s NRB from £325,000 to £455,000 (£325,000 + £130,000 (40% of £325k)).
Example: Passing TNRB to new spouse
· A died 15 years ago, survived by wife, B. A left all assets to B, meaning A’s NRB was unused.
· B married C five years ago.
· B died two years ago, leaving her entire estate to the children from her first marriage. 50% of her NRB remained unused. B’s PRs didn’t need to claim TNRB from A because B didn’t use her whole NRB.
Example: Passing TNRB to new spouse
C died recently, leaving his estate (worth £700,000) to his siblings. He has a full NRB available.
C’s NRB doesn’t cover the full value of his estate. His PRs will therefore want to claim the TNRB from B’s estate.
B’s total available NRB included B’s own NRB (of which 50% remained unused) and A’s full NRB, to which B’s estate was entitled but did not claim (worth £325,000).
The claim by C’s PRs for a TNRB will be capped at one full NRB. C’s PRs can increase C’s NRB to £650,000, but no more, even though B’s total ‘available but unused’ NRB would be worth more than £325,000.
TNRB: Making a claim
No claim needs to be made when the first spouse dies.
The PRs of the surviving spouse must make a claim for the TNRB in the IHT return within two years of the end of the month of death (or within three months of the PRs first acting, if this is later). If they fail to do so, anyone else who is liable to pay the IHT on the surviving spouse’s death can make the claim after the deadline for the PRs to claim has passed.
HMRC has discretion to extend the deadline.
TNRB: Making a claim
If an individual survives more than one spouse, a separate claim must be made for each TNRB. It is advisable to do this even though the cap means that only one TNRB might actually be needed (in case there is an error discovered in the IHT returns of any of the deceased spouses).
The PRs of a surviving spouse can also make a claim for any TNRB the deceased spouse was entitled to on the death of a previous spouse (if their own PRs had not made such a claim already).
Residence nil rate band (‘RNRB’)
The RNRB was introduced by the Finance (No 2) Act 2015. It provides an additional nil rate band where the following conditions are satisfied:
· The deceased died on or after 6 April 2017
· Their death estate included a ‘qualifying residential interest’ (‘QRI’)
· The QRI was ‘closely inherited’ by a ‘direct descendent’
If part of the QRI is closely inherited but the other part is not, only the chargeable value of the share which is closely inherited is taken into account when calculating the value of the RNRB.
RNRB: Amount
The amount of a full RNRB is £175,000.
If the deceased’s share or interest in the property (after the deduction of any mortgage on the property) is worth less than £175,000, the RNRB amount is capped at the value of the property.
Where the RNRB is claimed it is applied to the death estate as a whole rather than set-off against the gift of the property separately.
RNRB: Amount
There is a tapered withdrawal of the RNRB for estates with a net value (here this means the value of the assets which comprise the taxable estate, after debts have been deducted, but before exemptions and reliefs are applied) of more than £2 million.
The reduction in the RNRB is £1 for every £2 above the £2 million threshold.
There is no RNRB available at all for net estates worth £2,350,000 or more (or £2,700,000 where a full transferred RNRB applies).
RNRB: Qualifying residential interest (QRI)
A QRI is a residential property interest which is part of the deceased’s estate immediately before death.
Where the deceased had more than one residential property interest in their estate at death, the PRs must nominate one of them as their QRI.
A residential property interest is an interest in a dwelling-house which the deceased occupied as their residence at some point during their period of ownership.
RNRB: Qualifying residential interest (QRI)
It includes property in which the deceased did not live (because they were living in other job-related accommodation) but intended to do so in in due course. It does not include rental investment properties in which the deceased never lived.
A dwelling-house can include the garden/grounds (if the land is not subject to a woodlands relief election).
RNRB: Meaning of ‘closely inherited’
A QRI must be ‘closely inherited’.
A beneficiary closely inherits from the deceased if they receive the QRI by:
· gift under the will - either as a specific legacy of the deceased’s home, or by taking a whole or part share of the residue which includes such property
· operation of the law of intestacy
· operation of the rules of survivorship
RNRB: Meaning of ‘closely inherited’
There are other circumstances in which a person will ‘closely inherit’ from a deceased e.g. where there are gifts into certain types of trust, or where the deceased has received a GROB, but these rules are beyond the scope of the module.
Unless a specific exception applies, a beneficiary with a contingent interest following death does not ‘closely inherit’ for these purposes as they are not receiving an absolute interest e.g. it would not apply to a gift to a grandchild who was aged 15 if the gift was contingent on their reaching 25.
RNRB: Meaning of ‘direct descendants’
A QRI must be ‘closely inherited’ by one or more direct descendants. The following are included as direct descendants of a deceased person (s 8K IHTA 1984)
1) The deceased’s children, grandchildren, great-grandchildren and other lineal descendants,
2) Spouse or civil partner of anyone included in 1) above,
3) Widow, widower or surviving civil partner of anyone included in 1) above who has pre-deceased the deceased, provided the survivor does not re-marry or enter a new civil partnership before the deceased dies.
RNRB: Meaning of ‘direct descendants’
When considering 1) above: adopted children, step-children (if their parent was married to the deceased), foster children and children for whom the deceased was a guardian or special guardian are included.
The deceased’s siblings, parents, nieces, nephews are not direct descendants.
Example: RNRB
A man died this year, leaving his entire estate (worth £500,000) to his children. He has a full basic NRB available. The estate includes the family home (worth £250,000).
Without the RNRB, the estate would not all be covered by the NRB.
Example: RNRB
The family home is a QRI and the man’s children are direct descendants. The conditions for using the RNRB are therefore met. As the family home is worth more than the RNRB, the full amount of the RNRB is available.
The man therefore can use both his NRB of £325,000 and RNRB of £175,000. Together they cover the value of the man’s estate. There is therefore no IHT to pay on the man’s estate.
Transferring unused Residence NRB
It is also possible to transfer any unused RNRB to a surviving spouse.
The transfer of the RNRB is relevant when the survivor of a married couple dies and their pre-deceased spouse did not use their own RNRB. This may arise where the first of the couple to die:
Transferring unused Residence NRB
· did not own a QRI e.g. they did not own a residential property; or
· they did not qualify for the RNRB because they left a QRI to someone who was not a lineal descendant e.g. they left their entire estate to the surviving spouse.
Transferring unused Residence NRB
Note that providing the survivor dies after April 2017 they will be able to claim a transferred RNRB even if their pre-deceasing souse died before this date.
A transferred RNRB can only be used if the surviving spouse leaves a QRI to a direct descendant (i.e. conditions for the RNRB must be met on the second death).
Transferring unused RNRB
The home that the surviving spouse leaves to their direct descendants does not have to be the same house that they lived in with their deceased spouse(s) (the deceased spouse does not need to have owned any QRI).
Transferring the RNRB works in the same way as transferring the basic NRB, allowing the surviving spouse to increase the value of their RNRB by up to 100% (based on the percentage remaining of the deceased spouse’s RNRB). Where a full transfer occurs, an estate may qualify for a RNRB of £350,000 (£175,000 + £175,000).
Transferring unused RNRB
The tapered withdrawal of the RNRB for net estates worth more than £2 million applies with reference to the total RNRB. Where the survivor’s estate could claim £350,000 RNRB this amount is reduced by £1 for every £2 in excess of £2m, and no RNRB can be claimed for net estates worth £2,700,000 or more.
Example: Transferring RNRB
A died five years ago, leaving her entire estate to civil partner, B.
B died this year, leaving her estate to daughter, C. The estate includes the family home (worth £350,000).
B’s PRs can make a claim for the unused RNRB from A’s estate.
The total RNRB available for B’s death estate is £350,000 (B’s own RNRB of £175,000 plus an additional 100% uplift in respect of A’s RNRB).
Where the RNRB is claimed it is applied to the death estate as a whole, rather than set-off against the gift of the QRI separately.
RNRB: Downsizing
You should be aware of rules which allow an estate to qualify for a full RNRB even if the deceased did not own a QRI when they died (or the value of their QRI is less than the RNRB). These rules are referred to as the “downsizing” rules and the additional amount of the RNRB referred to as the downsizing addition.
Broadly, to qualify:
the deceased must have given away their QRI or downsized to a less valuable QRI on or after July 2015 (i.e. have lost the benefit of the full RNRB)
the former home would have been a QRI if it had been retained
RNRB: Downsizing
a direct descendant inherits the replacement QRI and/or other assets
The amount of the addition is calculated with reference to the amount of the RNRB which would otherwise be lost because the former QRI is no longer owned (or a less valuable QRI has taken its place).
A claim for the downsizing addition is made by the PRs within 2 years of the end of the month of death, not when the sale/gift of the former home takes place. However, details of the lifetime sale/gift will be needed by the PRs to bring the claim.
RNRB: Downsizing
The downsizing addition is only relevant if there is no QRI in the estate when the deceased died (but there was historically), or the value of the new QRI following a downsizing move is less than the current maximum RNRB.
The downsizing rules are not relevant if:
· there is no loss of the RNRB because the value of any new QRI in the estate is the same/more than the maximum available RNRB, or,
· the RNRB is not available, because the new QRI or assets are not left to a direct descendant
Application of the rules is complex and beyond the scope of this module but will never produce a total RNRB greater than the maximum otherwise normally available.
Maximum combined NRB
It is possible for a person’s estate to qualify for a total NRB amount of £1million.
Consider the following:
· A and B are married. A dies leaving all of their estate to B. A made no lifetime gifts.
· On A’s death no NRB is used because the whole of A’s estate passes to their spouse and is spouse exempt.
· B then dies leaving the whole of their estate to their children. B made no lifetime gifts.
· B’s estate is worth £1million and includes a family home worth £500,000.
Maximum combined NRB
When B dies, B’s PRs can claim:
· B basic NRB of £325,000
· B’s RNRB of £175,000 (the house passes to a direct descendent)
· A’s unused basic NRB of £325,000 (TNRB)
· A’s unused RNRB of £175,000 (transferred RNRB)
This gives a total combined NRB of £1 million (£325,000 + £325,000 + £175,000 + £175,000).
No IHT is payable on B’s death.
Summary
· Each individual is entitled to a basic nil rate band of £325,000 (‘NRB’). Chargeable transfers up to the value of the NRB are taxed at 0%.
· The NRB available is reduced by a person’s cumulative total. The cumulative total = total value of the chargeable transfers made in the previous 7 years.
· The PRs of a surviving spouse/civil partner can claim the unused % of the NRB of the pre-deceased spouse/civil partner (the transferred NRB (‘TNRB’)). The TNRB is capped at 100% of the basic NRB at the date of the survivor’s death.
Summary
· On death, an additional nil rate band of £175,000 can be claimed if the deceased left a ‘QRI’ to a direct descendant, referred to as the ‘residence nil rate band’ (‘RNRB’). There is a tapered reduction in the RNRB for estates worth more than £2 million.
· The PRs of a surviving spouse/civil partner can claim the unused % of the RNRB of the former spouse/civil partner (the transferred RNRB). The transferred RNRB is capped at 100% of the amount of the RNRB at the date of the survivor’s death.
· Estates without a QRI (or a QRI worth less than the maximum RNRB) might benefit from the downsizing rules.
IHT calculation on lifetime transfers
In this element we look at the full process of calculating the inheritance tax (‘IHT’) due on lifetime transfers.
There are two separate calculations that may be required:
The tax due on an immediately chargeable lifetime transfer (LCTs only).The tax due as a result of the transferor dying within seven years of making a lifetime transfer (LCTs and failed PETs).
You will need a calculator to follow the examples in this element.
Potentially Exempt Transfer (‘PET’)
A PET is a lifetime transfer of value to another individual. If the individual doesn’t survive for seven years after making the transfer, it becomes chargeable alongside their death estate. The rationale behind PETs is to prevent individuals avoiding IHT by giving away property shortly before their death.
The tax treatment of a PET is as follows:
Potentially Exempt Transfer (‘PET’)
- The transfer is not chargeable at the point it is made. No IHT is payable yet.
- It becomes fully exempt if the transferor survives seven years from the date of the PET.
- If the transferor dies within seven years of making the PET, the PET ‘fails’ and becomes a chargeable transfer and thus subject to IHT.
Lifetime Chargeable Transfer (‘LCT’)
All lifetime transfers of value made by a person into a trust on or after 22 March 2006 will give rise to an LCT.
The tax treatment is as follows:
- An LCT is a chargeable transfer when it is made. IHT is payable on the chargeable value of the LCT at the lifetime rate of 20%.
- If the transferor survives 7 years following the LCT there is no further charge to tax.
- If the transferor dies within 7 years, the LCT will be reassessed to tax at the death rate, using the NRB at the date of death.
Practice Alert: There are different rules for trusts set up for disabled people provided that statutory requirements are met. These rules are outside the scope of this module.
Calculating IHT on lifetime transfers
The following formula should be used when calculating IHT on lifetime transfers:
Step A
Calculate cumulative total
Step B
Identify value transferred
Step C
Apply exemptions and reliefs
Step E
Apply taper relief
Step F
Give credit for tax paid in lifetime
Note that Steps E and F only apply when the IHT is being calculated after death.
Calculating IHT on lifetime transfers
Step A: Calculate cumulative total
The cumulative total is relevant to lifetime transfers as it tells us how much of the nil rate band (‘NRB’) is available for the transfer. The cumulative total is calculated by adding up the value of all chargeable transfers made in the 7 years prior to the transfer.
Although cumulation only takes into account chargeable transfers made in a 7 year period, where an LCT or PET is reassessed, this can mean looking back as far as 14 years before the transferor’s death.
For example, if an LCT was made 7 years before the transferor’s death, it will be reassessed to tax at the death rate when the testator dies. It is then necessary to calculate the cumulative total for the LCT based on the 7 years prior to the LCT (i.e. the 7 year period starting 14 years before the death)
Cumulation example
A man makes the following transfers:
- 10 years before death: An LCT (chargeable value £4,000)
- 6 years before death: PET 1 (chargeable value £50,000)
- 2 years before death: PET 2 (chargeable value £10,000)
Both PETs have failed, making them chargeable. The LCT is also a chargeable transfer. It is not reassessed (it was made more than 7 years before death) but is relevant to the cumulative total.
Cumulation example
- The cumulative total applicable when calculating the IHT due on PET 1 is £4,000 (as the LCT was made 4 years before PET 1).
- The cumulative total applicable when calculating the IHT due on PET 2 is £50,000 (as PET 1 failed, has become chargeable and was made 4 years before PET 2. NB: the LCT is not considered as it was made more than 7 years before PET 2).
- The cumulative total applicable when calculating the IHT due on the death estate is £60,000 (as both PETs have failed).
STEP B: Identify value transferred
A ‘transfer of value’ is a ‘disposition’ which results in an immediate decrease in the value of the individual’s estate (s 3(1) IHTA).
Broadly, this means gifts but it can also include transactions at an undervalue (e.g. selling your house to a family member for less than it is worth – the difference in value counts as a gift). It applies to gifts of all forms of property (i.e. anything with a monetary value).
Forlifetime transfers, the value of a transfer is assessed by reference to the loss in value to the donor at the date of the transfer.
STEP C: Apply exemptions and reliefs
It is then necessary to apply any available exemptions or reliefs.
For the purposes of this module the exemptions and reliefs that you may be required to apply when calculating IHT on lifetime transfers are:
- Spouse exemption
- Charity exemption
- Family maintenance exemption
- Annual exemption
- Small gifts allowance
- Normal expenditure from income
- Marriage exemption
- Business property relief
- Agricultural property relief
- Taper relief (applies at Step E)
Exemptions and reliefs example
After applying all relevant exemptions and reliefs you will reach a figure for the chargeable value of the transfer. There are a lot more exemptions and reliefs available for lifetime transfers than for the death estate, so make sure you make use of them in the most efficient way.
A man makes a wedding gift of £12,000 to his daughter. He has made no other gifts in the last two years.
Apply reliefs in the following order:
- Marriage exemption: £5,000
- Current Annual Exemption (‘AE’): £3,000
- Last year’s AE: £3,000
Deduct total value of exemptions from value of gift to reach chargeable value: £12,000 - £11,000 = £1,000
STEP D: Apply basic NRB and calculate tax
Once you have established the chargeable value of the transfer, the basic NRB can be applied against the remaining taxable value.
Establish the value of the NRB.
Reduce the total NRB by the value of the cumulative total (from Step A).
Apply a rate of 0% to the value of the remaining taxable estate up to the total NRB amount.
Apply the relevant rate to the rest to establish the IHT due.
Key points to note:
- The residence NRB never applies to lifetime transfers.
- The NRB applicable to an LCT when it is first made is the NRB at the date of the transfer.
- The NRB that applies to a failed PET or re-assessed LCTis the NRB at the date of death.
As the NRB has been fixed at £325,000 since April 2009, this is the figure you should use unless a question tells you otherwise.
Rates of tax
After deducting the NRB, it is necessary to apply IHT to the remaining amount at the appropriate rate. This rate will differ depending on whether you are dealing with the tax due immediately on an LCT or are re-assessing a lifetime transfer (LCT or PET) because the transferor has died within seven years.
LCTs: When calculating the tax due immediately on an LCT, the tax is payable at the lifetime rate of 20%. Step D is the final step in the calculation.
Failed PETs and re-assessed LCTs: Tax is payable at the death rate of 40%. If the transferor dies 3-7 years after making the transfer, it is also necessary to apply taper relief at the relevant rate to reduce the IHT payable.
LCT Example: Lifetime rate
A man settles £400,000 on trust for his grandchildren (an LCT).
He made one PET (£50,000) three years before the LCT.
Calculate the IHT due on the LCT.
Step A: Calculate cumulative total
£0 (as the earlier PET has not yet failed)
Step B: Identify value transferred
£400,000
Step C: Apply exemptions and reliefs
AE for year of LCT: £3,000
AE for previous year: £3,000
Chargeable value: £400,000 - £6,000 = £394,000
LCT Example: Lifetime rate
Step D: Apply basic NRB and calculate tax
Nil rate: £325,000
Lifetime rate: (£394,000 – £325,000) = £69,000
£69,000 @ 20% = £13,800
Steps E and F: Reassessed transfers
PETs or LCTs made in the 7 years before death must be reassessed to IHT. This is separate to the calculation of IHT on the death estate. Although death is the trigger for the lifetime transfer being reassessed, these transfers do not form part of the death estate. The tax payable on a failed PET or reassessed LCT must be calculated separately.
If a PET or LCT is being reassessed it is necessary to consider Step E of the calculation (which involves applying taper relief to transfers made 3-7 years before the death)
If tax was paid on an LCT during the transferor’s lifetime and it is later reassessed at the death rate, it may also be necessary to consider Step F (which involves giving credit for tax paid in the transferor’s lifetime).
LCT Example: Lifetime rate
Step E: Taper relief
The rates of taper relief are set out below. You will see these rates expressed either as a % reduction in the amount of IHT due, or confirmation of the % that remains payable. Both produce the same outcome.
Step F: Giving credit for tax paid in lifetime
Where an LCT is being reassessed at the death rate, it is also necessary to factor in any tax that was paid at the lifetime rate.
This is done by deducting the IHT paid previously from that due as a result of the death (after taper relief has been applied). Only the balance needs to be paid to HMRC.
If the balance is reduced to nil as a result of crediting the previous payment, there will be no further tax to pay.
It is not possible to obtain a refund for the lifetime payment if the balance is negative.
LCT Example: Reassessing LCT
A man settles £400,000 on trust for his grandchildren (an LCT). Tax of £13,800 was paid on the LCT during the man’s lifetime. He made one PET (chargeable value £50,000) three years before the LCT. He dies three years after the LCT. He has made no other transfers.
Calculate the IHT due on the LCT after the man’s death.
Step A: Calculate cumulative total
£50,000 (because PET has failed)
Step B: Identify value transferred
£400,000
Step C: Apply exemptions and reliefs
AE (£3,000) x 2 = £6,000
Chargeable value: £400,000 - £6,000 = £394,000
Calculate the IHT due on the LCT after the man’s death.
Step D: Apply basic NRB and calculate tax
Nil rate: (£325,000 - £50,000) = £275,000 @ 0%
Death rate: (£394,000 – £275,000) = £119,000
£119,000 @ 40% = £47,600
Step E: Apply taper relief
LCT 3 years ago. 80% of £47,600 = £38,080
Step F: Give credit for tax paid in lifetime
£38,080 - £13,800 = £24,280
Total IHT payable
Practice Alert: Grossing Up
If IHT is payable as a result of a lifetime transfer and the transferor pays the tax (in addition to the gift itself), the reduction in the value of his estate includes the amount of IHT paid as well as the gift itself.
The value of the gift must be ‘grossed up’ to find the total value transferred before the tax due is calculated.
Grossing up is outside of the scope of the module but it is something to be aware of if you encounter IHT (or indeed other taxes) in practice.
Summary
· LCTs are lifetime transfers into a trust. PETs are lifetime transfers to an individual.
· LCTs are immediately chargeable to IHT at a rate of 20%. Use the following process to calculate the tax due:
A. Calculate the cumulative total
B. Identify the value transferred
C. Apply exemptions and reliefs
D. Apply basic NRB and calculate tax at the appropriate rate
Summary
If the transferor dies within 7 years, the LCT must be reassessed, using the same 4 steps (but applying a tax rate of 40% at Step D). It is then necessary to apply taper relief (Step E) at the appropriate rate and apply credit for any tax paid during the transferor’s lifetime (Step F). (Credit is given for any tax paid in their lifetime but no refund is given if the tax due on death is less than that already paid at the lifetime rate).
· PETs are not chargeable unless the transferor dies within 7 years, in which case they are reassessed at the death rate of 40%. Follow Steps A to E to calculate the tax due.
Inheritance tax calculation on death
In this element we look at the full process of calculating the inheritance tax (“IHT”) due when someone has died.
It can be quite a complicated calculation, depending on the size and nature of the estate, as well as how the deceased dealt with their assets during their lifetime.
You should follow the seven step process below to help you break down the calculation and effectively work out the IHT due.
Inheritance tax calculation on death
Step 1
Calculate cumulative total
Step 2
Identify assets included in the taxable estate
Step 3
Value the taxable estate
Step 4
Deduct debts/expenses
Step 5
Apply exemptions & reliefs
Step 6
Apply RNRB
Step 7
Apply basic NRB and calculate tax
Step 1: Calculate the cumulative total
The cumulative total is relevant to the death estate as it tells us how much of the nil rate band (‘NRB’) is available. The cumulative total is calculated by adding up the value of all chargeable transfers made in the 7 years prior to the death.
Consider the example below. (Note this is a simplified example which doesn’t take into account the availability of any exemptions or reliefs.)
A man died last week. He made the following chargeable transfers in the last 7 years:
- A PET, three years ago (chargeable value £20,000). This has now failed.
- An LCT, two years ago, (chargeable ,value £5,000).
The man’s cumulative total is £25,000. His NRB is therefore reduced from £325,000 to £300,000.
Step 2: Identify the taxable death estate
It is crucial to appreciate that the rules determining the property included in a person’s estate for tax purposes are different to those which govern the property included in a person’s succession estate. Therefore, the value of a person’s taxable death estate will frequently be different to the value of their succession estate.
The general rule is that all property to which the deceased was beneficially entitled at the date of death is included in the estate for IHT purposes. This would include property situated both in the UK and abroad (where the taxpayer is UK-domiciled).
Step 2: Identify the taxable death estate
However, certain items of property may appear to belong to the deceased but are excluded for IHT purposes and conversely other types of property which do not belong to the deceased before death are included in the taxable estate. Everything that is not specifically excluded will be included in the taxable estate.
Assets included at Step 2
The following assets are included in the taxable estate even though, in some cases, it may not be immediately obvious why (e.g. because the deceased did not actually own the asset when they died):
- All jointly owned property
- Property subject to a reservation
- Donationes mortis causa
- Statutory nominations
- Some interests in possession
Jointly owned property
Where the deceased owned property as a tenant in common, this share passes into the deceased’s estate for both tax purposes and distribution purposes.
Where the deceased owned property as joint tenants with another/others the distribution of the property and the tax position are considered separately.
Although the survivorship rule applies for distribution purposes, for IHT purposes there is a deemed severance of the joint tenancy immediately before death. This means that the deceased’s ‘share’ of the property will be included in their taxable estate.
Example
A testator’s estate consists of:
- House in sole name: £300,000
- Chattels (joint tenants): £8,000
- Cottage (tenants in common in equal shares): £200,000
The succession estate is worth: £300,000 (house) + £100,000 (1/2 cottage) = £400,000. The chattels pass by survivorship.
The taxable estate is worth: £300,000 (house) + £4,000 (half chattels) + £100,000 (1/2 cottage) = £404,000.
