Keeping it in the family

For many people, the family home is the most significant asset to consider when looking at how to mitigate Inheritance Tax (IHT). Even though only six per cent of estates currently pay IHT, with rising house prices more are coming into the tax net. However, with careful consideration using wills and trusts, it is possible to mitigate that liability.
The latest Pre-Budget Report (PBR) announced changes that will help married couples and those with civil partners to reduce their IHT exposure. This article looks at those changes and ways for others to keep their tax bills down.

The nil-rate band and the Pre-Budget Report
Changes to the nil-rate band, the exemption given to every individual to reduce their exposure to IHT, were announced last year. This set the rate at £300,000 for 2007/08 and then set it for several years to come as follows: £312,000 for 2008/09 and £325,000 for 2009/10.
We were later told that the threshold for 2010/11 was to be £350,000. Over the past decade, the average house price in England and Wales has escalated by 140 per cent, compared to inflation, which has risen by just 33 per cent. If IHT had kept up with the property market the nil-rate band would be £515,000. This starkly shows how more people fear that IHT is a real, rather than an imagined, threat.
In the frenzy of political activity that erupted during the party conference season, the Conservative Party latched on to voters’ IHT concerns and promised to raise the nil-rate band to £1m if it was elected. For a married couple or civil partnership that would have given them a combined £2m exemption taking many thousands clearly out of IHT. However, this type of exemption comes at a cost (over £3bn). On 9 October 2007 the new Chancellor, Alistair Darling, seized the zeitgeist and put out the Labour version of IHT change within the PBR. This is not as generous for all as the Conservative Party proposals, but does provide some flexibility and simplicity for those in marriages and recognised partnerships.
With immediate effect, the IHT rules were changed for married couples and civil partnerships. Now, the benefit of any unused nil-rate band can be transferred to the surviving spouse or civil partner and used in working out the IHT liability on their estate when they subsequently die. This measure will also be backdated to include those estates currently held by widows and widowers where the nil-rate band was not fully used, or not used at all on the first death. This will lead to some interesting computations as is discussed further below.

How the change works
The basic rule is that when an individual dies, he or she is required to pay IHT on the value of the estate at a rate of 40 per cent over and above the available nil-rate band. Transfers between spouses are usually treated as exempt (there is a £55,000 limit on transfers by a UK domiciled individual to their non-UK domiciled spouse), but situations arise where the nil-rate band on the first death is not always used. The Chancellor has introduced measures so that a proportion of this ‘lost’ nil-rate band can be used on the second death. Therefore, the main reform is that in respect of the death of a surviving spouse or civil partner on or after 9 October 2007, a proportion of the unused nil-rate band from the death of the first spouse or civil partner can be used on the second death.
The amount that can be transferred will be based on the proportion of the nil-rate band unused at the date of first death, and applied in the same proportion to the nil-rate band in force at the time of the second death.

Example
Mr Claus left assets worth £150,000 to his children, with everything else to his long-suffering wife, who had spent every Christmas Eve for the last umpteen years on her own. The nil-rate band on his death was £300,000, which meant he had only used one half of the amount available. This left a proportion of 50 per cent unused and available for transfer. Mrs Claus dies when the nil-rate band has increased to £400,000. The amount available for transfer from her late husband will be 50 per cent of £400,000 or £200,000, giving her estate a nil-rate band of her own of £400,000 + £200,000, i.e. £600,000 in total.

Is this good news?
There is something attractive about allowing the nil-rate band to be so flexibly transferred. It will help some married couples and civil partners to plan without the need for more complex, will-based planning. However, many have already entered into nil-rate band planning ‘debt or charge’ style trusts, which are set up within a will and use the nil-rate band on the first death to ensure it is not wasted. Prior to the new rules, this was a very popular way of ensuring both spouses’ nil-rate band allowances were used. For these well advised or financially astute individuals, there is less to get excited about in the PBR announcements.
Of course, a periodic review of wills is always recommended, so those who planned to use a debt or charge arrangement using the value of the family may now feel that a simpler structure is now more appropriate.
However, including a trust arrangement may still be good planning for some couples such as those:

Who are not married;
Who have more complex succession plans, particularly second marriages and step children;
Who have assets expected to grow faster than the likely increase in the nil-rate band allowance; or
Who have assets eligible for business-property relief or agricultural-property relief, so the relief is claimed before it is lost, either through a sale of the asset or possibly a change in legislation.

It will also be worth looking at the ability to vary a will for those who died in the past two years to see if advantage can be taken of the new regime.

Maximum planning
The maximum nil-rate band that can then be claimed on the second death post the PBR is twice the individual nil-rate band for that year. This is intended to deal with the situation where an individual may have survived more than one spouse or civil partner and therefore potentially could have had more than one unused nil-rate band transferred to them.
A widower who is already entitled to an increased nil rate band following the death of his first wife may therefore be better off using his increased allowance on his own death, even though he has remarried and could transfer his own allowance to his surviving second wife. Otherwise the additional nil-rate band he received will be lost.
As one might expect, divorced couples cannot claim the nil-rate band when an ex spouse dies. Equally, the new rules do not help siblings who live together, like the elderly Burden sisters who have shared a house for many years but who lost their claim to defer IHT when the first one of them died.

How to make a claim
To take advantage of these rule changes, a claim is required for the transfer of the unused nil-rate band. This should be made by the personal representatives of the estate of the second spouse or civil partner on submission of the IHT return. (A new form IHT 216 has now been issued for this purpose). No claim is required on the first death. A claim needs to be made within two years of the second death, although there are provisions to extend this in certain circumstances.
Not surprisingly, documentation to support the claim (for example, marriage certificate, death certificate, probate papers, copy of will, any relevant valuations and so on) will be required.
A separate claim is required for each transfer of unused nil-rate band if there was more than one deceased spouse or civil partner.

Backdating
One of the most surprising elements of the PBR announcement was allowing existing widows and widowers to use the new measures. It is not often that legislation is effectively backdated for beneficial reasons.
This does lead to a trip down memory lane (and possibly into the archives in order to find all the information required to support the claim on the second death!). Where the first death was during the period 13 March 1975 to 18 March 1986, when an estate was subject to capital transfer tax, a claim may still be made for the unused nil-rate band to be transferred in the same way as it works for IHT.
Going back even further, before 13 March 1975 Estate Duty applied. Under Estate Duty there was no tax-free transfer permitted between spouses until 21 March 1972, when a tax-free transfer between spouses of up to £15,000 was introduced. This limit was removed for deaths after 12 November 1974. Where the first spouse died between 21 March 1972 and 13 March 1975, a claim to transfer the nil-rate band to the surviving spouse will be based on the amount of the tax free band that was unused on the death of the first spouse.
HMRC provides this example:

‘If a husband died in 1973 and left an estate valued at £10,000 that was all transferred to his wife, then as this is all within the spouse’s exemption the husband’s tax free band is unused. So, if his widow dies in December 2007, her nil-rate band can be increased by 100 per cent to £600,000. Where any part of the first spouse’s individual tax free band was used then there will be a proportionate reduction in the amount by which the surviving spouse’s IHT nil-rate band may be increased.’

Before 21 March 1972, there was no relief from Estate Duty for transfers between spouses, so the amount by which the surviving spouse’s IHT nil-rate band may be increased will be based on the proportion of the individual tax-free band that was unused on the death of the first spouse. HMRC has in fact published material going back to 1914 to enable backdating to occur for all existing widows and widowers.
It is also proposed that the IHT provisions for alternatively secured pensions (ASP) will be modified if the nil-rate band was not fully used when the original owner of the ASP died.

Statutory planning options for the family home
There are other ideas that may help to reduce IHT. For example, it is possible to gift the whole of the house and continue to live there if the donor pays ‘full consideration’ for their occupation. Full consideration usually equates to market rent, but it could make allowance for additional costs paid by the donor that are not usually paid by a tenant – for example, maintaining the gardens.
To be IHT effective, the donor will need to survive this gift by seven years (a potentially exempt transfer or PET) and to continue the payments until death. It is also important to review the payments each year to ensure the amount remains full consideration.
However, if the donor dies within seven years, IHT may become payable, but it depends on the value of the gift, the time elapsed since the gift and any other gifts in the seven years prior to death.
Where IHT becomes payable in respect of a failed PET, it is the donee who is liable to pay the tax, so life assurance may be a good idea. Where PETs are within the nil-rate band, then the donor may wish to take out life assurance to compensate the beneficiaries of the will, as they will effectively pay more IHT on the assets that they receive.
A second option is joint ownership and occupation by the donor and donee. A gift of say 50 per cent of the house by a parent to a child is a common situation although more extreme splits of 90:10 are not unheard of, but are more likely to be scrutinised by HMRC. The donor needs to show that they are not benefiting from the arrangement, so one of the main areas for challenge is the split of household bills. The donee should not pay more than a fair share of the bills, but it is acceptable for the donor to continue to pay all the household bills. This arrangement should continue until the death of the donor, so the donee moving out or premature death of the donee can cause problems.
This option may also be suitable for a second home or holiday home.

Other options for the family home
Clearly, the above options are not appropriate in all circumstances – for example the donor cannot afford to pay rent, or the prospective donee would be unable to take up occupation of the property on a long-term basis. So are there any other options available?
Many lifetime-planning options for the family home involved trust arrangements, so rules announced in legislation last year (Finance Act 2006) have stopped the more aggressive solutions.
However, IHT planning arrangement for the family home using offshore companies and debts may be effective under current legislation, but these must be considered high risk strategies given the possibility of legislative changes to counter any IHT effective arrangements.
An individual may wish to release equity from his or her home. This may be possible through a commercial arrangement with a third party or perhaps with family members, although the latter situation could give rise to other tax difficulties. It is always important to take professional advice in this area.

Next steps
IHT is likely to remain a concern for many taxpayers over the next few years. Despite the helpful PBR changes, it is still becoming easier for people to fall with the IHT net. However, with some pre-thought and careful planning, that exposure can be mitigated, if not eradicated.

Francesca Lagerberg is a partner and Rachael Dronfield a Capital Taxes Manager at Grant Thornton UK LLP.