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Inheritance tax: pitfalls and planning points

Author: Mei Lim Cooper

Published: 03 Aug 2023

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Inheritance tax has been in the public eye again in recent months, sparking media debate on the merits and demerits of one of the UK’s least favourite taxes. Mei Lim Cooper looks at some of the pitfalls and planning points for inheritance tax as it stands.

In the Autumn Statement, the Chancellor confirmed that the inheritance tax (IHT) thresholds would be frozen until at least 5 April 2028. Even before that, the IHT nil rate band (NRB) has effectively been frozen since 2009 and would be worth around £475,000 if it had been uprated with inflation.

As it stands, the NRB remains at £325,000 for the foreseeable future, with the residence nil rate band (RNRB) offering up to an additional £175,000 relief from IHT. In the face of increased property values over the past decades, more estates are being pulled into the scope of IHT. 

With this, more taxpayers and estates will be looking to make best use of IHT exemptions and reliefs. 

Downsizing relief and lifetime gifts

In the 2020/21 UK tax year, IHT was due on fewer than 4% of deaths. However, of those taxpaying estates, in most cases the largest asset will be the family home.

The RNRB offers up to an additional £175,000 of relief for individuals who leave a qualifying residential property to their direct descendants, and whose death estate does not exceed £1m. A taper of £1 is applied for every £2 that the limit is exceeded, until the RNRB is extinguished. Because the RNRB is only available where the family home is left to direct descendants, this may cause problems if homes are inhabited and inherited by siblings or friends.

So as not to penalise taxpayers who downsize to less valuable properties, potentially freeing up larger properties for growing families, a downsizing relief is available. This involves a slightly complicated computation of calculating the percentage difference between the amount of RNRB that would have been available before the property disposal, and the amount of the RNRB that is used after the downsize. This percentage is the ‘lost relievable amount’ that may be available as a relief against IHT, provided all applicable conditions are met.

So as not to penalise taxpayers who downsize to less valuable properties, a downsizing relief is available

The ‘downsizing addition’ applied to an estate is the lower of the ‘lost relievable amount’ and the value of death estate assets (excluding any replacement main property value) left to direct descendants.

Example 1: Letty and Ted

Letty and Ted owned a house worth £400,000 as tenants in common. On Ted’s death in May 2021, he left his 50% interest in the house to Letty. In July 2021, Letty decided to downsize and so disposed of the house for £400,000. She purchased a flat for £240,000 in which she lived until her death in July 2023. The flat was valued at £250,000 in July 2023.

At her death, Letty left the flat and £75,000 in cash to her daughter. Letty left other assets worth £50,000 to her friend Enid.

To calculate the lost relievable amount, both Ted and Letty’s RNRBs will need to be considered. Ted’s maximum RNRB at death would have been £175,000. At the date of downsizing, Letty’s RNRB was also £175,000, giving a total amount of £350,000. The house value at the point of downsizing exceeded this, meaning 100% of the potential RNRB is available.

The RNRB available on the new qualifying property is £250,000 ÷ £350,000 = 71.43%

The difference between the RNRB that would have been available at downsizing, and that which is available at death is 28.57% of £350,000, giving a lost relievable amount of £100,000.

The value of death estate assets, excluding the new flat, left to Letty’s direct descendants is £75,000.

The lower of the two values is £75,000, so this is the downsizing addition available to be applied to Letty’s death estate.

Care should be taken, therefore, when considering downsizing relief after gifting a main residence. Downsizing relief may be available, but only if the value of other assets left in the death estate being left to direct descendants meets or exceeds the downsizing allowance. Where the main home has already been gifted, some estates may lack sufficient assets to make full use of whatever lost relievable amount may have been available. 

The RNRB can only be applied on death, not to lifetime gifts. So in the event of a death within seven years of the gift, a previous disposal of the main home cannot be sheltered from IHT that way. It may, of course, be covered by the normal NRB.

Example 2: Alex and Courtney

Alex and Courtney owned a house worth £800,000 as tenants in common. In May 2022, they gifted their house to their adult children, and went on a round-the-world holiday. Unfortunately, they both died in a sudden accident in July 2023, leaving their whole estate of £200,000 in liquid assets to their children.

At the point of downsizing, their RNRB would have been £175,000 each, giving a total of £350,000. The house value at the point of downsizing exceeded this, meaning 100% of the potential RNRB is available.

The RNRB applicable on death is 0% as no qualifying property is held. The difference of 100% gives a lost relievable amount of £175,000 for each estate, totalling £350,000.

The value of death estate assets left to direct descendants is £200,000.

The lower of the values is £200,000, giving the downsizing addition.

As the RNRB cannot be applied to the gift in May 2022, the taxable estate will be calculated as follows:

•  Cash in estate £200,000 + Gifts made within seven years of death £800,000 = Total estate £1,000,000
•  Total estate £1,000,000 - RNRB downsizing £200,000 - (NRB x 2) £650,000 = Taxable estate £150,000

If Alex and Courtney had not gifted the house, the entire estate would have been covered by the RNRB and NRBs, and no IHT would be due.

Gifts with reservation

While we’re on the subject of gifting main residences, many tax advisers will have heard the old chestnut of an individual wanting to gift their main residence away while continuing to live in it. 

It bears repeating that in most cases this will be considered a gift with reservation of benefit, and the value of the property will remain in the donor’s IHT estate. At the point of death the greater of its value at gift or at death will be included in the calculation of the IHT estate. Of course, there are ways around its inclusion (eg, payment of market value rent, keeping use of the property under the de minimis limits), but these may not be palatable alternatives. A previous TAXline article looks at this in more detail.

Domicile and the statutory residence test

For individuals domiciled in one of the countries of the UK, IHT will be due on their worldwide estate. However, for taxpayers who are not UK domiciled, only their UK assets will be subject to IHT. Once non-domiciled individuals have been resident in the UK for at least 15 out of the previous 20 tax years, they are ‘deemed domiciled’ and, broadly, their worldwide assets come into scope of UK IHT. 

When relying on one of the few tax treaties covering inheritance tax, there may be slightly different implications of domicile. The application of a treaty may override deemed domicile status in the UK (or its equivalent overseas). In other situations, it may operate counterintuitively (see question 29 in TAXguide 11/20). 

When relying on one of the few tax treaties covering inheritance tax, there may be slightly different implications of domicile

In the recent case of Ameet Shah (As Executor of the Estate of Anantrai Maneklal Shah deceased) v HMRC [2023] UKFTT 00539 (TC), the First-tier Tribunal found that the deceased had a domicile of choice in England, after living in the UK since 1973. The executors of the estate asserted that the deceased intended to return to India, and so did not gain a domicile of choice in England. If the deceased had retained his common law domicile in India, the double tax treaty would have applied to exclude his non-UK assets from UK taxation.

Advisers may wish to review the fact pattern for clients in similar circumstances and apply a healthy dose of professional scepticism. Don’t forget, too, that the statutory residence test has special rules for the tax year of death. While you might expect that they are non-resident based on previous travel patterns, it’s best to check, especially if they have spent time in the UK early in the tax year.

Share relief

Turning to post-mortem IHT reliefs, where shares are sold for less than their value on death, relief may be available (see s179, Inheritance Tax Act 1984). This is only available for quoted shares and holdings in an authorised unit trust.

Qualifying shares and holdings must be sold within 12 months of the date of death. Currently His Majesty’s Courts and Tribunals Service is dealing with a backlog of probate applications, leading to average waits of 16 weeks for probate to be granted. This may put pressure on executors to be able to dispose of underperforming shares before the 12-month deadline expires. 

A cautionary tale 

Advisers may have noted the recent appeal case of Bhaur & Ors v Equity First Trustees (Nevis) Ltd & Ors [2023] EWCA Civ 534. Here the appellants sought to set aside the implications of an IHT avoidance scheme on the grounds of mistake.

The High Court had previously found that there had been no mistake, but merely a misprediction of the outcome of the avoidance scheme and refused the application. In considering the four grounds of appeal, the Court of Appeal examined the case law concerning whether use of an artificial tax avoidance scheme is a basis for the refusal of equitable relief. 

Agreeing with Lord Walker’s comments in Pitt v Holt  that “…artificial tax avoidance is a social evil that puts an unfair burden on the shoulders of those who do not adopt such measures”, but also accepting that tax avoidance is not unlawful, Snowden LJ concluded [at 106], “…it would not be unjust or unconscionable to refuse equitable relief and to leave the consequences of the Appellants’ mistaken belief uncorrected.”

Mistakes may apply to any transaction – not solely those relating to IHT. However, the case serves as a timely reminder that any IHT planning should be carefully thought through. Even when safely within tax law, actions taken cannot easily be set aside.

Mei Lim Cooper, Technical Manager, Personal Tax, ICAEW