I played to non-Latin strengths at school, but I do believe carpe diem means “seize the day!”. The Office of Tax Simplification (“OTS”) has issued its second report on inheritance tax. Is it the summer blockbuster trailed in what could be dubbed “OTS 1: the formfiller”? The second report moves far beyond the very administration-focussed initial report. It sets out a possible new future in a range of areas in the inheritance tax (and capital gains tax) landscape. But in trailing something of a new horizon (which we might very never get to), the second report highlights a number of legal and estate planning steps that should be understood and utilised now.
What is the Office of Tax Simplification? What is the current review?
A brief overview. Rather than tax policy, the OTS is interested in making recommendations about improving the administration of the UK tax system for those engaging with it. Consequently, the OTS will research and then make recommendations on rule changes which will help facilitate a smooth tax system. In the report the OTS stresses it is ultimately for government to reform inheritance tax and to institute any policy-based changes.
As with the first report, the OTS sets out the scoping document for the (oh so exotic sounding) “IHT General Simplification Review” which includes the statement that the “OTS’s remit [is] to provide advice on simplifying the tax system, with the Chancellor responsible for the final decisions on tax policy” and that “the overall aim of the review will be to identify opportunities and develop recommendations for simplifying IHT from both a tax technical and an administrative standpoint.” The OTS also raised the question of “is there a better way to tax transfers of wealth?” This has attracted media attention on a number of recent occasions. Again, the OTS emphasises, almost like an insurance meerkat, that it is about “simplification”.
The focus topics of the second report
There are a few parts of inheritance tax that received particular attention in the second report. These included:-
- the rules on gift exemptions… a new annual gift allowance and maybe removing gifts out of surplus income
- the length of time before a gift falls out of account for inheritance tax purposes
- who is liable for tax if one fails to survive the gift falling out of account
- the capital gains tax effects on death
- relief for businesses and farms… and the interaction with capital gains tax rules
- keeping life insurance and pensions out of the inheritance tax net
- extending the spouse/civil partner exemption to cohabitants and siblings
- homes… the residence nil rate band
Give a little bit…. [and be exempt from inheritance tax]
Roger Hodgson of Supertramp encouraged us to “give a little bit…”. The OTS says some might be able to give away a (little) bit more . But some could be restricted to giving a lot less away.
There are a number of gift exemptions. This blog recently gave a round-up of them. The OTS considers the mix of gifting exemptions can cause confusion about how they work and interact with each other. It is also suggested that the underused but valuable normal expenditure out of income (aka gifts out of surplus income) is “anomalous, confusing and can be difficult to document”. I think it would be fair to say we think it is one that is on the whole fairly straightforward conceptually and very valuable albeit underutilised. Indeed, the paperwork required for it can be maintained handily with the form HMRC ask executors to complete on death (we accept that feels a little odd to be completing such a form while alive, but it is efficient). The OTS also touched on gifts in maintenance which in the right circumstances can be an important exemption (to support an individual) never mind the inheritance tax benefits it brings.
The OTS thinks there could be merit in sweeping away the different gift exemptions and replacing with a single annual fixed allowance. The level of this is not a matter for the OTS. And the level could be set higher if one option for reform mooted by the OTS (the removal of the normal expenditure out of income exemption) was taken forward. While the OTS does not identify a suggested level for an annual gift allowance, it does provide a statistic that “a personal gift allowance of £25,000 would cover the value of 55% of all normal expenditure out of income claims.” What about the other 45%?
As many know, if one makes a gift of more than £3,000 (or perhaps in the future above the annual gifting allowance) they must survive seven years for it to be out of the estate for inheritance tax purposes. Where gifts are in excess of the nil rate band (£325,000) there is taper relief. With taper relief the closer you get to surviving seven years, any tax due attributable to the gift if you do not survive seven years is incrementally reduced. As ever, worth highlighting here that taper relief applies to larger gifts (individually or collectively over £325,000) and it is the tax that tapers not the value of the gift.
The OTS thinks there is simplification that could happen to the seven year and taper relief rules. The proposal: a single flat five year period with no taper relief. This would reduce the need to trawl for paperwork on gifts all the way back seven years. It would have the downside that some would lose out on taper relief, but many will see the reduced period of survival as a positive. It might also have an impact on decisions about whether or not likely survival periods mean investing in the assets that qualify for Business Property Relief (such as AIM shares). The topic of Business Property Relief is one to which will we return shortly.
And for those in Pedantry Corner, the OTS also recommends abolishing the fourteen year rule that crops up in certain situations where there is need to look back fourteen years to identify what is in the estate for inheritance tax.
So, as we started with Supertramp, we end this section with Destiny’s Child and the words they almost sang… “I will survive (what), keep on survivin’ (what)… for five years without taper.”
Just when you thought it was safe to go into the water… tax payable by recipients of gifts
Picture the scene. Someone gives you a gift. Great, you think. You spend the generous present. You are then saddened to hear of the death of person who gave you the gift. You then get asked to pay tax relating to the gift… which you have spent. This rule is the Jaws of inheritance tax. Lurking. Perhaps imperceptible. Can be indiscriminate. Certainly painful if it bites.
At the moment if there is tax on gifts made by someone who fails to survive seven years (this will be where the gifts are more than £325,000), the individual primarily responsible for any inheritance tax is the person who received the gift. That could have been many years before and the recipient might be quite unaware of this potential outcome. And the tax bill can be altered significantly by minor things like a bank transfer to one recipient being made on day 1 and to another day 2. The first beneficiary might avoid tax and the second could suffer all the tax.
The OTS give options without any recommendation on updating this rule. The options from the OTS are:-
- the tax should be paid by the estate (but of course the estate beneficiaries might be deliberately different from the gift beneficiaries); and
- change how the nil rate band is allocated among beneficiaries to avoid the day1/day 2 risk noted above.
Inheritance tax and capital gains tax… making everybody hurt?
The OTS looked at the interaction between inheritance tax and capital gains tax. the OTS also raised the idea of abolishing inheritance tax and having capital gains tax as the capital tax. That is an approach favoured elsewhere including Australia. The OTS sees this as tempting but that there are reasons this will not be an single-sweep tax simplification solution.
Beyond the big concept of capital gains tax taking over from inheritance tax, the OTS reviewed the capital gains ‘uplift’ on death. This is a rule that irrespective of inheritance tax consequences on a death all gains to date of death are wiped out as the assets are then revalued, for capital gains tax purposes, as at the date of death – not the date they were originally acquired. This can be very helpful. It enables ‘purer’ investment decisions to be made and helps unlock assets that due to the capital gains tax cost (real or perceived) would not be realised… and the value not released into the economy. The OTS does not seem to like the uplift on death. It notes that as it only applies on death it can lead to decisions about sales of assets being put off until death and not made at some apparently more appropriate point. It cites “anecdotal evidence” of trading businesses and farms suffering as the next generation has had to wait too long to take on the venture from older relatives. The OTS sets out a long list of situations where the capital gains tax rules during life distort decision making. The OTS solution (getting rid of the gains uplift on death) appears to mean the distortion is removed or simplified by making the situation unattractive both during life and following a death. A double loss now.
The real economy… trading businesses and farms
The engine room of the economy has valuable inheritance tax reliefs attaching to it. Business Property Relief (“BPR”) and Agricultural Property Relief (“APR”) are designed to enable certain businesses to continue and pass across generations without inheritance tax acting as a barrier. In many cases this is 100% inheritance tax relief. Hugely important.
While the OTS does not pursue it (as “beyond the scope of this review”), it does open with considering abolishing BPR and APR and having an overall lower rate of inheritance tax. That would seem a very big step.
The OTS is not about policy, but the report does consider whether or not certain aspects of the current BPR rules are within the policy intent of the relief. In particular, the OTS raised the issue of the qualification of AIM shares. The OTS makes no recommendation in this regard.
The current BPR rules require that a business must not be “wholly or mainly” in the nature of making investments. Broadly tip over the 50% threshold from a trading business into one that “mainly” makes investments and the whole entitlement to valuable BPR is lost. The OTS notes that for capital gains tax purposes the tipping point between trade and investment is regarded as being when investment goes above 20% of the business. The OTS conclusion is to examine the options on aligning the two (to the lower capital gains level). The OTS does recognise there are reasons for the differences in the tipping point between the two taxes.
A change to BPR could have significant impacts on businesses and lead to the need to consider and make significant restructuring of businesses.
On farms, the OTS makes what a fair suggestion about making sure the application of APR does not penalise farmers who end up in care or need similar assistance. This is an issue we have seen increasingly appear and already raises issues of equalities and discrimination. The issue is the current apparent strict need to be on the farm/in the farmhouse/cottage at the time of death. Woe betide the older or unwell farmer for the audacity to need care and assistance outwith the farm boundaries! A sensible and humane recommendation from OTS.
The OTS also recommends that there is a clearer and consistent definition of “agriculture”. That also seems no bad thing.
Putting your trust… in life policies – no more?
At the moment, to avoid a life policy (often taken out to fund an inheritance tax liability) from exacerbating the liability by forming part of one’s estate and the value of the policy itself being taxed, it should be placed in trust. The OTS recommends there should be a rule that policies should be automatically outwith the estate for inheritance tax to avoid the need for a trust. This proposal helps highlight that key reasons trusts are generally used are non-tax related. The holding of a policy in trust would nevertheless be advantageous to for example (1) facilitate speedier pay out of the policy, (2) ensure the policy proceeds are used for the right purposes, (3) avoid the proceeds being part of a legal rights entitlement (fixed succession rights of spouses/civil partners and children irrespective of what your will says).
On pensions, the OTS recommends there be a wider consideration across all the taxes that apply to pensions on death. The OTS also recommends HMRC issue further guidance on the application of rules that penalise certain changes to pensions arrangements made two years before death or during a period of illness. The OTS wishes to create clarity on the mischief of seemingly inappropriate changes to pension arrangements simply to create a inheritance tax free amount that can pass to the next generation or others.
The OTS briefly discusses trusts in their wider context in the report. They have no firm conclusions on trusts inheritance taxation (apart from it is “not straightforward”, “most individuals do not understand how trusts are… taxed” and it is “difficult to calculate”). It does however raise the spectre of ideas such as an annual trust charge (a wealth tax?). The OTS reaches no firm conclusions due to the on-going wider trust taxation consultation. Here’s our blog giving an overview of that consultation.
For the generous… charities
Well, for those who give, they can receive a whole blog focused on the charities aspects of the OTS report. Here it is.
Extending the spouse and civil partner exemption to others
No change here in the OTS report. The OTS concludes that any extension of the exemption to cohabiting partners or siblings is for government to consider as part of social policy rather than a tax technical point. We should remind cohabitants of the vital importance of having a will in place to avoid the uncertainties attached to having to make a cohabitant court claim after a death.
Home sweet home… but a less than inviting tax relief
The residence nil rate band was brought in with a fanfare from then Chancellor, George Osborne in Budget 2015: “The result for families is this. You can pass up to £1m on to your children free of inheritance tax. No more inheritance tax on family homes.” The analysis in the Brodies Budget 2015 update was: “In the end, what emerged from the Budget was even more complex than predicted, will take a number of years to come fully into effect, and has some significant stings in its tail.”
The residence nil rate band is full of (undue) complexity. The OTS moots changes such as abolishing it and increasing the nil rate band or amending the downsizing rules (we will spare you the details here!). Perhaps given the complexities of the residence nil rate band, the OTS concludes by saying the residence nil rate band is still very new and will take time to review its effectiveness before simplification recommendations can be made. We think a lot of people would say that time has already come to work on simplifications to this rule.
Carpe diem: the real conclusion of the OTS report
The OTS is about simplification not policy. Government will ultimately set the tax agenda. Some, many or all of the OTS recommendations might never happen. What the report does do is highlight the general inheritance tax landscape that we have today. It is with that current landscape plans can be made. There are important steps that can be taken based on the current rules to achieve the right estate planning ambitions and outcome for an individual, family or business. So, rather than us pontificate over what might be, let’s put in place steps to help achieve those ambitions and outcomes with the current rules and tools available today. And as the OTS points out, it is government that uses tax rules to pursue a policy agenda. It is government that can make changes, make them quickly and with a different research methodology from that employed by a body such as the OTS. Seize the (estate planning) day!
On July 10, 2019