denotes premium content | Jan 9 2009 Feature
posted 1 May 1996 in Volume 1 Issue 4
Inheritance Tax Mitigation
Using the Lifetime Exemptions.
Matthew Hutton MA (OXON), FTII, AIIT,TEP
Many elderly people are forming a view on the possibility of a change of Government. Having perhaps considered from time to time the need to make gifts in order to save "death duties" there is a new urgency to make full use of the existing tax regime lest, following the next Gen-eral Election, rapid steps are taken by a new Government to cut down the pre-sent opportunities for tax-efficient life-time giving. Advisers therefore need to be fully conversant with the range of exemptions which, for the time being at least, may be relied on.
Incidentally, the available reliefs and exemptions from Inheritance Tax fall into three categories: first, the five exemptions available to inter vivos gifts alone; second, the largest category com-prising those available both inter vivos and on death; and third, the two reliefs applicable only to transfers on death. While this article is restricted to a discussion of the first category, the other two must not be forgotten!
It is sometimes mistakenly thought that the exemptions available to elderly tax-payers are too limited to be of practical use. This is not necessarily correct. The use of the exemptions mentioned in this Article can, with proper forethought, achieve significant savings.
1. SMALL GIFTS
S21 Inheritance Tax 1984 (IHTA) allows for gifts of up to £250 to any one person in any tax year to be exempt. This cannot, however, be used in con-junction with the annual exemption mentioned below.
2. ANNUAL EXEMPTION
Perhaps the best known exemption is the annual exemption of £3,000 under s19 IHTA. This is allowed to each donor in each tax year. In so far as the exemption is not used in one year it may be carried forward, but gifts in any year are always treated as coming first out of the allowance for that year; and only when the allowance for the current year has been exhausted can they be set against the unused portion of allowances carried forward from the previous year. This effectively pre-vents the enjoyment of the allowance from being carried forward for more than one year.
Where more than one gift is made in a year the Capital Taxes Office consider that the £3,000 exemption is set against the first gift, regardless of the nature of the gift. This particular interpretation (with which the writer does not agree) can cause problems. For example a tax-payer may, in the same year, have made both a gift which is immediately chargeable and one which is potentially exempt. It is always better to make the chargeable gift before the potentially exempt one, so as to set the annual ex-emption against it, since that exemp-tion might be wasted on a gift which subsequently proved to be wholly ex-empt. Equally, if the potentially ex-empt transfer ("PET") becomes chargeable, it would by being made subsequently not affect the calculation of the exit and the yearly charges under an earlier chargeable transfer to a discretionary trust.
3. NORMAL EXPENDITURE OUT OF INCOME
This exemption is less well known and probably less used than the small gifts and annual exemptions. S21 IHTA exempts a transfer if, and to the extent that, it can be shown that it was made as part of the donor's normal expenditure; that it was made out of his income; and that after the gift the donor was still left with sufficient income to maintain his usual standard of living. The requirement for the gift to be made out of income is qualified, in that one year may be taken with another to satisfy the test.
Traditionally, the Inland Revenue have argued that at least three years of giving must be shown to establish a pattern sufficient to qualify for the exemption. This attitude was disapproved by the court in Bennett & Others v CIR [1995] STC 54 where Lightfoot J. observed that:
- "normal expenditure" means expenditure which, when it took place, accorded with the settled pattern of expenditure adopted by the donor;
- a settled pattern can be established either by examining the donor's expenditure over a period of time, or by showing that the donor has assumed a commitment, or adopted a firm resolution regarding future expenditure and has thereafter complied with it;
- there is no fixed minimum period during which expenditure has to be incurred: a single payment implementing the commitment or resolution may be sufficient;
- where there is no commitment or resolution, a series of payments may be required;
- a pattern need not be immutable, but it must be intended to remain for a sufficient period (barring unforeseen circumstances); thus, "death bed" resolutions would be excluded;
- the expenditure need not be fixed nor the recipient be the same on each occasion. The amount of the gift may be fixed by a formula, eg a percentage of earnings. It may also be fixed by reference to an ascertainable liability, eg the cost of nursing home fees. The people receiving the gift may be of a general class, eg needy friends or family members;
- tax planning does not disqualify the expenditure.
In the Bennett case itself the taxpayer was a tenant for life under the Will of her late husband. She gave instructions to the Trustees of the Will who then paid to her three sons income totalling £28,000 in February 1989. In February of the following year the Trustees, again on her instructions, paid out £180,000. A few days later she died. Lightfoot J., applying the criteria set out above, was satisfied that "normality of expenditure" had been achieved. The taxpayer had had a single and continuing intention regarding the surplus Will Trust income and that intention was put into effect.
For advisers of the elderly this case is very helpful in situations where a life insurance policy has been effected intrust and the grantee of the policy has died unexpectedly, having only paid one or a very limited number of regular premiums which would have continued to fall due if he had survived.
Care should, however, be taken to avoid the ambit of s21(2) IHTA which provides that payment of a premium on a policy of assurance on the life of the transferor, or a gift of money or money's worth which is applied either directly or indirectly in payment of a premium of that nature, is not for section 21 purposes to be regarded as coming within the exemption for normal expenditure where, when the policy of insurance was taken out or at any earlier or later time, an annuity is purchased on the life of the giver. There is, however, an exception to the general rule under s21(2) where it is shown that the purchase of the annuity and the taking out of the insurance policy or varying of an earlier policy are not associated operations.
4. MARRIAGE
Marriage is perhaps less common among the young in the 1990's than it used to be, but for those who do marry, and thereby doubtless inflict financial liability on their parents, some help is still available under s22 IHTA. Parents may give £5,000; grandparents or remoter ancestors £2,500; and other people (whether or not members of the family) £1,000. The gift must be an outright one and must be made to or for a party to the marriage.
If, therefore, the wedding is called off, the exemption totally fails and recourse should be had to one or other of the exemptions.
£5,000 is perhaps on its own not sufficient to warrant the making of a settlement, but where a party does wish to make a settled gift advisers should consult s24(4) IHTA which sets out detailed conditions to be satisfied to comply with the exemption. That section provides that a gift which is not made outright will not be regarded as being made in consideration of marriage if there is a possibility that people are or may become entitled to some benefit under the settlement who are not within the categories set out in the sixth sub-paragraph of that section. Those categories include, in general terms, "the happy couple", their children and children-in-law, people entitled on the failure of trusts for children, second husbands or wives, beneficiaries under protective trusts and the trustees in respect of reasonable remuneration.
5. POTENTIALLY EXEMPT TRANSFERS (or PET's)
It is widely thought that the rules for PETs are sufficiently simple not to warrant a specialised article. One simply gives the asset away and hopes to live seven years, without any tax problems. As always with tax law that is not quite the whole story. It is certainly true in general terms that an outright gift without reservation of benefit, by an individual to another individual or to a life interest trust, to a disabled trust or to an accumulation and maintenance trust is potentially exempt and will become chargeable only if the donor dies within seven years.
Tapering relief is available if death follows at least three years but less than seven years after the gift. That relief is, however, in many cases of no value whatever, because it is a relief not from cumulation of the gift but from the tax. If therefore, as will frequently be the case, the lifetime gift is within the donor's nil-rate band, there is effectively no tapering relief, because no IHT will be charged on that particular gift. This principle is of no comfort to the executors and beneficiaries, because effectively the failed tax has used up some of the nil-rate band which would otherwise have been available. A failed PET can, however, still have some advantages, if for example the asset given away increases in value after the gift, because the value for IHT purposes is that at the date of the gift not at the date of the donor's death.
* The "7 + 7 = 14" trap
There is a particular problem, of the insidious kind which can generate claims on the professional indemnity insurance of advisers, arising out of s7(1) IHTA. Where a PET follows a chargeable transfer made within the previous seven years, and itself becomes chargeable, the nil-rate band may unexpectedly disappear.
EXAMPLE:
Jennifer made a gift of £200,000 to a discretionary trust on Ist June 1988. This was at that time a chargeable transfer and IHT was paid on it. Five years later she made a further gift, this time a PET, of £100,000 to her son. She died on 1st December 1995 with a fully chargeable estate of £500,000. At that date it will be noticed that more than seven years had elapsed since the gift to the discretionary trust so that it fell out of cumulation, but the gift to the son was still within three years so that taper relief could not begin to operate on it.
At the rates applicable when Jennifer died the IHT on the failed PET to the son is £40,000, since at the time of making that gift Jennifer's cumulative total included the discretionary trust even though it later fell out of account.
The executors face IHT on the estate at death of £178,400 calculated by including as part of the cumulative total the failed PET to the son.
Had Jennifer not made the gift to her son in her lifetime but left him instead a share of residue under her Will, her estate at death would have been £600,000 on which the tax suffered by the executors would still be £178,400. The family would, however, have saved the £40,000 on the gift to the son which failed.
The problem could have been avoided if Jennifer had waited until the full seven years had expired after the gift into thediscretionary trust.
In the above example no account has been taken of the possibility that the gift made by Jennifer to her son, although suffering so much tax, might have increased in value after the date of thegift, allowing some measure of comfort to the son.
* Falls in value
Where an asset is given away which later falls in value there may be some relief. No help is available where the asset given away is a wasting asset, nor to the extent that the fall in value occurs within the nil-rate band. The scope therefore of the relief offered by s131 IHTA is far more limited than might first appear. It allows (subject to conditions) the person liable to pay tax on the PET or on a chargeable lifetime transfer to claim, where the value of the asset falls following the gift so that it is lower at the date of the Testator's death (within seven years of the gifts) that it was as the time of the gift, that tax should be paid on the lower value.
Since the relief cannot apply within the nil-rate band it has the effect of pushing the IHT liability onto the rest of the estate by denying that estate part of the nil-rate band. This is apparently the intention of the legislation.
Where the donee has actually sold the asset before the donor's death, by s131 IHTA the lower sale value may be taken into account instead of the market value at the date of death. This rule however will only apply if the sale has been made by the donee or his spouse in a sale at arm's length to an unconnected purchaser.
Detailed reference should be made to the legislation, which runs from s131 to s140 IHTA before attempting to advise on the availability of relief, particularly in the slightly more complicated situation where for example the gift was of shares and there is a call in respect of them; or there is a reorganisation of share capital; or there is a capital distribution in respect of them or, perhaps most complicated of all, where the gift consists of shares in a close company. Where the gift is of land then detailed reference to s137 and s138 IHTA will highlight the conditions to be satisfied, making adjustments where, for example, after the date of the gift the land is made subject to some restriction as to use giving rise to compensationwhich is received by the donee or his spouse and similar matters.
Five "straightforward" exemptions can therefore present the adviser with both a range of exciting opportunities and a number of potential "heffalump" traps: you have been warned!
Matthew Hutton MA (OXON), FTII, AIIT, TEP
