Inheritance Tax (IHT) was introduced in 1986 to replace Capital Transfer Tax. The main charge to IHT arises on death. IHT is also charged on some lifetime gifts and on certain events in relation to trusts.
Scope of IHT
If an individual is domiciled in the United Kingdom, IHT applies to all their property wherever it is situated. If the individual is domiciled abroad, IHT usually applies only to property situated in the United Kingdom. Special rules extend the meaning of domicile for IHT purposes.
What are lifetime gifts?
There are three distinct categories of lifetime gift:
- Exempt transfers are gifts which are wholly exempt from IHT (e.g. gifts between spouses* and gifts within the annual exemption).
- Potentially exempt transfers (PETs) are outright gifts between individuals and gifts into trusts for the disabled. A PET does not give rise to an immediate charge to IHT. If the donor survives for 7 years, the PET becomes an exempt transfer. If the donor dies within 7 years of the gift, the PET becomes a chargeable transfer: see 3 below.
- Chargeable transfers are gifts made by an individual other than exempt transfers or PETs. This category covers a gift to most types of trust. If the cumulative total of chargeable transfers in any 7 year period exceeds the nil rate band threshold (currently £325,000), a lifetime transfer is immediately taxable at up to 20%.
In the case of a lifetime gift, the amount on which IHT is charged is measured by the loss to the donor’s estate as a result of the gift. This is not necessarily the same as the value received by the recipient, or the open market value of the property.
What about taper relief?
A gift made within 7 years before death is taxed by reference to its value at the date of the gift.
There is a sliding scale of taper relief which applies in the case of a PET or a chargeable transfer made less than 7 but more than 3 years before death; in such a case the tax charged on death on the PET or chargeable transfer is reduced by 20%, 40%, 60% or 80%, according to whether the death occurs in the fourth, fifth, sixth or seventh years respectively. Since taper relief reduces the tax charged on death and not the value of the gift, the tax on the donor’s remaining estate is unaffected and the taper relief will be worthless if the PET or chargeable transfer falls within the donor’s nil rate band.
Transfers on death or within 7 years of death
The charge to IHT on death takes into account the value of the estate on death and also any other property in which the deceased had a beneficial interest, such as certain trust property in respect of which the deceased either had the right to the income produced, or the right to occupy (in the case of real estate). Lifetime gifts within 7 years of death must also be taken into account.
Deeds of Variation
It may be possible for those entitled to a deceased person’s estate to sign a Deed of Variation to vary the way in which the estate is distributed. IHT will then be payable as if the revised distribution had operated at death. Further details are available in the information sheet entitled Deeds of Variation.
How much IHT will you pay and what are the rates of IHT?
Tax is chargeable cumulatively on each chargeable transfer by reference to the total chargeable transfers made within the previous 7 years. This rule applies to transfers which are immediately chargeable, to PETs which become chargeable, and to transfers on death. Thus, a record of gifts made by a donor in the previous 14 years may be needed in order to determine the IHT payable on any one occasion. By way of illustration, to establish the rate of IHT on a lifetime gift in 2017, it may be necessary to aggregate chargeable transfers made as far back as 2010.
No IHT is payable on the first part of the cumulative total, which is taxed at nil%. This nil rate band, or tax-free allowance, is currently £325,000 and has been frozen since 2009.
The rates of IHT are as follows:
- Chargeable Transfers – Rate
- Up to £325,000 – Nil
- Excess over £325,000 – 40%
If a PET becomes chargeable because the donor dies within 7 years, it will become taxable at the death rate then in force. The PET takes its chronological position for cumulation purposes at the time the gift was made at its value at that time. Any tax charge (but not the value transferred) is reduced by taper relief as set out above.
Chargeable lifetime transfers which are not PETs are immediately chargeable to tax at half the death rate, currently 20%. Additional tax may be due if the donor dies within 7 years after making the transfer.
Residence nil rate band
An additional residence nil rate band is available for estates where death occurs on or after 6 April 2017 and a share of the deceased’s residence is left to lineal descendants. This allowance is currently £175,000 for the tax year 2023/24.
If the value of the deceased’s estate exceeds £2m on their death, some or all of the residence nil rate band will be lost. The amount lost is £1 of the relief for every £2 that the estate is over £2m. Further details are available in the information sheet entitled The Residence Nil Rate Band.
Transferable nil rate band
In the case of a married couple, to the extent that it is not used on the first death, an individual’s nil rate band can be transferred to the estate of their surviving spouse on their subsequent death: see our Information Sheet about Inheritance Tax – efficient Wills.
Any unused proportion of the residence nil rate band will also be transferable to a surviving spouse’s estate.
How do gifts impact IHT and pre owned assets tax?
Gifts made on or after 18 March 1986 are subject to special rules to prevent the avoidance of IHT where the donor reserves or enjoys a benefit from the gifted property. This applies where at any time since the date of the gift the donor has not been entirely excluded from the gifted property and from any benefit by contract or otherwise. An example of such a gift is where a house is given away, but the donor continues to live in it without paying a full market rent. The result is that, if and so long as a donor reserves a benefit in the gifted property, the 7 year period will not begin to run.
An annual tax charge known as the Pre-Owned Assets Tax was introduced from 6 April 2005. It is an income tax charge on the benefit of the continuing enjoyment of certain assets given away or paid for since 18 March 1986 in cases where the IHT reservation of benefit rules do not apply. There are various exceptions to this charge. If they do not apply, the charge relates to the continuing occupation of land or use of chattels. There will be an annual income tax liability if the person occupying property or using chattels, but not owning them, has since 18 March 1986 either disposed of them or contributed directly or indirectly to their acquisition. The charge can also apply in certain circumstances to other assets (i.e. not land or chattels) if they are held in a trust of which the settlor is an actual or possible beneficiary.
What is exempt from IHT?
Certain gifts are exempt from IHT.
Some of the most important of the exemptions are as follows:
- Husband and wife
All outright transfers between spouses are completely exempt (unless the donor is domiciled in the United Kingdom but the recipient is not).
- Annual exemption
Lifetime gifts are exempt up to a total of £3,000 in a tax year (plus any unused part of the exemption for the previous tax year).
- Small gifts
Outright lifetime gifts to any one person in a tax year are exempt if the value of all gifts in that year to that person does not exceed £250.
- Normal expenditure out of income
Lifetime gifts made from income are exempt to the extent that they form part of normal (i.e. habitual) expenditure while leaving the donor sufficient income to maintain their usual standard of living.
- Gifts in consideration of marriage
The main exemptions are for gifts up to £5,000 if the donor is a parent of one of the marriage partners, and up to £2,500 if a grandparent or great-grandparent.
Gifts and bequests to UK charities are wholly exempt. From 6 April 2012 where 10% or more of a deceased’s estate is left to charity, the rate of IHT on the rest of the estate will be reduced to 36%.
What are special reliefs when it comes to IHT?
There are special reliefs for transfers of particular types of property. The most important of these reliefs are Business Property Relief (also known as Business Relief) and Agricultural Property Relief (also known as Agricultural Relief).
Business Relief (BR)
BR is available for certain business property which has been owned by the transferor for at least 2 years. The relief is given against the value of the relevant business property. Different rates of relief are available according to the class of property and assuming that all the necessary conditions are satisfied.
Broadly, BR at 100% (i.e. complete exemption) is available for:
- A business (e.g. a sole trader) or an interest in a business (e.g. the share of a partner);
- Unquoted shareholdings; and
- Unquoted securities of a company which (either by themselves or together with other securities and any unquoted shares owned by the transferor) gave the transferor control of the company.
In general, BR at 50% is available for:
- Quoted controlling shareholdings;
- Property, plant or machinery used by a partnership or controlled company.
Shares traded on the Unlisted Securities Market and the Alternative Investment Market are treated as unquoted for BR purposes.
Agricultural Relief (AR)
AR is available for certain agricultural property; this is limited by a number of conditions and applies only to the agricultural value of property.
Broadly, AR at 100% is available for:
- Agricultural land owned by the transferor for at least 2 years and occupied by the transferor for agricultural purposes;
- Let agricultural land owned by the transferor for at least 7 years and occupied for agricultural purposes if the transferor’s interest carries the right to vacant possession within 12 months (or 24 months by concession);
- Let agricultural land owned by the transferor for at least 7 years and occupied for agricultural purposes if the tenancy began on or after 1 September 1995 or if there has been a succession since then to an earlier tenancy.
In most cases, AR at 50% is available for agricultural land owned by the transferor for at least 7 years and let on a tenancy which started before and continues after 1 September 1995 where the transferor’s interest does not carry the right to vacant possession within 12 months (or 24 months by concession).
As regards both BR and AR, where a lifetime transfer of business or agricultural property has been made, and the donor dies within 7 years, no relief will be available on the donor’s death unless the donee has retained the business or agricultural property (or qualifying replacement property) and the other conditions for relief are still satisfied.
Until 2006 the charge to IHT on settled property varied according to the type of trust. With some exceptions relating to Life Interest Trusts, almost all trusts are now taxed as Discretionary Trusts. They are treated as independent taxable entities and, instead of the trust being taxed on death, it is charged at lower rates (presently not exceeding 6% on any one occasion) every 10 years, or when capital distributions are made from the trust fund.