HOW INHERITANCE TAX WORKS

The previous chapter which dealt with gifts to the young and age contingent gifts touched upon the different tax consequences of leaving bequests to young people in different ways and there are other ways in which the tax payable by your family can be increased or decreased by your will. When making a will you should consider your family’s position overall and as a single entity.

The main tax involved with death is inheritance tax and you need to have a basic understanding of how inheritance tax works, and how it is calculated, to enable you to decide if you can take steps by your will to minimise it.

Which of your assets are taxed?

If you have your domicile in the United Kingdom inheritance tax applies to all your non-exempt assets in whatever country they may be, but if your domicile is outside the United Kingdom the tax will only apply to those of your non-exempt assets that are situated in the United Kingdom. The United Kingdom for the purpose of inheritance tax includes England, Wales, Scotland and Northern Ireland but does not include the Channel Islands or the Isle of Man. Please refer to Chapter 3, pages 26 and 27 for an explanation of the meaning of ‘domicile’ and where you are deemed to be domiciled for the purposes of inheritance tax.

How the tax is calculated

Unless it is ‘excluded property’, upon your death inheritance tax is charged upon the total of

• the market value at the date of your death of everything you own and everything you have given away in the last seven years of your life which is not specifically exempted from the tax.

(A list of excluded property and a list of exempt gifts is set out on pages 68-72.)

• The full capital value of the assets of any trust created before 22 March 2006 of which you are entitled to the income or a share of the income for your life;
• the full value of the assets of any trust which qualifies as a disablement trust under section 89 of the Inheritance Tax Act 1984 (see pages 64 and 65) and of which you are the disabled beneficiary; and
• the value of anything you have purported to give away but from which you continued to benefit.

You may deduct from the total of these figures:

• a)the cost of realising or administering any property outside the United Kingdom up to 50 per cent of its value;
• b)your reasonable funeral expenses; and
• c)any debts and liabilities you have at the date of your death.

The tax is calculated as a percentage of the resultant figure less the ‘Nil Rate Band’ currently at £300,000. The percentage is 40 per cent at the time of writing (2007).

Some relief from inheritance tax is given in respect of the following assets if they have been owned for two years or more prior to death:

• most shares traded on the Alternative Investment Market (AIM);
• the agricultural value of agricultural property;
• businesses (other than property and investment businesses); and
• woodlands.

Conditional relief may also be available in respect of Heritage Assets.

Which assets are exempt from the tax?

The following are excluded property:

• Savings Certificates and Premium Bonds owned by people who are domiciled in the Channel Islands or the Isle of Man;
• certain British government stock owned by those living abroad;
• certain overseas pensions and lump sums payable on your death;
• emoluments and tangible movable property which is owned by visiting armed forces;
• property of service people who die as a result of active military service;
• by concession, awards for valour or gallantry (not necessarily in a military context), which have never been transferred in return for money or money’s worth. The award need not have remained in the same family and need not have been a medal but could be a sword or silverware for example;
• property situated outside the United Kingdom if you are domiciled outside the United Kingdom;
• your foreign currency bank accounts with most banks in the United Kingdom if you are of foreign domicile and not resident or ordinarily resident in the United Kingdom;
• most reversionary interests, i.e. most presently owned rights you have to property upon the death of someone who is currently entitled to the property during their lifetime under a trust. As an example consider the following: A by his will left his house on trust for B during B’s life and after B’s death for you. After A’s death B would have a life interest in the house and be known as the tenant for life and you would have a reversionary interest in the house and be known as the remainderman. Reversionary interests are excluded property unless they are rights to which the person who set up the trust or his spouse or civil partner is or has been entitled or they have been acquired at any time for money or money’s worth (e.g. by exchange for something which could have been sold).

Gifts which are exempt from tax

The following gifts are exempt from inheritance tax.

• Out and out gifts you make more than seven years prior to your death without retaining any benefit from the gift, unless the gift is made to a company or to a trust (other than a trust for the disabled). Gifts you make to a company or to a trust (other than a trust for the disabled) are immediately chargeable gifts. With the exception of immediately chargeable gifts, gifts remain only potentially liable to inheritance tax for the seven years after they have been made and are known as PETS, a concept and an acronym which should be remembered because they will feature prominently in later pages. If you survive the making of a PET by seven years the PET is completely exempt from the tax whatever its value.
• Gifts of any amount you make to your spouse or registered civil partner, unless you are domiciled in the United Kingdom but your spouse or civil partner is not, in which case the exemption is limited to £55,000.
• Gifts of not more than £3,000 in total which you make in any tax year. Any unused benefit from this exemption can be carried forward for one, but only one, tax year and the annual exemption for any current tax year is used up before the unused balance of the annual exemption from any previous tax year. Suppose, therefore, that you make a gift of £1,000 to your son in tax year 1 and a gift of £4,000 to your daughter in year 2. In tax year one the £1,000 gift is exempt because it is less than the £3,000 exemption level and there is £2,000 of the exemption for year 1 that can be carried forward to tax year 2. In tax year 2 the benefit of the £2,000 unused exemption from year 1 is available, together with the £3,000 annual exemption for year 2, to be set against the gift of £4,000 made to your daughter in year 2 with the result that that gift is also completely exempt, but the rule is that the excess of £2,000 from year 1 is to be used up after the £3,000 annual exemption for current year 2 has been applied and accordingly only £1,000 of the excess from year 1 is used in year 2. Because it can only be carried forward for one year, £1,000 of the £2,000 unused from the exemption in year 1 is wasted and cannot be used against any gift of over £3,000 made in tax year 3.
  
  If the total value of gifts which are not covered by any other exemption in any tax year exceed this annual exemption and any useable balance from any previous tax year, the excess is taxable.
• Gifts made during your life which are made as part of your normal expenditure out of your income and not from capital and which do not reduce your standard of living. Normal expenditure is expenditure which is in accordance with a settled pattern of your expenditure and that pattern may be proved either by showing that you have made such payments regularly in the past or that you have taken a decision to make them in the future, for example, by entering into a covenant to do so. There is no minimum period during which the payments must be made as long as the period is more than nominal and a single payment will be sufficient if there is sufficient evidence to show that you intended to continue them.
• Wedding gifts made before the ceremony during your life, up to £5,000 to your child, up to £2,500 to your grandchild and up to £1,000 to anyone else.
• Gifts made in your lifetime for the maintenance of your spouse, ex-spouse, civil partner, ex-civil partner, or dependant relatives and dependant children who are under the age of 18 or are in full-time education.
• Gifts to registered charities for charitable purposes.
• Gifts for certain national purposes including gifts to most museums and art galleries and to political parties which have at least two sitting members of the House of Commons or which have one sitting member and whose candidates polled 150,000 votes at the last general election.
• Gifts of land to registered Housing Associations.

You can make gifts in any number of the above classes to the same person without losing the benefit of the exemption and, in addition, under what is known as the small gifts exemption, you can make any number of gifts of up to £250 in a tax year provided that you have made no other gift to the same person in the same tax year. If the sum you give under the small gifts exemption exceeds £250 the benefit of the exemption is lost and the entire sum is taxable. This is in contrast to the situation in respect of the annual exemption where only the excess over the amount of the exemption is taxable and the remainder is exempt.

Married people and those with a registered civil partner should remember that each spouse and civil partner has a separate set of gift exemptions.

How the tax on gifts is calculated

Gifts are valued for inheritance tax purposes at the amount by which your estate is diminished as a result of the gift and not by the amount by which the donee benefits from the gift. Inheritance Tax at 20 per cent will have been paid on immediately chargeable non-exempt gifts made in your lifetime if the total value of the gifts in the previous seven years exceeded the then tax threshold and you will be given credit on your death for tax which has been paid on them, but if the tax paid exceeds the tax payable on them at death, the excess is not repayable. As mentioned above, immediately chargeable gifts are gifts to discretionary trusts and gifts to companies. Currently, inheritance tax is charged on chargeable gifts made in your lifetime at 20 per cent, one half of the rate charged in respect of your chargeable estate at your death.

The inheritance tax threshold is £300,000 for the tax year 2007/8, £312,000 for the tax year 2008/9 and £325,000 for the tax year 2009/2010 and the amount of your estate that falls between nil and the tax threshold is known as the nil-rate band. Inheritance tax is only payable on the value of your estate, calculated as above, which exceeds the tax threshold, the amount of your estate which is below the tax threshold being exempt.

Any non-exempt gifts you make in the seven years prior to your death will reduce the tax threshold available to set against your estate at your death.

Gifts made between three and seven years before your death are known as potentially exempt transfers (PETS) and in the case of such gifts only a proportion of the tax is charged, the proportion depending upon how long you survive the making of the gift.

• At the time of writing (2007), if you survive the making of the gift by over seven years no inheritance tax is payable in respect of the gift.
• If you survive the making of the gift by between six and seven years, tax is payable in respect of the gift at 20 per cent of the death rate, i.e. at the rate of 8 per cent.
• If you survive the making of the gift by gift between five and six years, tax is payable in respect of the gift at 40 per cent of the death rate, i.e. at the rate of 16 per cent.
• If you survive the making of the gift by between four and five years, tax is payable in respect of the gift at 60 per cent of the death rate, i.e. at the rate of 24 per cent.
• If you survive the making of the gift by between three and four years, tax is payable in respect of the gift at 80 per cent of the death rate, i.e. at the rate of 32 per cent.

This reduction of the tax payable on PETS is known as taper relief.

Benefiting from things you have given away

The reservation of a benefit rule

If, to use the technical term, you reserve a benefit from the gift, that is to say retain an interest in or continue to benefit in some way from the property you give away, for example, if you give away your house but

• continue to live in it at a less than a commercial rent; or
• retain the right to live in it as long as you wish prior to your death; or
• occupy it for the occasional holiday;

you will gain no inheritance tax relief in respect of the gift and it will be counted as part of your estate when you die. Making a gift to reduce inheritance tax must be a case of giving all or nothing. You cannot have your cake and eat it. HM Revenue and Customs takes a strict view of what constitutes reservation of a benefit.

The rules relating to pre-owned assets

Various complicated schemes, (usually based upon the use of trusts), have been marketed to avoid the inheritance tax liability resulting from the gifts with a reservation of an interest rule. As with any artificial arrangements which are solely for the purpose of saving of tax you should think carefully before entering into them because they have a habit of rebounding upon the taxpayer. In his budget of March 2004 the Chancellor of the Exchequer outlined proposals for a ‘free standing income tax charge’ based on ‘pre-owned assets’ to counteract such schemes and ‘the benefit people get from having free or low cost enjoyment of assets they formerly owned or provided funds to purchase’. The proposals were enacted into law by Schedule 15 of the Finance Act 2004 and apply from 6 April 2005.

A ‘note’ was issued by the Treasury and what follows is largely based upon that note and the Act. To the extent that it is Crown copyright material, Crown copyright is acknowledged and it is reproduced with the general permission given by the Controller of HMSO.

The income tax charge is similar to the income tax charge made upon employees for benefits in kind supplied by their employers and quantifies in cash the annual benefit enjoyed. The charge applies both to tangible and intangible assets and to any funds or contributions to the funds used to acquire the assets whether the funds or contributions are directly or indirectly provided. It is equivalent in the case of property to the annual rental value of the asset or in the case of other assets, the value of the asset at a rate of interest, and in each case less any payment made under any legally binding agreement for the use of the asset.

After the deduction of the amount paid for the benefit, the sum so ascertained is added to your taxable income and taxed at your top rate of tax. The first £5,000 per annum is ignored but once the £5,000 exemption is exceeded, the exemption is totally lost and tax is payable on the entire sum, not just on the excess.

The income tax charge does not apply to the extent that:

• the asset was disposed of before 18 March 1986;
• the formerly owned asset is currently owned by your civil partner or your spouse;
• the asset still counts as an asset for inheritance tax purposes under the gift with a reservation rules;
• the asset was transferred to your spouse, former spouse, civil partner or former civil partner by court order;
• the asset was sold for cash at arm’s length whether or not the parties were connected persons;
• the owner of the asset was formerly the owner of the asset only by virtue of a will or intestacy which has subsequently been varied by agreement between the parties (i.e. by a deed of family arrangement, as explained in Chapter 10);
• any enjoyment is no more than incidental, including cases where an out and out gift to a member of your family comes to benefit you as a result of a change in his circumstances;
• it is the case of an outright gift of money made more than seven years or more before the earliest date upon which you either occupied the land or had the use of the asset as applicable;
• the original gift was for the maintenance of your family or within the small gifts exemption or within the inheritance tax annual gifts allowance.

Former owners are not regarded as enjoying a taxable benefit if they retain an interest which is consistent with their ongoing enjoyment of the property. For example, the charge will not arise if your elderly parent owning the whole of their home passes a 50 per cent interest to you and you live with your parent. It could well apply if they gave a 90 per cent interest to you.

If you so elect before 31 January after the end of the first tax year in which the pre-owned asset rules apply to you, you may choose to have the property concerned treated as part of your estate for inheritance tax purposes as a gift with reservation of an interest rather than have the benefit taxed as income. In those circumstances, the property would be eligible for the normal IHT reliefs and exemptions available, for example, to business and agricultural property and to heritage assets. As to these reliefs and exemptions, please see below.

If you have, or are deemed to have, a UK domicile, the scheme imposing the income tax liability in respect of pre-owned assets affects all your assets wherever the assets are; if you do not have and are not deemed to have a UK domicile, only your assets in the UK are affected.

If you give an asset away and pay a full commercial rent or hiring fee to use it, although doing so will save inheritance tax and a possible pre-owned assets charge, it will not be an otherwise tax efficient transaction because as far as income tax is concerned, you will be paying the rent out of your taxed income and the recipient of the gift will have to pay income tax on the rent. Moreover, if it was your principal private residence you will lose your capital gains tax exemption for a principal private residence.

Reliefs against inheritance tax

There are certain circumstances and certain types of property viz. agricultural property and businesses (other than investment company or property businesses) and woodlands, which have been owned for at least two years prior to death, in respect of which relief is given against inheritance tax and it is either reduced or not charged at all.

Business property relief

How business property relief works

Business property relief operates to reduce by 100 per cent or 50 per cent, for inheritance tax purposes, the value of ‘relevant business property’ in a qualifying business which has been owned for two years and operates whether the property is situated here or overseas. Relevant business property that has been owned for less than two years but replaces relevant business property which has been owned for two of the preceding five years also qualifies for relief. The amount of the reduction depends upon the type of relevant business property concerned.

What property is entitled to business relief?

Broadly speaking, relevant business property which is entitled to 100 per cent relief consists of:

• an unincorporated business or a share of an unincorporated business, such as a share in a partnership;
• shares in a company which are not quoted on a recognised stock exchange (although most shares which are traded on the Alternative Investment Market (AIM) do benefit from 100 per cent relief);
• securities that are not quoted on a recognised stock exchange, which you own and which, either by themselves or when combined with other unquoted shares or securities you own, give you control of the majority of the voting rights in the company;
• assets you use in the business that are assets of a trust which you are presently entitled to use under the terms of the trust.

Relevant business property entitled to 50 per cent relief consists of:

• securities or shares that you own in a company which are quoted on a recognised stock exchange and which, either by themselves or when combined with other quoted shares or securities you own, give you control of the majority of the voting rights in the company;
• assets that you own personally which are used, mainly or wholly by a qualifying business in which you are either a partner or a controlling shareholder.

Business property relief does not apply to assets that have not been used wholly or mainly for the purpose of the business throughout the preceding two years or are not required for an identified future use in the business, e.g. investments of the business or excessive cash balances. Parts of buildings or land which are used exclusively for the business are treated separately and entitled to business relief if they fulfil the other requirements.

Assets of the business which have not been owned for the preceding two years can qualify if they replace assets that have been owned for two of the preceding five years. In the case of assets inherited from your spouse or registered civil partner, the period during which your spouse or civil partner owned the assets can be included to make up the period of two years of the two-year business property relief rule. Further, the rule does not apply to otherwise qualifying relevant business property which was entitled to relief when it was acquired by you, by your spouse or civil partner, if either the current disposal or the earlier disposal was or is made on death.

What businesses are entitled to business relief?

The business must be one that is carried on for profit and it must be a trading business and not an investment business. The relief does not apply to businesses wholly or mainly engaged in dealing in land, buildings, securities, shares, or the making or holding of investments, although the business of a market maker or discount house in the United Kingdom qualifies for business relief. Neither does the relief apply to businesses or business property which are subject to a contract of sale at the relevant time, unless the sale is in return for shares in the acquiring company which will continue the business. Therefore the relief does not apply to a share in a partnership if it is a term of the partnership deed that the partnership share must be sold to the remaining partner or partners.

Agricultural property relief

How and when agricultural property relief is applied

In many ways agricultural property relief resembles business property relief. It operates to reduce for inheritance tax purposes the agricultural value transferred by a transfer of an asset by 100 per cent or 50 per cent and does not apply if the asset is under a binding contract for sale at the time of the disposition. The relief applies only to the agricultural value of the property concerned, i.e. it does not apply to the value which the property would have if it were used, or could ever be used, for any purpose other than agriculture. Consequently, the value of an asset for the purpose of calculating agricultural property relief is sometimes less than its value as a business asset. If agricultural assets form part of a business, although double relief is not possible, it is sometimes possible to claim business relief on the excess of their business value over their value as agricultural assets if they do not qualify for agricultural property relief and if the appropriate conditions for business property relief are met. If assets qualify for both agricultural relief and business relief, only one relief is given and that relief is agricultural property relief.

Except for the situation set out in the next paragraph, to claim agricultural property relief you must either have occupied the property for agricultural purposes for the two years immediately preceding the disposition or it must have been owned by you throughout the period of seven years immediately preceding the disposition and occupied by you or by someone else for agricultural purposes throughout that period. If you inherited the property upon the death of your spouse or registered civil partner, the period of ownership and occupation by your spouse or civil partner can be included when computing the periods of occupation or ownership as the case may be and occupation by a company in which you control the majority of the voting rights counts as occupation by you.

If the property was entitled to agricultural relief when you, your spouse or your civil partner acquired it on a death or the present disposition occurs on your death, the relief can be claimed without the necessity for complying with the time conditions, provided that the property was occupied for agricultural purposes by the personal representatives of the person from whose estate it was acquired or you so occupy it when you die.

The property to which agricultural property relief applies

Agricultural property relief only applies to certain agricultural property situated in the United Kingdom, the Isle of Man or the Channel Islands. It does not apply to agricultural property situated elsewhere.

The agricultural property concerned is:

• agricultural land;
• woodlands and buildings occupied with agricultural land and used for the intensive rearing of livestock or fish if the occupation is ancillary to the use of the agricultural land. To be ancillary to the use of the agricultural land the woodland or buildings, as the case may be, must be used as a subordinate part of the farm;
• farmhouses and other farm buildings which are of a size and character appropriate to the requirements of the farm concerned and farm cottages occupied by agricultural employees of the farm. If the size of the ‘farmhouse’ is disproportionate to the size of the land being farmed with it and more like a country house, it will not be considered to be a farmhouse and not be entitled to agricultural property relief. Similarly if you own the ‘farmhouse’ and live in it but let the land to another who farms it, the ‘farmhouse’ will not be entitled to agricultural property relief because it will not be a farmhouse in the true sense of the word in that it is not occupied for the agricultural purpose of farming the land. The extent to which the person who occupies the farmhouse must be involved in the actual day-to-day working of the land to retain the farmhouse’s entitlement to agricultural relief is an interesting but unresolved question. Is it sufficient that the occupier retains general control of the strategy and running of the farm and is entitled to its fluctuating profits whilst contracting out the day-to-day work on the farm to a manager, or must the occupier actually carry out the farming processes in person? Perhaps the best way of looking at the question is to ask how great a convenience or necessity it is for the occupier of the house to live there if he is to carry out the functions he carries out in connection with the farming of the land;
• growing crops transferred with the relevant land;
• stud farms for horses and associated pasture;
• land which is part of a habitat scheme;
• controlling shareholdings which meet the time test in farming companies that also meet the two- or seven-year test in relation to the qualifying assets of the companies, but only to the extent that the agricultural value of the companies’ qualifying assets is represented in the shareholding. To calculate the proportion of the value of the shares in respect of which agricultural relief is available, divide the value of the company’s eligible assets by the value of its total assets and multiply the resulting figure by the value of the shares. Agricultural property relief is not given in respect of shareholdings in such companies other than controlling shareholdings and is not given in respect of any value other than the agricultural value. Nor is it given in respect of assets that are not eligible assets.

It should be noted that agricultural relief does not apply to agricultural machinery or stock.

Which rate of relief applies?

The agricultural value of the asset transferred is reduced by 100 per cent for inheritance tax purposes if:

• you have owner occupation or have the right to obtain vacant possession within 24 months; or
• you have an agricultural tenancy which commenced on or after 1 September 1995; or
• the case is the unusual one of land let on a tenancy commencing before 10 April 1981 in respect of which certain conditions apply and in respect of which transitional relief is given at 100 per cent.

In all other cases it is reduced by 50 per cent.

Agricultural relief and mortgaged property

If a mortgage is secured upon agricultural and non-agricultural property, it is necessary to apportion the amount of the mortgage between the agricultural value of the agricultural property and the full commercial value of the non-agricultural property in proportion to the respective values and then deduct the respective apportioned amounts of the mortgage from the respective gross values to ascertain the net value of each part. Agricultural relief at the appropriate rate is then applied to the net value agricultural value of the agricultural part and the resultant figure is then added to the net value of the non-agricultural property to ascertain the total value upon which inheritance tax is to be charged.

Woodland relief

In some circumstances you can obtain temporary relief from inheritance tax on your death on the value of timber growing on land (other than agricultural land) within the United Kingdom, but not on the value of the land upon which the timber is growing. Throughout the five years prior to your death you must have owned or had an interest in possession (such as a life interest) in the land upon which the timber is growing or you must have been given and not purchased it. This condition is to prevent you from making a deathbed purchase of woodland as a tax avoidance measure. The relief is not available for disposals in your lifetime and must be claimed by your personal representatives who must make an election within two years of your death unless the Revenue is prepared to exercise its discretion and accept an election made at a later date.

Woodland relief does not apply to shares in companies which own woodlands and is seldom used because the conditions for business relief or agricultural relief can usually be complied with.

On a later disposal of the timber (other than to the owner’s spouse or registered civil partner) inheritance tax is payable on its net value at the time of disposal but at the rate applicable on your death, unless the rate has been reduced when the appropriate rate is that applicable at the date of the disposal. The value of the timber is likely to be higher then than it was on your death. In calculating the net value, the expenses of replanting the woodland within three years and the expenses incurred in disposal can be deducted if they are not claimable for income tax.

Relief for heritage assets

Limited conditional relief is given in respect of land, buildings and objects which appear to the Treasury to be of outstanding importance from the point of view of the national heritage, the relief being dependent upon specified obligations designed to preserve the asset and afford public access to it in this country being undertaken by your beneficiaries.

Double taxation relief

If an asset which you own is situated in a foreign country which will charge a tax similar to inheritance tax and inheritance tax would also be chargeable in the United Kingdom, relief will be given as a credit against the United Kingdom tax payable in respect of the overseas asset. The relief given is the lower of the foreign tax which will have to be paid in respect of the asset and the United Kingdom tax which would otherwise be payable in respect of the asset, the United Kingdom tax being calculated at the average percentage rate payable in respect of your estate.

Other reliefs from inheritance tax exist but they cannot be planned for and are consequently not material to a book on making a will.

Who bears the inheritance tax?

In brief

• If you make a PET (including a transfer of value into a trust for disabled beneficiaries) no tax is payable unless you die within seven years in which case it is borne by the donee and taper relief will be available if you survive the gift by three years or more.
• If you make an immediately chargeable transfer (such as a transfer of value into a trust other than a trust for disabled beneficiaries or a transfer to a company) during your life and the transfer causes your unused nil-rate band to be exceeded
  • a)you can agree with the donee who will bear the immediately chargeable tax, but if you bear the tax the transfer will be treated as a gift of the sum given and of the relevant tax and the sum must be grossed up to ascertain the tax payable. The tax is payable at the lifetime rate which is one half of the rate chargeable on death;
  • b)if you die within seven years of making the gift additional tax will become payable to bring the tax paid up to the death rate and the additional tax will be the responsibility of and be borne by the donee irrespective of who paid the immediately chargeable lifetime rate tax.
• On your death the wording of your will can determine who pays any inheritance tax on bequests made by the will. Unless you state otherwise in your will, tax is borne by those who inherit your residuary estate except in the case of jointly owned or foreign property in which cases the tax is payable by the beneficiary.
• Any inheritance tax payable as the result of your death if you are entitled to a present interest in a trust for the disabled is borne by your personal representatives and the trustees of the trust in the proportion to the relative values of your own estate and the trust funds. To work out the proportions calculate an estate rate by dividing the total inheritance tax payable by the value of the total chargeable estate (your own assets and the trust funds in which you had an interest) and multiply the resulting figure by 100. The value of your own assets is then multiplied by the estate rate to ascertain the tax payable by your estate and the value of the trust funds is multiplied by the estate rate to ascertain the amount of the tax to be borne by the trust.
• If your will leaves your residuary estate between exempt beneficiaries (such as charities, your spouse or civil partner) and taxable beneficiaries, any inheritance tax which is payable on your estate must be paid out of the shares of your non-exempt beneficiaries after the estate has been divided between them but before it is distributed.

CALCULATING THE INHERITANCE TAX

To calculate the inheritance tax payable on a non-exempt lifetime gift, deduct the tax threshold from the value of the gift and apply the full tax rate to the resulting figure to obtain the figure for the tax. Then apply taper relief to the resulting figure. Tax is only payable on lifetime gifts if the total of your chargeable gifts themselves exceed the tax threshold, in which case apply taper relief to the tax, not to the value of the gift.

To calculate the inheritance tax payable on your death estate, add the total of your death estate to the total of the chargeable gifts and deduct the tax threshold. Apply the full tax rate to the resultant figure and then deduct the full tax payable on the lifetime gifts (calculated as above before the application of taper relief).

In both cases remember to apply business relief, agricultural relief and the relief for woodlands as explained above if they are relevant.

MAKING GIFTS IN YOUR LIFETIME

I agree the above calculations are complex and if you have difficulty in following them, don’t worry too much, just remember that when once your estate, calculated as above, crosses the inheritance tax exemption threshold, your beneficiaries will be paying tax at a very high rate on the excess and that any non-taxable gift you make, either in your lifetime or by your will, will only cost your estate £60 for every £100 given because the other £40 would have been payable to the Revenue as inheritance tax. It is therefore important to make the best use possible of any inheritance tax exemptions and from a tax point of view, provided you do not impoverish yourself, it is an excellent idea to give as much as you can away in your lifetime and the sooner you give it, the more tax you will save. You might also have the pleasure of seeing the recipients enjoy the gifts and perhaps even make good use of them, something that it is debatable that you will be able to do after your death!

In deciding whether what you give away in your lifetime will impoverish you, do not forget the effect of inflation and remember that you cannot have your cake and eat it. To be a tax-effective gift it must go completely and you cannot retain any benefit from it, even by a behind the scenes arrangement.

Deciding what to give and to whom

When deciding which assets to give, consider giving the assets with the greatest growth potential because the asset given will be valued as at the date you make the gift and the gift of assets with the greatest growth between the date of the gift and the date of your death will bring about the greatest reduction in the value of your estate for inheritance tax purposes, if you survive the seven years.

If you are able to make such gifts to younger rather than older individuals, so much the better because in the normal course of things they will have longer to live before inheritance tax is payable on the recipients’ death. Similarly you should bear in mind and tend to retain assets which might receive some inheritance tax relief or exemption such as gifts of shares in unquoted companies which have been held for two years or more, some business property and agricultural property and commercial woodlands. If possible give assets that can benefit from inheritance tax relief to those who are qualified and able to use them so that the reliefs are not wasted.

In the choice of which assets should be given and which retained, bear in mind which assets are exempt from capital gains tax and that there is no capital gains payable on death, so that assets on which you already have a large capital gain might be those to retain unless they can be given away under your annual capital gain exemption limit.

Lifetime gifts by terminally ill spouses and civil partners

If one spouse or partner becomes terminally ill, try to make use of exempt lifetime gifts to the maximum as each tax year progresses and use the fact that lifetime gifts between spouses or registered civil partners are exempt from both inheritance and capital gains taxes to ensure that any estate of the spouse or partner who is likely to die first which is not to be left to the survivor will exceed the exempt threshold by as little as possible; the survivor can then use his own lifetime gift exemptions to make gifts from the excess to the intended beneficiaries which would have been taxable if made on the first death.

REDUCING INHERITANCE TAX BY MAKING A WILL

Using exempt gifts in your will

Several of the types of gift which are exempt from inheritance tax if made during your lifetime are also exempt if made by your will, notably:

• gifts to registered charities for their charitable purposes;
• the gifts for national purposes including gifts to most museums and art galleries;
• gifts to some political parties;
• gifts of land to housing associations;
• gifts to your spouse or civil partner.

Leaving any of these gifts by will reduces the inheritance tax which would otherwise be payable.

Equalisation of estates between civil partners, the survivor exemption and the nil-rate band

If you are in a happy marriage or civil partnership and believe that you are likely to remain so, then because there is usually no means of knowing which spouse or partner will be the first to die, the most obvious and effective way of reducing the amount of inheritance tax payable on your death and the death of your partner or your spouse is to equalise your taxable estates during your joint lives by the richer making gifts to the other and for each of you to make use of the survivor exemption and the nil-rate band. You do this by leaving value up to the nil-rate band to beneficiaries other than your spouse or partner and the remainder of your estate to your spouse or partner. Whether or not you can afford to do so will depend upon the total value of your joint estates, the state of your marriage or civil partnership and the standard of living each of you are accustomed to and are prepared to accept.

However, in considering how to equalise the estates and whether or not it will be sensible to equalise the estates, as always, bear in mind the effect on your income tax positions. From an income tax point of view, it is best, as far as possible, to ensure that both parties make equal use of their lower and basic rate income tax bands and this might decide which party shall hold which assets and, indeed, whether and to what extent you should equalise your assets to help with inheritance tax planning.

Let us compare the positions if you and your wife or partner make use of the survivor exemption and the nil-rate band and if you do not.

Suppose that you and your wife or partner have a total estate between you valued, after payment of the funeral expenses, at £510,000 of which £230,000 is made up of the unmortgaged family home.

If everything is in your name and you die first and leave all your estate to your widow or civil partner no inheritance tax will be payable on your death because everything you leave to the survivor is exempt (the survivor exemption).

On the survivor’s subsequent death the first £300,000 of the estate will be exempt from tax because it does not exceed the tax threshold. The remaining £210,000 will incur tax at the rate of 40 per cent, i.e. £84,000 tax will be payable and the beneficiaries will inherit £426,000 of the £510,000 estate.

If the joint estate had been equalised so that each party held £255,000, on your death you could leave your share of the home (£115,000) to your wife or partner and this would be exempt under the survivor exemption and the remaining £140,000 to your other chosen beneficiaries, which legacy of £140,000 would also be exempt because it would be below the tax threshold and within the nil-rate band of £300,000.

Your widow or surviving civil partner would then have an unmortgaged home (worth £230,000) and £140,000 with the income it produces, in addition to her state bereavement allowance and any private pension, to keep her during her remaining days. On her death £300,000 of her estate of £370,000 would be exempt as not exceeding the tax threshold and the remaining £70,000 would suffer tax at 40 per cent which would amount to £28,000. Thus a tax saving of £56,000 (£84,000 minus £28,000) would have been achieved and would be available to the beneficiaries.

If your joint estates do not exceed twice the nil-rate band, tax can always be completely avoided by equalising the estates and making use of the exemption of the nil-rate band by leaving the estates to beneficiaries other than the partner or spouse on the first death. If the joint estates exceed twice the tax threshold consider making full use of the lifetime gift exemptions, the nil-rate band and the exemption of gifts to spouses and registered civil partners, but in every case take care not to impoverish yourself or your spouse or partner, and remember the Inheritance (Provision for Family and Dependants) Act of 1975. Remember also that the survivor exemption only applies to those who are legally married or who have a valid registered partnership.

If you do find that you have impoverished yourself or your spouse by making gifts with a view to tax planning there is always the possibility that the donees might be prepared to make a loan repayable on death to the impoverished person, thus assisting during his life but not reducing his taxable estate on his death in view of section 103 of The Finance Act 1986, as to which please see later under the heading ‘The Loan Scheme’. To have any hope of succeeding in reducing inheritance tax the loan should be a completely independent arrangement unconnected with and not a condition of, or formally tied to, the original gift. Such a loan would also have to be considered carefully from an income tax point of view if a commercial rate of interest were charged, and from the point of view of the gratuitous element being considered as a gift if a commercial rate of interest were not charged.

Equalisation of estates between spouses might also prove to be a wise precaution if a future government were to decide to institute a wealth tax.

Nil-rate band discretionary trusts

Although you can leave your entire estate to your spouse or registered civil partner without paying any inheritance tax on your death, doing so might compound the inheritance tax problem when your spouse or partner subsequently dies, in that what you leave and what she does not give away seven years or more before her death or spend before her death, will be added to the assets she already holds in her name, and in some cases to the assets of a trust under which she has a right to benefit during her lifetime and might thus cause her estate to exceed the nil-rate band and incur 40 per cent tax. On the other hand, if you are only moderately well off, your surviving spouse or civil partner will need the family home and your other assets to live reasonably comfortably after your death and assets cannot easily be given to others to make use of your nil-rate band. This dichotomy can be solved to some extent by making use of a nil-rate band discretionary trust of which your spouse or civil partner is one of the potential beneficiaries and leaving the remainder of your estate to your spouse or partner.

The basics of a nil-rate band discretionary will trust scheme are that a discretionary trust is set up in the will of a married person or a civil partner to the value of the testator’s unused nil-rate band and the testator’s other assets are left to the testator’s spouse or civil partner. On the testator’s death the assets left to the trust are exempt from inheritance tax because they do not exceed the testator’s nil-rate band and the remainder of the estate escapes inheritance tax under the surviving civil partner/spouse exemption. The potential beneficiaries of the trust include the survivor who is frequently appointed to be one of the trustees of the trust. The intention is that the surviving spouse/civil partner shall benefit from the trust funds or the income they produce from time to time during her lifetime, as far as is considered necessary or desirable. It is therefore possible that the survivor will have the benefit of the entirety of the testator’s estate and be in no worse a position than she would have been if the assets had been left to her directly but there is, and necessarily should be, no guarantee, because it is the essence of a discretionary trust that the allocation of the trust funds and their income shall be in the discretion of the trustees and no one shall have a right to benefit from them unless the trustees make a decision to that effect.

If the first spouse/partner to die leaves sufficient liquid assets, such as cash or investments, they are transferred to the trustees of the trust and then the trustees are able to exercise their discretion to make such payments to the survivor as the trustees think fit. There is no problem, there is a reduction in the inheritance tax and the survivor has the possibility (but not a guarantee because it involves the exercise by the trustees of their discretion in her favour) of benefiting from the estate to the extent that she would have benefited from it if it had been left directly to her.

If the family home is jointly owned and it is intended to use the testator’s share of the home in a discretionary trust scheme, the co-owners must own the home as tenants in common and not as joint tenants because, as you will remember from Chapter 3, pages 30-32, property owned as joint tenants passes on death to the survivor notwithstanding any provisions to the contrary in the deceased’s will. If the home is owned as joint tenants the co-ownership joint tenancy must first be converted into a tenancy in common. To do that please refer to pages 31 and 32.

The debt/charge discretionary will trust scheme

This is a scheme that is often used if the first spouse/partner to die leaves insufficient liquid assets (such as cash or investments) to use to pay the nil-rate band legacy, the survivor wishes to continue living in the family home and the trustees do not wish to risk a large capital gains tax bill on the first to die’s share of the family home when it is eventually sold.

The will setting up the trust will have contained a clause which authorises the trustees of the trust to accept an unsecured debt repayable on demand or a charge on assets as part or as the entirety of the trust funds. If the first spouse/partner to die leaves insufficient liquid assets to be transferred to the trust, the trustees exercise that power and the deceased’s executors give the trustees an IOU for the nil rate band legacy or the deficiency or place a charge in favour of the trust upon assets of the estate and then transfer the assets including the deceased testator’s share of the family home to the survivor subject to the charge. Placing a charge on the assets is, in layman’s terms, mortgaging them to the trust.

The debt or charge is paid off when the assets are sold or as and when the survivor is able to repay it or when the survivor dies. If it still exists at the survivor’s death the debt or charge will reduce the value of the survivor’s estate and consequently any inheritance tax payable in respect of the estate.

The Loan Scheme

A variant of the debt/charge scheme is the Loan Scheme under which assets are loaned by the trust to the survivor who signs an IOU for them. The effect of Section 103 of the Finance Act 1986 is that a person cannot give cash or assets to another and then borrow them back and count the debt or borrowing as a debt against his estate for inheritance tax purposes. Section 103 therefore prevents the Loan Scheme from successfully reducing the tax if the spouse/ partner who dies is one who has never had assets not derived from the survivor spouse/partner, e.g. a spouse who has never worked and never had an inheritance. The Loan Scheme seems to differ little from the Debt/Charge Scheme but in the Debt/Charge Scheme it is the executors and not the survivor who create the charge or sign the IOU. The Loan Scheme is much riskier and more likely to be considered by the Revenue to be an artificial scheme entered into solely for the purpose of avoiding tax and a sham.

Warnings

I repeat that anyone contemplating a discretionary trust must employ an expert. Remember that as is the case with most tax avoidance schemes - they are complicated schemes, expensive if they go wrong and they are often difficult or impossible to unscramble if the law changes. If a government feels that too much tax is being lost it might decide to clamp down on the trusts or even introduce retrospective legislation to do so.

A nil-rate band discretionary trust will only be effective in reducing inheritance tax if it can be seen to be a genuine discretionary trust and not a sham simply aimed at avoiding tax. The trustees should therefore hold regular meetings, minutes should be taken and kept, the trust’s investments should be monitored, accounts kept, income tax returns made and the needs of each potential beneficiary should be considered and resolutions passed. Not all the income of the trust should be paid to the survivor and it certainly should not be paid by regular payments or a bank mandate. A near cash reserve should be maintained to meet tax and administrative expenses and if necessary part of the loan should be recalled to meet them. The debt or loan can be structured to be index linked or bear interest. Every effort should be made to show that the trust is not merely a gift to the survivor in which case it would form part of the survivor’s estate and be taxable when he or she died.

Taxation of nil-rate band discretionary will trusts

Tax is charged on the estate of the person whose will sets up the trust, at his death, in the usual manner allowing for the nil charge for any unused nil rate band. As is usual with discretionary trusts, the trust funds might suffer an inheritance tax charge every ten years if they exceed the nil rate band at that date. The current maximum rate for the charge is six per cent. The tax is also charged upon capital paid out of the trust at the same maximum rate but there is no inheritance tax payable on capital paid out of the trust in the first ten years because in that period the tax rate is calculated upon the value of the trust at the date of the death which by definition did not exceed the nil-rate band. Neither is tax payable on the death of a potential beneficiary because the trust funds belong to the trust and do not belong to or form part of the estate of any potential beneficiary. No potential beneficiary has any entitlement until the trustees make an allocation to him.

Using nil-rate band legacies without a discretionary trust

If you are married or in a civil partnership you can save inheritance tax by each making use of your respective nil-rate band by leaving a legacy equivalent to the value of the unused nil-rate band to others and the residue of the estate to your surviving spouse/partner or a charity without the necessity of a discretionary trust if you wish, but by not using a nil-rate band discretionary trust you lose the flexibility which a discretionary trust gives and the surviving spouse/civil partner will not have the possibility of benefiting from the funds bequeathed by the legacy.

Similarly if you have no civil partner or spouse and you leave the residue of your estate for charitable purposes and a legacy equivalent to the balance of your unused nil-rate band to others your estate will suffer no inheritance tax.

The advantages of using a nil-rate band discretionary will trust

The main advantage of using a discretionary trust, instead of a straight legacy, is flexibility. Your spouse/civil partner can be appointed as a trustee if your will so provides and if the trustees make income and capital payments in her favour she need be little worse off than if the entire estate had been left to her and the funds formed part of her estate and were potentially taxable on her death. At the same time the trustees are able to consider and meet the needs of the other potential beneficiaries. Because the trust is discretionary and the funds belong to the trust and not to the survivor they will not be taken into account for means-tested benefits.

The cost of setting up and administering a discretionary trust are substantial but have to be compared with the tax saving which can be achieved (up to £120,000 on present taxation rates).

The two-year discretionary will trust

Because you cannot foretell the precise date of your death, you cannot know what the financial position of the individual members of your family will be at that date or indeed which of your family members or friends will survive you. Neither can you know how much of your nil-rate band will have been used up by the gifts you have made in your lifetime nor what the value of your estate or tax rates will be when you die. It is possible to overcome these problems by creating what is commonly known as a two-year discretionary trust in your will.

To create such a trust you leave your estate to your executors upon trust, with power for them to allocate it between three months and two years of your death, in such a manner as they see fit between certain specified beneficiaries and with a long stop provision for the devolution of the estate if your executors fail to make an allocation within that period. It is usual to leave a letter with your will to explain to your executors the principles you wish them to use in exercising the discretion you have given to them. The letter should make it clear that it is not binding upon your executors.

If the executors make their decision between three months and two years following your death, inheritance tax in relation to your estate will be calculated as though the decision they make was contained in your will.

A two-year discretionary trust can be a very efficient tax-saving tool and useful if you have good executors and are apt to be tardy in reviewing your will.

The use of survivorship clauses and bequests to your spouse or civil partner

Frequently a provision is put in a will to the effect that any person who does not survive the testator by a specified number of days shall be deemed to have predeceased the testator. Great care must be taken when using such a clause if your will contains a bequest to your surviving spouse or civil partner and the likely size of each estate should be considered when deciding whether to include the clause or not. An example will make this clearer.

Suppose that you have an estate of £375,000 and your wife has an estate in her own right of £250,000. You propose to leave £300,000 to your children to make full use of the nil-rate band and the remaining £75,000 to your wife if she survives you and to your children if she does not. You include a clause in your will to the effect that any beneficiary who does not survive you for a period of 28 days shall be deemed to have predeceased you. If both you and your wife die in a common accident and she survives you by 20 days, for the purposes of your will, she will be deemed to have predeceased you and your children will inherit your entire estate of £375,000. The first £300,000 of the estate will be exempt because it is within the £300,000 nil-rate band and the remaining £75,000 will bear tax at 40 per cent, i.e. £30,000 tax. On your widow’s death her estate will be £250,000 and no tax will be payable on her estate because it is below the threshold and within the nil-rate band.

If the survivorship clause had not been included, on your death your children would have inherited the £300,000 which would be exempt from tax as not exceeding the threshold and your widow would have inherited the remaining £75,000 of your estate which would be exempt being a bequest to a surviving spouse. No tax would have been payable on your estate. On your widow’s death, the value of her estate including the bequest she inherited from you would be £325,000 and tax of £10,000 (40 per cent of her estate of £325,000 minus the exempt band of £300,000, i.e. 40 per cent of £25,000) would be payable, a saving of £20,000 (£30,000 minus £10,000).

As a general rule it may be said that it is advantageous not to include a survivorship clause in your will if your spouse or civil partner is likely to be the survivor and has an estate in her own right (as opposed to what she would inherit from you) which is less than the nil-rate band. In that way both parties are more likely to be able to make full use of their individual nil-rate band exemptions. If both you and your spouse have estates which exceed the nil-rate band before inheriting from the other it is of no consequence, from an inheritance tax point of view, whether a survivorship clause is included or omitted.

In the above example for the sake of simplicity, I have ignored any lifetime gifts that may have been made, the grossing-up rules which are referred to in the next section and assets such as business property in respect of which any tax will be payable at special rates if certain conditions are satisfied.

The case of Re Figgis decided in 1969 established several important points in respect of the meaning of words frequently used in survivorship clauses viz. that ‘month’ prima facie means calendar month, that in computing a period ‘from my death’ the day of the death is to be excluded and that the time in the day is to be ignored, the full day being included in the computation.

Special rules where exempt beneficiaries are involved

‘Grossing-up’ of legacies and gifts

Reference has been made above to the grossing-up of immediately chargeable lifetime gifts. If you do not state that any tax payable in respect of a bequest in your will is to be paid out of the bequest, i.e. that the bequest is subject to tax or to bear its own tax, then unless the property is joint or foreign property, any tax payable will be payable out of the residue of your estate. In these circumstances, if you leave the residue of your estate to an exempt beneficiary such as your spouse or a registered charity, the law directs that, when calculating the inheritance tax payable in respect of your estate, for inheritance tax purposes, any legacies given free of tax shall be ‘grossed up’ i.e. treated as a legacy of the stated sum and in addition the relevant amount of tax. If you do not remember this point, i.e. that any non-exempt legacy given free of tax is grossed up if the residue of the estate is given to an exempt beneficiary, you could inadvertently exceed the nil-rate band with the legacy. You should also bear in mind any non-exempt lifetime gifts you have made when calculating what remains to you of the nil-rate band.

HM Revenue and Customs publish grossing-up tables to help you calculate the sums involved, but the easiest way of avoiding trouble in these circumstances is to give the bequests ‘subject to tax’ and not ‘free of tax’, or to leave legacies of specific amounts to the exempt beneficiaries and the residue to the non-exempt beneficiaries, to be inherited by them in specified proportions or percentages with a provision that should a residuary beneficiary not be alive or in existence at the date of your death, that beneficiary’s interest in your residuary estate shall not lapse but shall accrue to the remaining beneficiaries in the stated proportions.

In deciding which beneficiaries are to suffer payable inheritance tax, you must bear in mind Section 41 of The Inheritance Tax Act 1984 which provides, in essence, that notwithstanding any provision of a will to the contrary, no exempt beneficiary shall be made to suffer the inheritance tax payable in respect of an exempt gift or exempt share of residue.

‘Related property’ valuation rules

When calculating whether or not a bequest will exceed the nil-rate band you must also bear in mind whether or not the Revenue will consider the subject of the bequest to be ‘related property’. Related property is property which would have an increased value if owned with other property which is owned by a person or body to whom an exempt transfer could be made, e.g. a spouse or a charity and whether or not an exempt transfer is or has been made.

An example will assist: suppose you own one of a set of three candelabra and your spouse owns the other two, the set of three will be worth more than treble the single candelabra, and even though you may have bought yours at an auction and your spouse inherited hers and, even if you propose to leave yours to your son and not to your spouse, the candelabra will be related property for inheritance tax purposes.

Related property is valued in a special way when calculating inheritance tax. To ascertain the inheritance tax valuation of an asset where related property is involved, divide the asset’s normal value by the total of its normal value and the normal value of the related property and multiply the result by their combined value. Thus if your candelabra alone is normally worth £100 and your spouse’s two candelabra are together worth £300 but the three would be worth £500, then the value of your one candelabra for inheritance tax purposes is £100 divided by (£100 + £300) multiplied by £500, i.e. £100 divided by £400 multiplied by £500 i.e. £0.25 multiplied by £500, i.e. £125.

Cohabitees and the survivor exemption

It is important to remember that in the case of Holland v IRC it was decided that for the purposes of inheritance tax the word ‘spouse’ only applies to those who are legally married and not to cohabitees no matter how long cohabitees have been living together. The decision does not infringe the right to family life recognised by The European Convention on Human Rights or The Human Rights Act. Long-term partners have been known to marry to obtain the spouse’s inheritance tax exemption and widow’s bereavement allowance. The Finance Act 2005 has changed the position to the extent that partners in a registered civil partnership have the benefit of the survivor exemption, but it still does not apply to other partners.

Skipping a generation

If your children are wealthy you might wish to consider skipping a generation and instead of leaving bequests your children, leaving the bequests to or for the benefit of your grandchildren to avoid increased inheritance tax being payable on your children’s deaths. In this way the bequest is only taxed once instead of twice before the grandchildren inherit it.

To skip a generation can also have income tax advantages if the grandchildren inherit before they become of age. The income tax advantage arises from the fact that if capital transferred to a child by a parent earns income in excess of £100 in any tax year, the income is taxed as if it were the parent’s income, but income earned by capital transferred by a grandparent is treated as the grandchild’s own income irrespective of the amount of the income and if it does not bring the grandchild’s income above the grandchild’s personal income tax allowance, any income tax deducted from the income can be recovered on behalf of the child.