The Office of Tax Simplification (OTS) has published its long-awaited second report on inheritance tax.
This is part of a wider review commissioned by the then chancellor Philip Hammond in January 2018.
Following an unprecedented level of engagement from representative bodies, advisers, academics and members of the public, the OTS published its first IHT report in November, covering administration of the tax.
This second report contains substantive recommendations intended to simplify the design of IHT.
The headline suggestions from the OTS include:
- Replacing the current “multiplicity” of gift exemptions with a single lifetime personal gift allowance, set at a sensible level;
- Reforming the exemption for normal expenditure out of income or replacing it with a higher personal gift allowance;
- Reducing the period during which lifetime gifts may become subject to IHT from seven years to five years, but abolishing taper relief; and
- Removing the capital gains tax (CGT) base cost uplift if an IHT relief or exemption applies on death.
It's worth examining these in a bit more detail to understand the implications for advisers and planners, as well as for clients.
Reducing the seven-year period to five years would be a significant concession.
But it is the scrapping of taper relief that could cause some concern, given that it creates a five-year cliff edge.
Currently with taper relief, if an individual dies within three years of a gift, the full amount of IHT is payable, and if death is within four to seven years there are tapered amounts to pay.
The OTS survey found that most people think the gift is tapered, when it’s actually the tax liability that the taper applies to.
Under the new proposals, gifts made five years before death would be exempt, and gifts made five years less one day before death could be subject to 40 per cent IHT.
A more welcome proposal is the removal of the little-understood 14 year rule. This requires some gifts made outside the normal seven-year period to be factored into IHT calculations in certain circumstances, particularly when assets have been transferred to a trust.
Other proposals include changes to the rules on tax liability on lifetime gifts to individuals, and the allocation of the nil-rate band.
While the report notes the residence nil-rate band is seen as complex, the OTS says because it's still very new more time is needed to understand how effective the residence nil-rate band is.
Interaction with CGT
When someone inherits an asset, its acquisition value for CGT purposes is the market value as at the date of death.
As CGT is not payable on death, any gain on behalf of the deceased is effectively wiped out for CGT purposes. This is known as the CGT ‘uplift’ on death.
This uplift applies even if no IHT is payable because a relief such as business property relief (BPR) or agricultural property relief applies.
It allows someone to inherit assets qualifying for BPR free of any IHT, to then sell that asset shortly afterwards with little or no CGT liability.
The OTS believes the CGT uplift is a distorting factor causing people to delay business succession and so make decisions that are tax-driven rather than for commercial reasons.
As a result, the OTS wants the government to consider amending the rules so that, if an IHT relief or exemption applies, the recipient is treated as acquiring the asset at the historic base cost of the person who has died.
The OTS points to the relatively low qualifying threshold for BPR compared with CGT reliefs such as entrepreneurs relief. It suggests having a common test for IHT and CGT reliefs for business assets would be easier for taxpayers to understand and would reduce distorted decision making.
Shares in unquoted trading companies qualify for BPR. For this purpose only, shares in trading companies listed on the Alternative Investment Market (Aim) are considered unquoted.
This has led to many people investing in Aim-listed shares in order to mitigate IHT liabilities on death, and the OTS questions whether this was the intention of the policy.
In its response to the Patient Capital Review, the government committed to supporting investment in Aim and other growth markets.
Yet the OTS hints that the continuing availability of BPR isn't necessary to prevent Aim-listed companies from being broken up or sold.
The OTS says even experienced advisers can make errors when it comes to trusts, as the IHT charged on trusts is difficult to calculate.
It has stopped short of making any specific recommendations on trusts, but says the IHT treatment of trusts should be addressed in the round alongside other taxes.
The OTS has suggested the government may wish to carry out a wider review of the taxation of pensions.
While it doesn't make any high level recommendations here, the report acknowledges the uncertainty surrounding transfers shortly before death.
The OTS says HM Revenue & Customs (HMRC) should provide further detailed guidance on the circumstances in which it would consider a pension transfer, say from a defined benefit to a defined contribution scheme, within the two years prior to death to be a transfer of value for IHT purposes.
It note there is a “mismatch” between the financial planners concerns on this issue and the comparatively low number of cases HMRC actually pursues.
Any further guidance will depend on the outcome of the Staveley case, which has now been appealed to the Supreme Court.
The report also highlights the separate issue of establishing whether a pension is part of a member's estate for IHT purposes being based on whether a provider has discretion over beneficiaries on death.
The OTS notes providers' need to operate discretion via trustees is considered “an unwelcome operational administrative cost” by many. It says if the position could be simplified, “it would remain a separate issue as to whether the use of discretionary trusts would still be appropriate for reasons that are not related to tax”.
The OTS notes an “uneven playing field” in IHT treatment of financial products, particularly the different treatment of similar life assurance policies based on whether or not the policy is written in trust. It suggests this should be considered by HMRC as part of its ongoing review of the taxation of trusts.
What happens next?
As the OTS is an independent adviser to the government, there's no obligation for the government to act on these recommendations - it's up government and parliament to decide on this.
Financial planners, tax advisers and lawyers will be closely monitoring the implementation of any changes in the hope that the government will seek to minimise unfair outcomes.
This is particularly true for those who've carried out planning and drafted wills based on the current rules.