On 5 July 2019 the Office of Tax Simplification published a report that made recommendations to the government to reform inheritance tax.
The proposal that has received the most attention is the reduction of the period during which a lifetime gift remains subject to inheritance tax in the hands of the person making the gift (the donor) from seven to five years. A number of other changes have been suggested – including in relation to agricultural property relief and business property relief. This article discusses the most significant recommendations below.
This is the second report from the Office of Tax Simplification following the announcement of its inheritance tax review in Spring 2018. The first report, published in November 2018, dealt mainly with administrative matters and made suggestions for streamlining probate and other inheritance tax-related processes.
The stated purpose of the second report is to reduce the complexity of the inheritance tax rules.
The main recommendations concern:
- lifetime gifts;
- the interaction between inheritance tax and capital gains tax; and
- businesses and farms (business property relief and agricultural property relief).
The report suggests that some of the existing inheritance tax exemptions and reliefs for lifetime gifts are poorly understood and makes recommendations for their reform. These include the following:
- replacing the existing annual gift exemption (£3,000) and the exemption for gifts in consideration of marriage or civil partnership (the permitted value of which is £1,000, £2,000 or £5,000 depending on the relationship between the donor and donee) with a single annual personal gifts allowance;
- reviewing this new exemption and the existing small gifts exemption (£250) to ensure that they reflect current asset values;
- reforming the exemption for normal expenditure out of income, which is regarded as being complex and often difficult to claim. The Office of Tax Simplification suggests that the need for regularity of expenditure could be abolished and a limit of a fixed percentage of income introduced, potentially based on the most recent tax return; and
- alternatively, replacing normal expenditure out of income with a higher personal gift allowance (ie, £25,000, which the report suggests would cover the value of 55% of all normal expenditure out of income claims).
The report recommends reducing the existing period after which lifetime gifts cease to be subject to inheritance tax in the hands of the donor from seven to five years.
This is not as generous as it first appears. The proposed reduction in the run-off period is coupled with a recommendation to abolish taper relief. At present, taper relief gradually reduces the amount of tax payable if an individual dies more than three years after making a gift until the gift becomes exempt after seven years.
The Office of Tax Simplification recognises that its proposals would lead to a cliff edge, in that a gift made five years before death would escape inheritance tax, whereas a gift made a day later would attract a 40% charge. Simplicity is a worthy ambition, but it does not always produce equitable results. This part of the proposal is likely to attract discussion.
At present, capital gains tax is not payable on death. Instead, assets are treated as being acquired by the individual who inherits them at their then market value. This is known as the capital gains tax uplift. Where inherited assets are also exempted or relieved from inheritance tax (eg, because of the spouse exemption, business property relief or agricultural property relief) the result may be that the assets can be sold shortly after death free of both inheritance tax and capital gains tax.
The report suggests that this may influence decision making by encouraging individuals to retain assets which are exempt or relievable from inheritance tax until death, as opposed to passing them on during their lifetime. To rectify what seems to be regarded by the Office of Tax Simplification as an undesirable distortion, the report recommends that where an inheritance tax exemption or relief is available on death, the capital gains tax uplift should not apply.
Under the proposals, assets which are exempt or relievable from inheritance tax on death would be treated as inherited at the deceased's original acquisition cost, rather than at the market value on death. While this simplification may well be attractive to the government, those with trading or farming businesses will be less enthusiastic.
The rules for business property relief and agricultural property relief are complex. Eligibility for relief is often subject to fine distinctions. Her Majesty's Revenue and Customs makes determinations on a case-by-case basis and aspects of both reliefs have given rise to a body of case law.
In its report, the Office of Tax Simplification draws attention to aspects of business property relief and agricultural property relief that in its view give rise to complexity or other difficulties. The most notable recommendation concerns a recalibration of the level of trading activity required for a business to qualify for business property relief. This is currently based on a 'wholly or mainly' test, which is generally considered to mean that an interest in a business will qualify for relief if trading activity accounts for more than 50% of the business as a whole. The suggestion is that this should be brought in line with the 80% trading requirement that applies to capital gains tax trading reliefs.
If the thresholds for inheritance tax and the capital gains tax trading reliefs are aligned, this would have a significant impact on many businesses and rural estates. It may be ambitious to expect the thresholds to instead be aligned in favour of the more generous inheritance tax rules.
Other proposals include:
- providing that death benefit payments from life insurance policies are exempt from inheritance tax, thereby ensuring that there is no need to write death benefits into trusts; and
- reviewing the pre-owned assets tax rules that were introduced in the Finance Act 2004 in relation to planning involving the family home.
Notably, the report makes no suggestions in relation to the recently introduced residence nil rate band, which has received significant criticism for being inaccessibly complicated.
The Office of Tax Simplification is tasked with making recommendations for simplifying tax rules for the government to consider. It is now for the government to consider the recommendations. Professional bodies will submit their views on the proposals.
Changes to tax legislation require parliamentary time. Given current distractions, it may be a while before any of the recommendations in this report are taken forward. The government may also wait for the outcome of its own consultation on the taxation of trusts before making any substantial changes to inheritance tax rules.
Inheritance tax is an emotive issue, splitting opinion politically. The recommendations made by the Office of Tax Simplification come at an interesting time, following announcements by the Labour Party that it is considering proposals to abolish inheritance tax and instead treat lifetime gifts and inheritances (above a greatly reduced tax-free threshold) as taxable income in the hands of the recipients.
Over the next few months, political developments are both certain and uncertain. The well advised should stay in close contact with their advisors.
It is encouraging that the Office of Tax Simplification clearly recognises the value and importance of retaining inheritance tax reliefs and exemptions.
The availability of trading reliefs encourages activity both from UK residents and the owners of internationally mobile businesses who are considering relocating and have a choice of jurisdictions available to them.
In certain circumstances, those considering making a lifetime gift or a transfer of a business or other asset in the near future may wish to do so sooner rather than later to avoid the impact of some of the recommendations, should they be introduced.
Considerations include the withdrawal of taper relief for lifetime gifts, which is not wholly mitigated by the reduction of the seven-year period to five years. Similarly, businesses that might be affected by a change in the required level of trading activity for business property relief purposes may wish to consider whether restructuring or other changes are needed in order to preserve relief.
The benefits or otherwise of taking action will depend on the circumstances, and ultimately what comes of the Office of Tax Simplification's recommendations. As always, taking advice is crucial.
This article was first published by the International Law Office, a premium online legal update service for major companies and law firms worldwide. Register for a free subscription.