The confusing array of inheritance tax rules on giveaways to loved ones should be swept away and replaced with a single ‘personal gift allowance’, say Government officials.
The ‘seven-year’ rule for large gifts, which means that if you survive the money gradually becomes free of inheritance tax, should be axed in favour of a set five-year period, says the Office of Tax Simplification.
An exemption for wedding presents should be dropped, and one for giving away money out of your income either reformed or abandoned, according to its new report.
The report arrives on the heels of far more controversial plans floated by Labour to overhaul inheritance tax, which would remove a couple’s ability to leave almost £1million tax-free and replace the current IHT system with a £125,000 per person lifetime gift allowance. Above this level income tax rates would apply.
Confusing system for families: Chancellor Philip Hammond ordered a review of inheritance tax and whether it ’causes any distortions to taxpayer decisions’
Inheritance tax is one of the most hated taxes, with the Office of Tax Simplification noting that it ‘appears to be almost uniquely unpopular’. It is also considered to be overly complicated and an outsized burden on people.
Just 5 per cent of bereaved families pay the ‘death tax’ on estates over a certain level, yet half have to fill in the form to notify the taxman even when there is nothing to pay.
More are expected to be dragged into the inheritance tax net, however, with the Office of Budget Responsibility forecasting the government’s tax take will rise almost a third from £5.2billion in 2017 to 2018 to £6.9billion in 2024.
A complicated set of annual gift exemptions that have not risen in many years, leaving figures for gifts each year looking outdated, were recommended to be scrapped and replaced with a sole annual gift allowance.
The Office of Tax Simplification, which was tasked with reviewing the current regime by Chancellor Phillip Hammond, said it was not its job to recommend a new personal gift allowance set at any particular level.
But it suggested there should be no rollover of unused annual limits, to aid in the goal of simplification, and added ‘there may be merit in acknowledging the impact of inflation since the original limits were set’.
‘Many of these exemptions have been frozen at the same level since the early 1980s (the annual £3,000 exemption hasn’t changed since 1981)’, said Sean McCann, chartered financial adviser at NFU Mutual.
Exemptions, such as for small gifts at £250 and annual gifts at £3,000, have been the same for many years and would be £1,010 and £11,900 respectively if they had been raised in line with inflation. See the chart below.
The OTS has previously recommended that inheritance tax forms should be overhauled to make them shorter and simpler as a first step to improving a burdensome system, in the first report arising from its review.
Today’s second report, which also suggests changes to how capital gains tax interacts with inheritance tax, and rules on bequeathing businesses and farms, comes just ahead of Hammond’s likely departure from the Treasury.
It is uncertain whether his successor, appointed by one of the current Tory leadership contenders – or a Labour Chancellor in the event of an election and change of government – will take up its recommendations.
But the OTS, which is an independent arm of the Treasury that focuses on improving tax administration as well as simplifying the rules, made clear that it believes the inheritance tax system requires an overhaul.
‘The OTS’s extensive consultation exercise revealed many areas where inheritance tax is either poorly understood, counter-intuitive, requires substantial record keeping, creates distortions, or where the application of the law is simply unclear,’ it said.
How does inheritance tax work?
Inheritance tax was originally designed as a levy on the very wealthy, but triple digit property inflation since the 1980s has dragged more ordinary families living in expensive areas into its net.
Just 5 per cent of people leave estates sufficiently large to make their beneficiaries liable for inheritance tax.
However, the property boom of recent decades means that figure is expected to rise, with those inheriting in house price hotspots bearing the biggest financial burden.
Essentially, you need to be worth £325,000 if you are single, or £650,000 jointly if you are married or in a civil partnership, for your loved ones to have to stump up death duties.
But a new own home allowance – known as the residence nil rate band – lets you pass on more than that.
If you have a partner, own a property, and intend to leave money to your direct descendants, that threshold has started to rise in stages and will reach a joint £1million by 2020.
If you are worth more than this, your heirs will have to hand over 40 per cent of your assets above those levels to the Government.
Cut the seven-year rule to five – but critics say this could prove a tax grab?
The OTS also made recommendations in other areas.
The seven-year rule allows money or assets given away to become inheritance tax-free after this period, but the OTS said the way this works is ‘widely misunderstood’.
If the person who gave the money or asset away dies within the seven years then it will become liable for inheritance tax, but a taper means this is on a sliding scale.
The OTS said: ‘In particular, many people do not appreciate that taper relief is only relevant to people who make very large lifetime gifts totalling more than the nil rate band [£325,000].’
It said the seven-year rule should become five and the taper removed, however, critics said this could lead to more tax being taken.
Laura Suter, personal finance analyst at AJ Bell, said: ‘The OTS rightly acknowledges that the seven-year taper rule is hideously complex, and can cause people to be landed with an unexpected inheritance tax bill years after they were gifted money.
‘However, the suggestion of reducing the seven years down to five and scrapping taper relief entirely looks like a bald tax grab and revenue-raising move.
‘Instead the taper could be simplified into a two-step process for example, or if it’s scrapped entirely then the period should be shorter than five years.
‘The same goes for the suggestion of removing the ability to gift money from disposable income.
‘While this is little understood and there have never been clear guidelines on exactly how much you can gift under this rule, removing it entirely would take away a very lucrative tax break.’
The OTS also noted confusion over the rule that gifts are assessed against the nil rate band chronologically – meaning a child who received a gift first might escape a tax bill, while a sibling given one later might have to shell out a large sum.
The OTS therefore recommended: ‘The nil rate band should no longer be allocated to lifetime gifts in chronological order but, rather, first be allocated proportionately across the total value of all the lifetime gifts, with any remainder then being available to the death estate.’
It added: ‘Any inheritance tax due in relation to lifetime gifts to individuals should be payable by the estate.’
The OTS published a table detailing the complicated list of inheritance tax exemptions
The own home allowance shouldn’t be axed… yet
The new own home allowance – known as the residence nil rate band – has come in for a lot of criticism. The rules are complicated, especially around downsizing your home, and unfair to childless people, experts say.
But the OTS said: ‘Since the residence nil rate band is still relatively new, more time is needed to evaluate its effectiveness before recommendations can be made on how best to simplify it.’
One exemption that could be widened, however, was on life insurance, the OTS said. It recommended a change regarding term life insurance policies, which are free from inheritance tax if left in trust but not otherwise.
The OTS said: ‘The Government should consider ensuring that death benefit payments from term life insurance are inheritance Tax free on the death of the life assured without the need for them to be written in trust.’
Read more here on the benefits of leaving life insurance in trust.
The OTS detailed how the sven-year rule and tax levels are tapered down
On capital gains tax, the OTS recommends getting rid of the ‘uplift’, where someone inheriting an asset is treated as acquiring it at its market value on the date of death, rather than the amount it was bought for.
This means the beneficiary can sell it shortly after the death without paying CGT. If the asset is a farm or business, and therefore exempted or relieved from inheritance tax, it can be sold without that being due either.
‘This can put people off passing on assets to the next generation during their lifetime,’ says the OTS.
‘It distorts and can complicate the decision making process around passing on assets to the next generation.
‘The OTS has concluded that this distortion would be best addressed by amending the CGT rules rather than changing inheritance tax.’
There are some questions over how this would work in practice, however, and whether it would only apply to businesses and agricultural property and farms cited in the report, or could lead to people who hold onto an inherited property facing big capital gains tax bills.
Rachael Griffin, tax and financial planning expert at Quilter, said:’The OTS suggests the government get rid of the capital gains tax uplift on death. In other words if they sell the asset they will be subject to CGT on the gains made.
‘This will drastically increase the number of people who inherit things they can’t afford and means that someone who was responsible enough to buy a property and hold on to it will not be able to let their loved ones benefit fully from the growth of that property.
‘The rationale here seems sound, that the CGT uplift encourages people to hold onto assets until they die and restricts the flow of assets through generations.
‘However, changing the rules on CGT isn’t the way to tackle this issue. If anything it exacerbates intergenerational inequality.’
The OTS highlighted how many more people must complete IHT forms than actually owe tax
What do financial experts say?
‘Inheritance tax is one of the least understood and most feared taxes so any efforts to encourage more families to discuss what can often be a very sensitive subject are to be welcomed,’ said Sean McCann, of NFU Mutual.
‘Most people simply aren’t aware of the myriad of exemptions on gifts – annual gifts, small gifts, gifts on marriage and gifts out of normal income are poorly understood.
STEVE WEBB ANSWERS YOUR PENSION QUESTIONS
He added: ‘The ‘gifts out of normal income’ exemption is claimed after death and families often miss out if proper records of income, expenditure and gifts aren’t kept.
‘Replacing with one annual personal gifting allowance would make it easier to understand and encourage more people to pass on wealth to younger generation.’
Rachael Griffin, of Quilter, said: ‘There is no way to avoid inflation in day to day life – it eats away at our savings, it increases the cost of daily expenses and much more.
‘And yet the Government have avoided the eroding nature of inflation as the gifting allowance has remained frozen at the same rate since the early 1980s. Bringing it in line with the modern day is a no-brainer.
Emily Deane, technical counsel at STEP, a body for inheritance professionals, said: ‘STEP has long argued that the current system of inheritance tax is too complex, so any proposed simplifications to the regime are to be welcomed.
‘However, we are very disappointed that there are no recommendations around the nil-rate band, the residence nil-rate band or the treatment of trusts.
‘We believe that the Government could go further still and look at a wholesale change in policy towards inheritance tax, which this report acknowledges to be out of its scope.’
Some links in this article may be affiliate links. If you click on them we may earn a small commission. That helps us fund This Is Money, and keep it free to use. We do not write articles to promote products. We do not allow any commercial relationship to affect our editorial independence.