Proposals to overhaul inheritance tax may look good on the surface but it is a case of removal of complexity which would lead to the abolition of some useful tax breaks like taper relief and gifting exemptions.
Clearly the stand-out proposal from the Office of Tax Simplification (OTS) must be the reduction of the seven-year gifting rule to five years. This will see individuals being able to gift down to their children and only have to survive five years for it to fall out of their estate for inheritance tax (IHT) purposes. This is a welcome proposal.
However, it does come with the removal of taper relief which means that substantial gifts will see no tax deduction after three years and will need to have a survival rate of the full five years to have any IHT benefit.
The OTS is also proposing to amend the general exemptions around gifting and bring them all into one pot. These have not been changed for several decades and cover small capital gifts, the annual exemption and gifts for weddings, etc. This would see one large annual exemption of capital gifting which makes a lot of sense.
The sting in the tail is the proposal for the removal of gifting excess income after the deduction of normal expenditure. This is not widely used or even known about, yet for high earning individuals can be a way to pass substantial money down without running the risk of dying within seven years. High earners should be looking now to make such gifts as if this proposal is followed, this exemption will be removed.
It is a shame that the residence nil rate band has not been properly assessed. I appreciate the comments of the OTS that it has only just started and they need time to assess, however even in the short period of time it has been active, it is clearly over complicated with inbuilt unfairness depending on the family situation. It would have been good to have seen proposals to simplify it for a simple increase in the nil rate band. Perhaps this is more of a political decision than an OTS decision.
The suggestion that life insurance and other death benefit payments should be IHT-free on death, whether they are written into a trust or not, is welcome. There are instances where IHT has been paid on life insurance, which is ironic as the insurance was intended to pay the IHT. This will make it simpler for people taking out these policies in order to mitigate IHT.
Capital gains tax interaction
There is a change proposed regarding the interaction between capital gains tax (CGT) and IHT that will be negative for the taxpayer. This is the proposal to abolish the base cost uplift for CGT on death when there is no IHT payable on the asset. How this works is that if say a husband was to die and leave a buy-to-let flat to his wife, there is no IHT due to the spouse exemption.
However, there is CGT uplift so that the wife could then sell the property if she wishes using the date of death value as the base cost. The proposed changes means that the buy-to-let flat would not have an uplift to probate value and there would be a CGT bill based on the husband’s acquisition costs, not the value at the date of his death.
This takes out a particular strong area of planning and would also potentially see HMRC picking up more capital gains and making it harder for people to sell property without a substantial CGT bill.
Overall, while some of the changes proposed by the OTS are welcome and sensible, some - like the proposal to remove excess income exemption and the uplift in base cost on death - will see tax mitigating tools removed for wealthy clients.
The reduction of the seven-year gifting rule trumps it all and will make gifting that little bit easier (either to survive or to insure against).
Of course, if we see a Corbyn-led Labour government, this well thought-out paper may find itself quickly looking like moving chairs around the Titanic. Inheritance tax as we know it would most likely totally change with the introduction of a punitive lifetime gift tax charge. This would stall inter-generational gifting which has become so vital for the younger generation.