Simplifying the design of inheritance tax

This is the title of a report issued by the Office of Tax Simplification (OTS) at beginning of July.  It is in fact the second report issued by the OTS on inheritance tax but the first related purely to the administration and is not the sort of thing of great interest to most of us. There have been articles on this, both in the national press and in the professional press, and the writer hopes that his thoughts on the subject won’t just repeat what everybody else has said

Before commenting on the recommendations contained in the report, it is perhaps worth considering some of the items on which no recommendations were made. The principal reason that no recommendations were made on these topics was because they were outside the scope of the report and reading it, one rather felt that the authors would very much like to have made some recommendations on one or more of these topics.  Firstly, there was the Residence Nil Rate Band. This is the latest big change to inheritance tax, and whilst it is popular with those who benefit from it, it is universally disliked by most professionals; partially for its complexity and partially because it is perceived as operating in a very unfair manner. Despite this, the OTS felt constrained from making any recommendations but suggested that the government should in the not too distant future review the operation of the exemption. The OTS also did a fairly comprehensive review of the treatment of trusts and concluded that the rules were less than straightforward with many people, both professionals and amateurs misunderstanding them and making mistakes. However, her Majesty’s Revenue and Customs are currently engaged in a wide consultation on trusts and for this reason the OTS refused to make any recommendations

The OTS also examined and provided illustrations of the impact on the tax in the event that the various reliefs had been indexed. The Nil Rate Band (as distinct from the Residence Nil Rate Band) which is currently £325,000, has been frozen since 2008, and if this had been indexed in line with inflation it would now be worth an inheritance tax exemption of £423,000.  Even more dramatic is the annual gift exemption which is currently £3000 and has not been increased since 1980.  If this was increased in line with inflation, the annual limit would be £11,900. Whilst the OTS made no recommendations in respect of either of these, there seems to be an underlying tone in their report that government should look at increasing these limits as part of any review.  

Turning now to what the OTS did actually recommend, these make quite interesting reading and could have some quite dramatic effects

Firstly, they recommended that the period for which lifetime gifts could be brought into tax should be reduced from 7 to 5 years. This is what is commonly known as a “failed Potential Exempt Transfer” or “a failed PET”. The reasoning behind this was mainly to do with practical matters such as record-keeping, but there was also strong indication that the number of failed PETs made between 5 and 7 years before death is actually quite small and the taxation impact of this change probably be very limited.  More controversially they suggested abolishing taper relief.  I hear many of you shouting in horror at this, but from experience I suspect that almost everybody who raises this shout does not understand how Taper relief works and indeed that ignorance is one of the reasons for recommending its abolition.  Taper relief only benefits the very rich who can afford to give away very large sums of money (more than the current Nil Rate band of £325,000), for the majority of us, taper relief has absolutely no effect.  The writer has spent much of the last 30 years lecturing on this topic, the abolition of taper relief would remove a shock factor from some of his seminars but would hurt very few people.  There was also a recommendation to remove an obscure rule which affects relatively few people when it is required to look back not 7 years before someone’s death, but 14 years.  

Following on from the above, there was recommendation that there should be a package of amendments to the annual exemption rules, including the possibility of getting rid of some of the special exemptions, such as those for marriage gifts and for the amendment of, or removal of the Normal Expenditure out of Income Exemption (NEIE).  Broadly speaking, the suggestion here was that the annual exemption should be significantly raised at the same time, made very much simpler. This recommendation is an interesting one because it seems likely that one universal annual exemption would undoubtedly benefit the majority of the population who want to make gifts but get scared when they are told about the £3000 limit.  However the NEIE is a very valuable exemption particularly for those who are lucky enough to have a high level of disposable income and is something on which we regularly advise clients and help them to obtain very substantial cumulative exemption from tax in their twilight years.

Still on the subject of lifetime giving, it was suggested that perhaps there should be some reform of the way in which tax was charged on failed PETs as there are some unpredictable and sometimes unjust results that follow from the current system.

Another recommendation was that the proceeds of Term assurance policies should be exempt from tax. Term assurance is a form of protection against unexpected death, amongst things it is commonly used to fund the tax on failed PETs.  Many term policies are written in trust which usually takes them outside the Inheritance tax net.  The point of the recommendation was simply to ensure a level playing field irrespective of whether or not a policy is written in trust.

Almost inevitably and as expected by many of us, the other area on which the report concentrated was the availability of Agricultural Property and Business Property reliefs (APR and BPR). This is a battleground for practitioners, the relief is worth vast amount of saved tax but it has been argued for a number of years that these reliefs are failing to achieve their objectives. The principal idea behind APR and BPR relief’s was to enable small family businesses to be passed down the generations without inheritance tax forcing the family to sell the business following a death. Increasingly however, professional advisers such as ourselves have sought to help clients use these reliefs to avoid inheritance tax without necessarily passing on the business.  

It followed from this that there were a number of recommendations which were designed to result in a flatter playing field and to encourage entrepreneurs and farmers to pass their businesses on.  Some of this related to trying to make the rules relating to inheritance tax mirror the rules that apply to other taxes, for example certain capital gains tax reliefs have much stricter requirements than inheritance tax, while in other areas the capital gains and income tax rules are more relaxed than those that apply to Inheritance tax.  

On top of this there was one recommendation that will almost certainly prove to be a real political hot potato. This was that in cases where another exemption applied, principally APR and BPR but possibly also Spouse exemption then what is called the “free capital gains tax uplift”, should be denied. The current situation is that when somebody dies it is treated as if that person sold all their assets on their death and that the executors immediately reacquired them at a price equal to their value on the date of death and that any capital gain that accrued to the deceased person is wiped out.  The free capital gains tax uplift only applies on death and this tends to encourage them to hang on to their farms and businesses, so as to get the benefit of the free capital gains tax uplift which when combined with the exemption from inheritance tax is a very attractive option for their family who then inherit free of both inheritance tax and any accumulated capital gains. 

In such a situation, the family can and frequently do then immediately sell the business or the farm and pocket the proceeds tax-free. The OTS claimed there was quite a bit of evidence that encouraged farmers and entrepreneurs to hang onto their businesses, often managing them less and less effectively and actually making the idea of inheriting a working business less and less attractive. The recommendation from the OTS is an extremely interesting one and would almost certainly result in some changes of behaviour. In particular, it might encourage a few farmers to retire rather than to try and keep working less and less productively during their twilight years stop. If this recommendation was put in place, it would probably be possible to take over the family business free of both Inheritance tax and capital gains tax BUT the liability for capital gains tax would remain making a sale of the business less attractive.

Inevitably there was quite a bit more in the OTS report but is it impossible to cover it in one short article such as this.

In summary, the ideas presented are very interesting. There would inevitably be winners and losers, but unlike so many recommendations that we see, the aim was to try and make life simpler and not to find a way of sneaking extra tax rises in.  As to whether or not some or all of this will ever be enacted is difficult to say. Most of this article was written prior to Boris Johnson’s arrival at 10 Downing Street.  The OTS is very much the brainchild of Messrs. Osborne and Hammond neither of whom are great fans of Boris, nor Boris fans of them, and in any event there are currently bigger fish to fry. On the other side of the fence we have Messrs Corbyn and his friends whose views on inheritance tax are well-known and would almost certainly condemn this report to the rubbish bin.  It follows that this is probably a space to watch.

This writer believes that its report merits further consideration and would like to see at least some of its recommendations implemented, albeit that wearing his cynic’s hat he is a little concerned that making Inheritance tax easier to understand may not be good for his own future as a specialist tax adviser! It will however be a case of watch this space.  For further advice on inheritance tax and particularly on matters relating to the NEIE, APR or BPR contact a member of the private client’s team.  While these reliefs are still available we are only too happy to advise on them

This reflects the law at the date of publication and is written as a general guide. It does not contain definitive legal advice, which should be sought as appropriate in relation to a particular matter.

Graeme Black
Partner, Private Wealth & Inheritance
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This reflects the law and market position at the date of publication and is written as a general guide. It does not contain definitive legal advice, which should be sought in relation to a specific matter.

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