WHAT IS THE NATURE OF INHERITANCE TAX?

Inheritance tax is, in essence, a tax on giving and on giving in a very wide sense of the word. The tax applies to gifts which are made during the life of the taxpayer, to gifts made by the taxpayer’s will at the moment of his death and to gifts which the state’s laws of intestacy deem that he would have made at that instant had indolence, incompetence, forgetfulness, procrastination or indeed sheer cussedness not caused him to die without a valid will. As far as the government and the Inland Revenue are concerned, it seems that the distinction between tax avoidance (arranging one’s affairs so as to incur as little tax as possible) and tax evasion (dodging the tax which is incurred and legally due) is becoming increasingly blurred and disappearing into the mists. The state is determined and struggles valiantly to ensure that it shall have its tax and often the taxpayer’s death is the first occasion upon which he pays tax at the highest rate. The state will have its pound of flesh, even though it might be tardy in taking it.

If the state is not to get his bones along with a kilo of his flesh, the taxpayer needs to have a basic understanding of how the tax works, how it is calculated and how it applies to his own particular circumstances.

IN WHAT CIRCUMSTANCES DOES A LIABILITY TO THE TAX ARISE AND WHAT PROPERTY INCURS LIABILITY TO THE TAX?

The law of inheritance tax is based upon the Inheritance Tax Act 1984 as subsequently amended. In broad terms the tax becomes payable whenever a person’s wealth is reduced, that is to say there is a transfer of value, as the result of a gratuitous transfer of property (i.e. the making of a gift) or a failure to act, unless the transfer or the failure is within one of the exceptions specified by the Act or the amendments (when it is known as an ‘exempt disposition’). A transfer is also exempt if the property in respect of which the transfer takes place is ‘excluded property’, which is defined in the Act and its amendments, or if it is a gift which is exempted from the tax by the Act. The tax payable is less if the inheritance tax ‘reliefs’ specified in the Act notionally reduce either the value of the property or the tax itself.

In slightly greater detail and using more technical terms, if a taxpayer has his domicile in the United Kingdom or is deemed to have it there, inheritance tax is charged whenever there is any gratuitous transfer of value (other than an exempt disposition or exempt gift) in respect of any of his assets in whatever country they may be, unless it is a transfer of excluded property and whether the transfer takes place during the taxpayer’s lifetime or on his death. The tax is calculated by reference to the value transferred.

If the taxpayer’s domicile or deemed domicile is outside the United Kingdom, the tax only applies to those of his assets (other than excluded property) that are situated in the United Kingdom.

The fundamental concepts to keep in mind when considering liability for inheritance tax are those set out in bold type above. The meanings of ‘domicile’ and ‘deemed domicile’ are explained below, transfer of value is explained on pages 6–7, exempt dispositions are enumerated on pages 7–9, the exempt gifts are set out on pages 12–15 and a list of excluded property is set out on pages 9–10.

The questions to be asked are:

• Is the taxpayer domiciled or deemed to be domiciled in the United Kingdom?
• Has there been a gratuitous transfer of value? (see page 6).
• If so ‘Was the transfer an exempt disposition?’ (see page 7).
• If the transfer was not an exempt disposition, ‘Are the assets which were transferred excluded property (see pages 9–10) or was the gift an exempt gift? (See pages 12–15).

Ascertaining domicile

Domicile must not be confused with residence. A person has his tax residence in the state where he spends most of his time or has accommodation so that he can spend most of his time there. Residence is of little or no importance as far as inheritance tax is concerned. The concept of domicile is extremely important when considering liability for inheritance tax. Broadly speaking and subject to the concept of deemed domicile, a person has his domicile in the state which he considers to be his permanent home, even though he might have no legal right to live there.

Domicile of origin

At birth a person has the same domicile as his mother if he is illegitimate or his father is dead, otherwise the domicile of the father. This is known as domicile of origin.

Domicile of choice

A person who is legally mentally capable and over the age of 16 can exchange a domicile of origin for what is known as a domicile of choice by abandoning ties with the state in which he has his domicile of origin and moving to live in the other state with the intention of living there indefinitely or making it his permanent home. This is so even if he is an illegal immigrant and has no legal right to be in that other state.

To acquire a domicile of choice in a state one must be both resident there and have the intention of residing in the state either indefinitely or permanently; to lose a domicile of choice one must both cease to reside in the state and change one’s intention to reside there indefinitely or permanently. If a domicile of choice or dependency is lost and no new domicile of choice is acquired, the domicile of origin is reacquired.

A new domicile of choice can be acquired as frequently as is desired, but it is only possible to have one domicile at any given time and the burden of proving a change of domicile lies upon the person who asserts that it has taken place. The standard of proof required is that it must be proved on a balance of probabilities that the change of domicile has taken place; i.e. it is not necessary to prove without any reasonable doubt that the change has taken place but only that it is more likely than not that it has taken place. It should be noted that the decisions of Her Majesty’s Inland Revenue and Customs (henceforth referred to as ‘the Revenue’) on the question are not binding on the courts.

Domicile of dependency

Those who are mentally incapable or under the age of 16 have the domicile of the person upon whom they are dependent and their domicile will follow any change in that person’s domicile. This is known as a domicile of dependency. A woman who married before 1 January 1974 acquired her husband’s domicile by virtue of the marriage, but after that date she can change it and her domicile is no longer dependent upon her husband.

Deemed domicile

There are exceptions to the above rules for inheritance tax purposes, in that for those purposes:

• people are deemed to retain their domicile in the relevant part of the United Kingdom for three years after leaving it
• those who have been resident in any part of the United Kingdom are deemed to be domiciled here if they have been resident here for at least 17 or more of the 20 preceding tax years.

People who are deemed to be domiciled in the United Kingdom for inheritance tax purposes might be able to claim a non-United Kingdom domicile for capital gains tax and income tax purposes.

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.

The word ‘state’ is used in connection with domicile rather than ‘country’ because domicile is defined not by national boundaries but by places that have their own independent system of law.

Transfers of value

A transfer of value is defined in the Inheritance Tax Act 1984 (Section 3) as ‘a disposition made by a person . . . as a result of which the value of his estate immediately after the disposition is less than it would be but for the disposition; and the amount by which it is less is the “value transferred” by the transfer’. Therefore calculation of inheritance tax is based upon the reduction the transaction causes to the wealth of the giver and not the increase in the recipient’s wealth, which is not always the same, and will never be the same if the value of an asset is greater than the value of its separate parts and only part is transferred. Consider the example of a pair of candlesticks. A pair is worth more than two single ones and the loss suffered by giving one away and retaining the other is greater than the gain obtained by receiving one. Similarly, in the case of a gift of shares by a shareholder who has a controlling interest in a company, a gift of a number of shares which reduces the giver’s shareholding so that it is no longer a controlling interest in the company is a transfer of greater value than a gift of the same number of shares by any other shareholder and the benefit to a recipient who does not obtain control of the company by the gift is less than the loss to the giver.

A disposition includes not only a positive act, but also failure to exercise a right, if the failure was deliberate and increases the value of another person’s assets. For example:

• the failure by a landlord to exercise a right given by the lease to review and increase rent
• a failure to attempt to collect a debt
• failure to use a power given by a will or settlement to appoint property to oneself.

Taxable and non-taxable dispositions

Some transactions which cause a reduction in the taxpayer’s wealth are declared by the Act not to be transfers of value and are therefore not taxable dispositions and are exempt.

• A disposition which ‘is not intended. . . to confer any gratuitous benefit’ and which is either entered into at arm’s length between ‘persons not connected with each other’ or which is ‘such as might be expected to be’ entered into ‘at arms [sic] length between persons not connected with each other’ is not taxable (section 10 of the Inheritance Tax Act 1984). Persons connected with each other for this purpose are, roughly speaking, the taxpayer’s family including his spouse or civil partner, his ancestors, lineal descendants, brothers and sisters, uncles and aunts, nephews and nieces, the spouse or civil partner of the above family members and the relatives in the same categories of the taxpayer’s spouse or civil partner. Except in respect of commercial transactions relating to the partnership assets, the taxpayer’s business partner and the partner’s spouse or registered civil partner are also considered to be connected to him. This section prevents normal commercial transactions which in the event prove to have been loss-making from the taxpayer’s point of view from being caught by inheritance tax.

• Transfers made during the taxpayer’s life in favour of a spouse, registered civil partner or a child of the taxpayer or child of his spouse or registered civil partner, for the purpose of family maintenance. This exemption applies not only during the subsistence of the relationship but also in respect of arrangements made on the annulment or dissolution of the relationship, e.g. on divorce, and upon the variation of such arrangements. It also applies to transfers for the reasonable maintenance of a dependant relative. In the case of a child it only applies to transfers of value for the maintenance, education or training of the child until the year in which the child attains the age of 18 or until he ceases to undergo full-time education or training, if later.
• The grant of an agricultural tenancy for full consideration payable in money or money’s worth. Consideration in law is the price of a legal bargain or agreement; for example, in the grant of a tenancy it might be a lump sum or a rent or both.

There are also a few other dispositions connected with companies and employment which are declared not to be taxable, such as waiver of dividends in the 12-month period before the right to the dividends arises.

Excluded property, i.e. property which is never liable to incur inheritance 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 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, decorations awarded for valour or gallantry. (not necessarily in a military context), which have never been transferred in return for money or money’s worth. The decoration 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 which belongs to a person who is domiciled outside the United Kingdom.
• Foreign-currency bank accounts with most banks in the United Kingdom that are held by people who are of foreign domicile and not resident or ordinarily resident in the United Kingdom.
• Most reversionary interests, i.e. most presently owned rights 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 C. After A’s death B would have a life interest in the house and be known as the tenant for life and C 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).

Which assets incur a liability to inheritance tax (unless they are specifically exempted by legislation or are excluded property)?

The taxpayer’s assets that suffer inheritance tax, unless they are assets specifically exempted by legislation or excluded property, are as follows:

• 1.Everything the taxpayer owns (including his share of any property he owns jointly with anyone else).
• 2.Everything he has given away in the last seven years of his life unless they are exempt gifts as specified on pages 12–15.
• 3.Every non-exempt gift he has ever made from which he has reserved a right to benefit in the last seven years.
• 4.Everything owned by someone else from which the taxpayer is entitled to benefit for the remainder of the taxpayer’s life or for any other limited period, (called a life tenancy), e.g. the full market value of any house in which the taxpayer has the right to live rent free for the remainder of his life or the assets of any trust fund of which the taxpayer has a right to the income for the remainder of his life, if
  • the life tenant was entitled as a disabled person under a trust for the disabled as explained in Chapter 7, or
  • the life tenancy was created by a will or intestacy and began immediately upon the death, or
  • the life tenancy was created by an arrangement or trust created before 22 March 2006, or
  • the life tenancy follows immediately upon a life tenancy in existence on 6 April 2006 that ended before 6 April 2008, or
  • the life tenant was the spouse or civil partner of a person who was a life tenant under a pre-6 April 2006 trust at that date who died on or after 6 April 2008 and the life tenant’s entitlement immediately followed on that of his spouse or civil partner, or
  • the life tenancy is the first or a subsequent life tenancy in a trust created before 22 of March 2006 which is a trust of a life policy or life policies, provided that there has been no break in the sequence of life tenancies.

1, 2 and 3 above are known as the taxpayer’s free estate and 4, is known as his settled estate.

From the total of these assets it is permissible to deduct the debts and financial liabilities transferred with the assets to which they relate and if the transfer of value takes place as the result of the taxpayer’s death, the amount of the taxpayer’s debts and reasonable funeral and mourning expenses, but if the taxpayer is insolvent it is not permissible to deduct any deficiency in the free estate from the settled estate.

Exempt Gifts

The gifts, i.e. gratuitous transfers of value, that are exempt from inheritance tax are the following.

• Out-and-out gifts made by the taxpayer more than seven years prior to his 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 made to a company or to a trust (other than a trust for the disabled) are known as 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 (potentially exempt transfers), a concept and an acronym which should be remembered because they will feature prominently in later pages. If the donor survives the making of a PET by seven years the PET is completely exempt from the tax whatever its value.
• Gifts of any amount to a spouse or civil partner, unless the taxpayer is domiciled in the United Kingdom but the 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 made in any tax year during the life of the taxpayer. 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.

If the total value of gifts which are not covered by any other exemption in any tax year exceeds this annual exemption and any useable balance from any previous tax year, the excess is taxable.

• Gifts made during the taxpayer’s lifetime which are made as part of the normal expenditure of the taxpayer out of his income and not from capital and which do not reduce his standard of living. Normal expenditure is expenditure which is in accordance with a settled pattern of the donor’s expenditure and that pattern may be proved either by showing that the taxpayer has made such payments regularly in the past or that he has 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 an intention to continue them.
• Wedding gifts made before the ceremony during the taxpayer’s lifetime, up to £5,000 to his child, up to £2,500 to his grandchild and up to £1,000 in the case of anyone else.
• Gifts made in the taxpayer’s lifetime for the maintenance of a spouse, ex-spouse, civil-partner, ex-civil partner, 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.

Gifts in any number of the above classes can be made to the same person without losing the benefit of the exemption and in addition, under what is known as the small gifts exemption, any number of gifts of up to £250 can be made in a tax year provided that no other gift has been made to the same person in the same tax year. If the sum given 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.

The percentage of the value of any gift which is not an exempt disposition or a gift of excluded property that is extracted as tax, i.e. the rate of tax charged, is dependent upon:

• whether the gift is deemed to have been made at the time of the taxpayer’s death or whether it was made during his life and, if so, how long he survived the making of the gift
• who or what organisation was the recipient of the gift
• the type of property given.

It is therefore essential to keep full documentary evidence which shows the dates and the value of all gifts, what was given and to whom the gifts were made. If it is likely that the normal expenditure exemption will be relied upon it is also necessary to keep details of all income, income tax paid, spending, bills and other expenses for the relevant year at least.