The 7-year rule

Most gifts made during a person’s lifetime are not subject to Inheritance Tax at the time of the gift. These lifetime transfers are known as 'potentially exempt transfers' or 'PETs'.  These gifts or transfers achieve their potential of becoming exempt if the taxpayer survives for more than 7-years after making the gift. If the taxpayer dies within 3-years of making the gift, then the Inheritance Tax position is as if the gift was made on death. A tapered relief is available if death occurs between 3 and 7 years after the gift is made.

The rules surrounding PETs have resulted in many people wanting to make gifts long before they die. The problem in practice is that they do not want to give up control over the assets concerned.

The effective rates of tax on the excess over the nil rate band are:

  • 0 to 3 years before death            40%
  • 3 to 4 years before death            32%
  • 4 to 5 years before death            24%
  • 5 to 6 years before death            16%
  • 6 to 7 years before death              8%
  • 7 or more years before death        0%

These tapered rates cannot reduce the tax due on a lifetime chargeable transfer below the amount chargeable when the transfer was made and so are of no benefit to a transfer within the nil rate band.

We would strongly recommend that you keep a list of any PETs that you make. It is also important to keep a record of any exemptions that are used as well as details of any regular gifts made from surplus income.

IHT immediately chargeable transfers

There are special rules concerning the liability to IHT on a transfer made during a person's lifetime. Most gifts made during this period are not subject to tax at the time of the gift.

These lifetime transfers are known as 'potentially exempt transfers' or 'PETs'.  The gifts or transfers achieve their potential exempt status if the taxpayer survives for more than seven years after making the gift. If the taxpayer dies within three years of making the gift, then the IHT position is as if the gift was made on death. A tapered relief is available if death occurs between three and seven years after the gift is made.

However, if a transfer does not qualify as a PET, then IHT will become immediately chargeable on the transfer. HMRC’s internal manual lists the following scenarios where transfers may be immediately chargeable:

  • transfer into a relevant property trust, because the gift is not to an individual or a specified trust, and
  • transfer to a company.

There may also be an alternative charge on the property transferred under the gift with reservation rules.

There are four other transfers of value that are specifically prevented from being PETs. These are a

  • transfer by a close company
  • the deemed disposition on the alteration in the capital or share rights of close companies
  • the release of a life interest between 18 March 1986 and 16 March 1987, and
  • the transfer of woodlands subject to an outstanding Estate Duty charge, which only qualifies for partial PET treatment.

OTS recommended changes to IHT

The Financial Secretary to the Treasury has written to the Office of Tax Simplification (OTS) to confirm that HM Treasury strongly supports some key recommendations on changes to Inheritance Tax.

The government announced on 23 March 2021 that it will:

  • change reporting regulations so that from 1 January 2022 over 90 per cent of non-taxpaying estates each year will no longer have to complete Inheritance Tax forms for deaths when probate or confirmation is required; and 
  • make permanent the ability for those dealing with a trust or estate to provide an Inheritance Tax return without requiring physical signatures from all others involved, easing the administration burden in cases where an Inheritance Tax return is still required. 

These new rules will result in dramatic changes in reporting regulations from 1 January 2022 for more than 200,000 estates every year.

It was also announced that the government will continue to work on the remaining recommendations made by the OTS: for digitisation, improving processes for lifetime and trust charges, guidance, and working with court services. Some of these are longer term in nature and will be taken forward as part of the wider Tax Administration strategy.

Inheritance Tax – tax-free gifts

We wanted to remind our readers of the Inheritance Tax (IHT) implications of making cash gifts during the current tax 2020-21 tax year that ends on 5 April 2021.

You can give away up to £3,000 worth of gifts each tax year. This is known as your annual exemption. Any unused part of the annual exemption can be carried forward, but only for one year. So, if you didn’t make any cash gifts in 2019-20, you could gift up to £6,000 this tax year.

There are also generous exemptions for normal gifts made out of your income, but you must be able to maintain your standard of living after making the gift. There are also reliefs available for wedding or civil ceremony gifts. You can gift up to £1,000 per person with higher limits of £2,500 for a grandchild or great-grandchild, £5,000 for a child.

You can also give as many small gifts of up to £250 per person as you want during the tax year but only if you haven’t used another exemption on the same person.

There is no IHT to pay on lifetime gifts between you and your spouse or civil partner as long as you both live together, permanently in the UK.

Other gifts, outside these limits, count towards the value of your estate and should be carefully considered.

IHT Main Residence Nil Rate Band

The Inheritance Tax residence nil-rate band (RNRB) is a transferable allowance for married couples and civil partners (per person) when their main residence is passed down to a direct descendent such as children or grandchildren after their death. 

The RNRB came into effect on 6 April 2017 and was introduced in stages. The allowance increased to the present maximum level of £175,000 from 6 April 2020. Going forward, the allowance is set to increase in line with the Consumer Price Index. The allowance is available to the deceased person’s children or grandchildren. Any unused portion of the RNRB can be transferred to a surviving spouse or partner. The RNRB is on top of the existing £325,000 Inheritance Tax nil-rate band.

The allowance is available to the deceased person's children or grandchildren. Taken together with the current Inheritance Tax limit of £325,000 this means that married couples and civil partners can pass on property worth up to £1 million free of Inheritance Tax to their direct descendants. 

There is a tapering of the RNRB for estates worth more than £2 million even where the family home is left to direct descendants. The additional threshold will be reduced by £1 for every £2 that the estate is worth more than the £2 million taper threshold. This can result in the full amount of the RNRB being tapered away. 

Definition of a potentially exempt transfer

The majority of gifts made during a person's life are not subject to tax at the time of the gift. These lifetime transfers are known as 'potentially exempt transfers' or 'PETs'. These gifts or transfers achieve their potential of becoming exempt from Inheritance Tax if the taxpayer survives for more than seven years after making the gift. There is a tapered relief available if the donor dies between three and seven years after the gift is made.

The effective rates of tax on the excess over the nil rate band for PETs is:

  • 0 to 3 years before death 40%
  • 3 to 4 years before death 32%
  • 4 to 5 years before death 24%
  • 5 to 6 years before death 16%
  • 6 to 7 years before death 8%

HMRC’s internal Inheritance Tax manual states that subject to certain exceptions, a PET is a lifetime transfer of value that satisfies three conditions. They are that:

  • the transfer is by an individual on or after 18 March 1986
  • it would be a chargeable transfer apart from IHTA84/S3A (or, if only partly chargeable, is a PET to the extent that it would be chargeable), and
  • it is a gift to another individual or to a specified trust.

Video-witnessed wills

The Ministry of Justice (MoJ) has confirmed that video witnessed wills in England and Wales will be made legal during the coronavirus pandemic. The change in law to introduce this measure is due to come into force later this month – the reforms will be backdated to 31 January 2020 – the date of the first confirmed coronavirus case in the UK.

This means that any will witnessed by video technology from that date onwards will be legally accepted. The change will remain in place until 31 January 2022, or as long as deemed necessary, after which wills must return to being made with witnesses who are physically present.

Currently, the law states that a will must be made ‘in the presence of’ at least two witnesses. The changes will amend the law to include video-witnessing.

The MoJ has stated that the use of video technology should remain a last resort, and people must continue to arrange physical witnessing of wills where it is safe to do so. Wills witnessed through windows are already considered legitimate in case law as long as they have clear sight of the person signing it.

Even with video witnessing, the Wills still need to be signed by two witnesses who are not its beneficiaries and electronic signatures will not be permitted.

Who pays Inheritance Tax?

Inheritance Tax (IHT) is levied on a person’s estate when they die and can also be payable during a person’s lifetime on certain trusts and gifts. The rate of Inheritance Tax payable is 40% on death and 20% on lifetime gifts.  IHT is payable at a reduced rate on some assets if an individual leaves 10% or more of the 'net value' to charity of their estate.

There is a nil-rate band, currently £325,000 below which no Inheritance Tax is payable. In addition, there is an IHT residence nil-rate band (RNRB) which relates to a main residence passed down to a direct descendent such as children or grandchildren. The RNRB of £175,000 (where available) is additional to the £325,000 Inheritance Tax nil-rate band.

Funds from the deceased estate are usually used to pay IHT. If there is a will, it is usually the executor who deals with paying any IHT due to HMRC. IHT can be paid from funds within the estate, or from money raised from the sale of the assets. Payment of any IHT due is often made using the Direct Payment Scheme (DPS) whereby some or all of the IHT is paid from the deceased person’s accounts directly to HMRC. The deceased may also have used a life insurance policy to fund the payment of some / all the IHT due.

Once the IHT and any outstanding debts are paid, the executor or administrator can distribute what remains of the estate. The beneficiaries of the will do not normally need to pay IHT on their inheritance, but there are exceptions.

Trusts and CGT

A trust is an obligation that binds a trustee, an individual or a company to deal with the assets such as land, money and shares which form part of the trust. The person who places assets into a trust is known as a settlor and the trust benefits one or more beneficiaries.

The trustees make decisions about how the assets in the trust are to be managed, transferred or held back for the future use of the beneficiaries. They are also responsible for reporting and paying tax on behalf of the trust. A trust needs to be registered with HMRC if it pays or owes tax. CGT may be payable when assets are placed into or taken out of a trust.

If assets are transferred into a trust, then tax is paid by either the person selling the asset to the trust or the person transferring the asset (the 'settlor').

If assets are taken out of a trust, the trustees usually have to pay the tax if they sell or transfer assets on behalf of the beneficiary. However, the rules are complex and there are different types of trusts that need to be considered, such as bare trusts or non-UK resident trusts.

Most trusts have an annual exemption from CGT, currently £6,150 (2020-21). There is a higher limit of £12,300 if the beneficiary is vulnerable, a disabled person or a child whose parent has died.

IHT exemption for gifts out of income

It is possible for wealthier taxpayers to take advantage of the IHT exemption for gifts and payments that are paid as normal expenditure out of income. This is a very flexible exemption from IHT as there are no specific requirements, for example, making fixed, regular gifts to the same person. With proper planning this can be a particularly useful tool and could include helping grandparents pay school fees for their grandchildren.

However, careful consideration has to be given to ensure that these payments form part of the transferor’s normal expenditure and is made out of income and not out of capital. The person gifting the money must also ensure that they are left with enough money to maintain their normal standard of living. A gift must meet all of the conditions to qualify for the exemption and must not fall within any of the exceptions.

This relief is separate to the annual Inheritance Tax exemption of £3,000 for gifts. This exemption can also be carried forward to the following tax year if not used, to make a maximum gift of £6,000. Individuals can also give as many gifts of up to £250 per person as they want during the tax year but only if they have not used another exemption with the same person. There are also special allowances for gifts made at a wedding or civil ceremony.