The Office for Tax Simplification (OTS), an independent adviser to the UK government, has called on lawmakers to update current inheritance tax (IHT) legislation, as its design does not make it easy to navigate.
The main recommendation from the OTS is a reduction in the timeframe in which assets might be subject to IHT.
Currently, inheritance tax can be applied to transactions that took place as long as seven years before the person dies. But the OTS found it was “too long”, as it can be difficult for executors to find records going back that far, especially considering that banks can only provide statements up to six years prior.
Additionally, if people have “made gifts into trust”, the relevant period for IHT might go up to 14 years, the report said.
“The inheritance tax system has become so complicated that many people simply do not understand the system, so any simplification to make it easier for families to navigate would be a positive development,” said Laura Suter, personal finance analyst at AJ Bell.
Rachael Griffin, tax and financial planning expert at Quilter, said: “Simplification was the name of the game for this report and that is a welcome goal.”
But she warned that “further tinkering to the system may do just the opposite”.
Griffin said that the government should not be too quick to implement the OTS’ recommendations and, instead, review the intention behind IHT in the first place.
“Before the government jump feet first into making these changes, they need to step back and reflect on the purpose and vision of inheritance tax. If its purpose is to tax people based on how much wealth they have then the research is pointing to the necessity of reform. However, there needs to be proportionate reform.
“IHT makes up less than 1% of the total raised by the Exchequer and so would cover just one week’s worth of the cost of tax relief on pensions. It’s undeniably an issue, but government have bigger and more expensive fish to fry.”
The limits in place regarding monetary gifts to spouses, family members and other people are varied and have not been updated since the 1980s
For instance, the first £3,000 ($3,774, €3,344) given away each year is exempt from IHT; as are individual gifts of £250, gifts to someone getting married or entering a civil partnership and regular gifts coming from an individual’s disposable income.
“The taxation of lifetime gifts is widely misunderstood and administratively burdensome,” said Bill Dodwell, OTS tax director.
The OTS has recommended scrapping the different limits, and introducing a bigger single personal allowance instead.
“[The OTS’ recommendation] is not only fair, it will increase the flow of money through generations,” Griffin said. “Today’s personal annual gifting limit of £3,000 doesn’t go far, while the buying power of nearly £12,000, which is what it would be had it risen in line with inflation, could make the difference when it comes to paying school fees or buying a house.”
Neil Jones, wealth and tax specialist at Canada Life, argued that clients would benefit greatly if the suggestions made by the OTS were implemented.
“The rules around gifting are ripe for review. One recommendation is to cut the seven-year rule down to five, so if you gift after five years it can effectively be done outside of IHT. This would obviously help more clients.”
Nil band rate
The report also criticised the way inheritance tax is applied according to the nil band rate (set at £350,000).
For instance, if a parent were to gift £350,000 to each of their two children at different times and that parent happens to die within seven years from making the gift, IHT at 40% would only be paid by the child who received the gift second.
As a result, the OTS has outlined two alternatives and one potential amendment.
- Any inheritance tax due in relation to lifetime gifts to individuals should be payable by the estate, and;
- The nil rate band should no longer be allocated to lifetime gifts in chronological order but, rather, first be allocated proportionately across the total value of all the lifetime gifts, with any remainder then being available to the death estate.
- For executors to be liable to pay inheritance tax relating to lifetime gifts only out of assets they handle, and which are due to be distributed to the gift recipient in question, and if it has not proved possible for HM Revenue & Customs to collect the money directly from the gift recipient.
But to make things more complex, the amount of tax due is also determined by a tiered structure, Griffin said,
“If you have already used your nil rate band of £325,000 – through gifts or otherwise – and you continue to gift above this allowance, then die within seven years, how much tax has to be paid depends on a tiered structure linked to when you die.
“This is as clear as mud to most people and so a simplification is welcome and sensible.”
Capital gains tax
The interaction between capital gains tax (CGT) and IHT was another area of concern for the OTS.
It said that the applicability of the two is “complex and can distort decision making”. Generally there is no capital gains tax on death, and the asset a person is inheriting is treated as being acquired at market value, rather than the amount originally paid.
This is also known as capital gains uplift, and means that the asset can be sold without CGT being due. However, problems occur when an asset is also IHT exempt (especially when it comes to business property or spouse exemptions), meaning that the individual doesn’t have to pay either tax.
The OTS has suggested a change to CGT rather than to inheritance tax relief.
But this could exacerbate inequality, Griffin cautioned.
“The OTS suggests the government get rid of the capital gains tax uplift on death. In other words, if they sell the asset they will be subject to CGT on the gains made. This will drastically increase the number of people who inherit things they can’t afford and means that someone who was responsible enough to buy a property and hold on to it will not be able to let their loved ones benefit fully from the growth of that property.
“Again, the rationale here seems sound, that the CGT uplift encourages people to hold onto assets until they die and restricts the flow of assets through generations. However, changing the rules on CGT isn’t the way to tackle this issue.
“If anything, it exacerbates inter-generational inequality.”
Pensions and life insurance
The issue with pensions and life insurance is that IHT only applies in some cases.
Life insurance policies that have been written in trust are not counted as part of the deceased’s estate and, as a result, are not liable to IHT. And a similar rule applies to pension savings.
That is why the report is urging the government to consider ensuring that all death benefit payments from term life insurance are IHT-free on the death of the assured.
Griffin said: “The OTS has noted that there are many advantages for writing a life insurance policy in trust and many people don’t do this. So, to simplify it, they are recommending that all death benefits are inheritance tax free regardless of being placed in trust.”
Similarly, the OTS said pension policies should not be considered as part of a person’s estate and be exempt from inheritance tax.
“Pensions are given a cursory nod in the OTS paper and they rightly call for pension rules to be amended so all pension policies are not subject to inheritance tax. At the moment there are older style pension plans which are written in a way that means they are subject to inheritance tax.
“[…] the report is not explicit on the frankly bizarre rules about pension transfers during ill health. It would be both simpler and just to remove the rule that anyone who transfers their pension in ill health and dies within two years could see the remainder of their pot taxed at 40%,” Griffin added.
Chancellor of the Exchequer Phillip Hammond has welcomed the independent report he commissioned in January 2018, and said: “The government will consider the recommendations made in the report and will respond in due course.
“Any changes to inheritance tax and the wider tax system are the prerogative of the government and parliament.”
However, the UK has yet to announce who will succeed Theresa May as prime minister – with Boris Johnson and Jeremy Hunt battling for the top job – and it is very likely that the cabinet will see a reshuffle and the looming deadline of Brexit take priority.
“Chancellor Philip Hammond was the one that ordered this review over a year ago. With the current Tory leadership battle, it is likely that we will have a new chancellor in place soon and these recommendations may fall on deaf ears,” Griffin added.
“However, one hopes that politicians will take a long-term view and see the necessity for reform. Changes to IHT could be a nice giveaway for the Conservatives if and when they have to head into a general election. Really though, this should be a cross-party initiative as rules regarding inheritance tax are, by their very nature, long term and require advanced planning.
“A constantly shifting framework makes such planning impossible,” Griffin said.