FOR FINANCIAL ADVISERS ONLY
FOR FINANCIAL ADVISERS ONLY
Consumer
Share

IHT – the forgotten tax

IHT's impact isn’t felt until the client dies, when clients may have more pressing issues to deal with. This article provides some reminders of ways to save on the eventual IHT bill.

Inheritance tax (IHT) should not be overlooked when financial planning – its impact isn’t felt until your client dies, and often they may have more pressing issues to deal with in the here and now.

IHT could quite easily fall down the financial planning ’to do’ list. However, IHT collection still generates £3.4 billion in revenue and articles often quote IHT as a ‘tax of choice’. It’s a good time to remind ourselves of the IHT basics and some of the mitigation solutions available.

Who is liable to pay IHT?

Your liability to UK IHT depends on your domicile at the time of death and not your residency. Therefore if you are domiciled in the UK, IHT applies to your assets wherever they are situated.

Domicile is a concept of general law and is distinct from nationality or residence. Whilst it is possible to be resident in more than one country, it’s not possible to be domiciled in more than one country at any given time.

Domicile of origin

Domicile of origin is the domicile acquired at birth, normally that of the father. However, if the parents are unmarried or the child was born after the death of the father, then the mother’s domicile will normally be acquired. The domicile of origin can differ from the country of birth, as it follows the domicile of the relevant parent.

Under the general law, you will retain your ‘domicile of origin’ until a different domicile is acquired – either a ‘domicile of dependency’ or a ‘domicile of choice’.

Domicile of dependency

A child’s domicile will follow that of the person on whom they are legally dependent and is known as ‘domicile of dependency’.

If the domicile of that person changes, the child’s domicile will change in place of their domicile of origin. So if the father’s domicile changes after the birth of a child, the child follows that new domicile as a domicile of dependency. From the age of 16, the child can legally acquire a domicile of choice.

Domicile of choice

An individual can try to acquire a new domicile (a domicile of choice) by settling in a new country with the intention of living there permanently. It can be difficult to acquire a new domicile. There are no fixed rules as to what is required to do this and the burden falls on the individual to prove they have acquired a new domicile. Living in another country for a long time, although an important factor does not prove a new domicile has been acquired. There also needs to be the necessary intention of living there permanently.

HM Revenue & Customs (HMRC) make a judgement after reviewing the ties with the domicile of origin and those with the domicile of choice.

Disposing of assets in the country in which you were previously domiciled may help support a claim. It is unlikely that a domicile of choice will be acquired if there are still ties (other than insignificant ones) with your domicile of origin.

An objective intention to remain in a new country needs to be proved by actions rather than by just a claim of intention.

If we consider the real case of Charles Clore, a wealthy UK businessman, who left the UK in the mid-seventies to spend time in Monaco possibly in order to avoid a large potential capital gains tax liability. He visited London in 1979 where, tragically, he died. His executors, hoping to avoid substantial death duties, claimed that he had acquired a domicile of choice in Monaco. Unfortunately, he had told his lawyers that he was homesick and missed England. That was enough for the UK tax authorities to show that he had never actually ‘settled’ in Monaco and his estate was assessed in the order of £30 million in death duties.

Please note: case study is fictional and used purely to illustrate a potential real-life scenario.

IHT tax exemptions and reliefs

Nil-rate band

The IHT threshold (or ‘nil-rate band (NRB)’) is the amount up to which an estate will have no IHT to pay. The NRB for tax year 2016/17 is £325,000 and usually rises each year with inflation. However, the NRB is frozen at £325,000 until the tax year 2020/21. If the estate is more than the threshold, IHT will be due at 40% on the amount over the NRB.

In October 2007, the transferable NRB was introduced and means that upon the death of the surviving spouse/civil partner, their personal representatives not only have the deceased’s NRB but potentially they can also use 100% of their deceased spouse’s/civil partner’s NRB. On NRB figures for 2016/2017 this now means a potential of £650,000 (£325,000 x 2) can pass free from IHT upon the death of the surviving spouse/civil partner.

So consider Mr & Mrs Scown. Upon Mr Scown’s death he leaves all of his estate (valued at £325,000) to his wife. Since this is covered by the inter spousal exemption none of Mr Scown’s NRB has been used. This means that upon Mrs Scown’s death she will have her own NRB as well as 100% of Mr Scown’s NRB leaving a total available of £650,000 to pass free from IHT.If, however, upon his death Mr Scown only left half of this estate to his wife and the remaining half to his children he would have used 50% of this NRB. This would mean that upon Mrs Scown’s death she would have her NRB as well as 50% of Mr Scown’s.

Please note: case study is fictional and used purely to illustrate a potential real-life scenario.

The full NRB is only transferable if the surviving spouse/civil partner is UK domiciled. If the spouse or civil partner is domiciled outside of the UK then the relief for assets passed to them is restricted to £325,000 (therefore £325,000 + £325,000 is exempt, any assets above this are taxed at 40%).

This main residence NRB will be phased in from 2017 and will eventually reach £175,000 per person in the 2020/21 tax year. The additional allowance will only be available where a family home or ‘main residence’ is transferred to a direct descendant of the deceased. This could result in an overall NRB of £1 million for married couples or civil partners and is believed to keep the majority of UK homes free to be passed down the generations without a liability to IHT. 

Every little helps – other exemptions

Sometimes, even if your estate is over the threshold, you can pass on assets without having to pay IHT. A brief reminder of some of them are as follows:

  • Spouse or civil partner exemption. Your estate usually doesn’t owe IHT on anything you leave to a spouse or civil partner who has their permanent home in the UK – nor on gifts you make to them in your lifetime – even if the amount is over the threshold.
  • Charity exemption. Any gifts you make to a ‘qualifying’ charity – during your lifetime or in your will – will be exempt from IHT.
  • Annual exemption. This is an amount that can be gifted free of IHT. Currently the amount is £3,000 per year. Where the exemption has not been used in the previous tax year the amount can be carried forward but only for the current tax year – giving a maximum of £6,000. This exemption is available per individual and there are no restrictions on the recipient of the gift. For a married couple or civil partnership this therefore could mean a combined gift of £12,000.
  • Small gift exemption. You can make small gifts of up to £250 to as many individuals as you like tax-free.

Wedding and civil partnership gifts. Gifts to someone getting married or registering a civil partnership are exempt up to a certain amount.

Normal expenditure out of income

  • A transfer made out of normal expenditure of income will be exempt, providing a number of criteria are met. Firstly, the transfer has to be made as part of the normal expenditure of the person making the transfer (the transferor). Secondly, it has to be made out of natural ‘income’ for example from dividend payments, or interest from investments or salary. Thirdly, after allowing for all transfers which are part of normal expenditure, the transferor has to be left with sufficient income to maintain their usual standard of living. Finally the transfer has to be habitual or regular.

Potentially exempt transfers (pets)

  • The seven-year rule. Any gift given within seven years prior to death and above the available NRB is liable to 40% tax.
  • Gift with reservation. If a deceased person made a gift during their lifetime, its value could be added to their estate on death if they kept back some sort of benefit. This is ’reservation of benefit’.

For example,

  • A parent gives his house to his children, but the parent continues to live in the house rent free.
  • A brother gives some valuable antique furniture to his sister, but keeps the furniture in his living room for the time being.

In the first example, if the parent transferred the house to their children but paid full market rent, there would be no reservation of benefit. However, the children may be liable to pay income tax on the rent received.

Mitigating your liability to IHT – your options

There are a number of IHT mitigation schemes available which have stood the test of time – three examples of these follow;

Retaining access to the capital sum – the loan trust

The loan trust is a vehicle which allows your client access to a capital sum (the loan) whilst any growth on that sum is immediately outside the settlor’s estate. There are no age or health restrictions associated with the IHT savings, although any IHT benefits will be impacted by the amount of loan payments spent by the settlor, the growth on the initial sum and the amount of time the settlor lives after the IHT planning exercise.

The loan trust is an arrangement where a loan is made by an individual (the settlor/the lender) to trustees of a trust (either discretionary or bare) which the trustees then use to invest into an investment vehicle, usually a single premium investment bond. The loan is interest free and repayable on demand. Once the loan is made, any subsequent growth on it will immediately be outside the settlor’s estate.

Jake makes an interest free loan of £1,000,000 to his chosen trustee, Old Mutual International Trust Company. This money is held on discretionary trust. The trustee invests the money into an investment bond. If we assume no loan repayments are made for the first five years and the bond grows at a rate of 5%, in the first year the growth would be £50,000 and by year five the growth would be £276,282. This would give an immediate IHT saving of £110,513 (i.e. 40% of £276,282). Jake requests repayment of the loan over the next 15 years. He spends the repayments on holidays and home improvements. Unfortunately, Jake dies shortly after this time. The investment bond has grown by £557,000, which provides an IHT saving of £222,800. This is held in trust for Jake’s chosen beneficiaries.

Please note: case study is fictional and used purely to illustrate a potential real-life scenario.

A loan trust may be suitable for clients who have reached their NRB (£325,000 or £650,000 if combined with their spouse/civil partner) as any growth on the loan is not taxable. A loan trust may also be suitable for clients whose spouse/civil partner is not UK domiciled.

Retaining access to withdrawals – the discounted gift trust (DGT)

The discounted gift trust can be described in brief as a scheme which lets the settlor make a gift whilst retaining a right to withdrawals. Assuming that a client is of standard health for their age and below the age of 90, there should be an immediate IHT saving.

Consider Julie. She is 78 and in excellent health for her age. Her financial adviser has identified that she has an IHT issue and has recommended a discounted gift trust as one way of mitigating IHT. Julie makes a gift into a DGT of £500,000 and retains a 5% right to withdrawals. Based on a number of factors, such as age, health and interest rate assumptions, Julie is deemed to have made a discounted gift of £272,249. This means Julie has made an immediate IHT saving of £91,100 (ie 40% of £500,000 minus £272,249). The growth on the trust fund is also immediately outside of Julie’s estate.

Please note: case study is fictional and used purely to illustrate a potential real-life scenario.

One of the key differences between the DGT and the loan trust is that the settlor is unable to demand the full capital at anytime and the entitlement to withdrawals cannot be changed.

A DGT may be suitable for clients who have an existing Portfolio Bond or are looking to take one out and want to wrap a trust around it at a later date.

A comparison of the IHT efficient solutions:

 

LOAN TRUST

DISCOUNTED GIFT TRUST (DGT)

Lump sum contributions

Additional contributions possible

 

Restriction on when income can be taken

Any time until the contribution amount (the loan) is fully repaid

Preset frequency and amount decided at outset*. Withdrawals are selected at outset and start immediately or can be deferred for a pre-determined period

Access to capital

Up to the value of the loan

No access

Income/Withdrawal amount

Up to the value of the loan

Determined usually as a percentage of the contribution on setting up the trust

Variation of income/withdrawal amount

Can stop, start, increase or
decrease until the loan is fully repaid

Fixed at outset – reduction can be achieved by waiving income but this is a gift for IHT purposes

*May allow escalation at a preset rate.

IHT is a curious tax as its impact for most will only become clear after a client’s death. However, with careful planning and an adviser who is offering the full spectrum of financial planning, there are ways to lessen its impact.

Additional support

Old Mutual International UK IHT calculator

The Old Mutual International IHT calculator is a tool to assist you when assessing your clients’ UK IHT liability so you can advise what steps could be taken in order to mitigate any potential tax due.

When calculating the value of someone’s estate it is important to include all the assets they own a share of and those they own outright. The calculator gives you the flexibility to input the nil-rate band applicable to your client before calculating your client’s net taxable estate and their potential IHT liability. A useful function is the ability to show how much of the taxable estate the beneficiaries will receive after IHT has been paid. It also allows you to compare this with how much IHT may be paid in the future taking into account growth on the value of the estate and if the value of the nil-rate band increases in the future.

The Old Mutual International IHT calculator can be accessed here.

Financial Adviser Verification