Introduction to Inheritance Tax

Where an individual is UK domiciled or deemed UK domiciled for Inheritance Tax (IHT) purposes, their worldwide assets are potentially subject to IHT at a rate of 40% (2010/2011). Generally speaking, IHT is the tax payable on an individual’s estate when they die if the value of their estate exceeds the Inheritance Tax threshold which is known as the nil rate band. Inheritance Tax can also be charged during an individual’s lifetime.

Lifetime gifts can generally be classed into three main categories - exempt, potentially exempt or a chargeable transfer.

An exempt gift is totally exempt from Inheritance Tax. An example of an exempt gift would be a gift made from one UK domiciled spouse to another UK domiciled spouse.

A Potentially Exempt Transfer is where a lifetime gift is made outright to another individual or where the gift is being made to a Bare Trust (also known as an ‘Absolute Trust’) or a trust created for a disabled person (as defined under section 89(4) IHTA 1984). If a donor survives the potentially exempt transfer by seven years, it will be totally outside of his/her estate for IHT purposes.

A Chargeable Transfer is where an individual establishes a flexible or discretionary trust for the benefit of a wide range of beneficiaries. A chargeable transfer is not immediately chargeable to IHT if there is an available nil rate band with which to offset it and the amount of the gift made is not in excess of that available nil rate band.

On the death of an individual, the seven year period prior to death is reviewed to see what gifts have been made. If during that period a chargeable transfer has been made, it is then necessary to review the seven years prior to the chargeable transfer in order to ascertain whether or not there was an available nil rate band available at the time of the chargeable transfer. This is why, potentially, there is a 14 year period under review when an individual dies.

Potentially Exempt Transfers and Chargeable Transfers take their chronological position for cumulative purposes at the time the gift was made at its value at that time.

Taper Relief provides that if a donor survives for at least three years after making a potentially exempt or chargeable transfer, only a reduced percentage of the full death rates will be used as follows:
 

Although the taper relief reduces the amount of tax payable, it does not reduce the value of the gift.

It is important to remember that all transfers between UK domiciled spouses are completely exempt, unless the donor is domiciled in the UK but the donee is not, in which case the exemption is limited to £55,000.

Despite the changes announced in the Finance Act 2006, many lifetime gifts made from small to medium sized estates will generally still fall within the nil rate band. In many cases therefore, lifetime Inheritance Tax planning using trusts can still be carried out without an immediate Inheritance Tax charge arising. Provided the donor survives for seven years and undertakes no further IHT planning during this period which would impact on the availability of his or her nil rate band, the full nil rate band will be available again.

One potential strategy which could be utilised, is for individuals to make lifetime gifts up to the value of the nil rate band every seven years. Any gifts made in between those years could be to utilise exemptions such as the annual exemption for gifts or the normal expenditure out of income exemption. It is of course also possible to establish a Bare Trust where no nil rate band is available at that time.

There is, however, no doubt that the new rules may deter many clients from making large lifetime gifts into flexible trusts in excess of the available nil rate band, since this could result in a significant Inheritance Tax liability.

Important Notes

Please note that every care has been taken to ensure that the information provided is correct and in accordance with our current understanding of the law and Her Majesty's Revenue and Customs (HMRC) practice as at July 2010. You should note however, that we cannot take on the role of an individual taxation adviser and independent confirmation should be obtained before acting or refraining from acting upon the information given. The law and HMRC practice are subject to change. Legislation varies from country to country and the policyholder's country of residence may impact on any of the above.