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In the second of a series of extracts from his eBook 'Hutton on Estate Planning' (3rd Edition), Matthew Hutton outlines some tax tips and traps in connection with Inheritance Tax (IHT) exemptions.

The Principle

If a gift (or, technically, a ‘disposition’) is exempt when made, it does not matter, in IHT terms at least, that the donor dies within the following seven years – or, indeed, even a day later. Note, incidentally, that to be effective the gift must be ‘perfected’, that is if made by cheque the cheque must have been cleared (Curnock (Curnock’s personal representative) v CIR [2003] SSCD 283 (SpC 365)). Two of the exemptions mentioned below, those for gifts to spouse/civil partners or gifts to charities, apply whether the gift is made during lifetime or on death. But most of the exemptions apply only to lifetime gifts: once the prospective donor has died, it is too late. The first exemption (Potentially Exempt Transfers or PETS) is conditional on survivorship for seven years, whereas the following seven are absolute.

Exemptions should be distinguished from ‘reliefs’, especially for qualifying business or agricultural property: an exempt gift is not a chargeable transfer, whereas a gift of qualifying business or agricultural property is a chargeable transfer, albeit reduced to either 50% or nil.

Potentially Exempt Transfers (PETs)

The scope of the PET regime was dramatically cut down by Budget 2006, as a PET can no longer be made into a trust (other than a trust for a disabled person). However, in broad terms, a gift to an individual which he survives for seven years is IHT exempt, whatever the amount (IHTA 1984 s 3A). If he dies within the seven year period the gift is chargeable. The Nil-Rate Band is attributed to gifts made in the seven years before death according to the order in which they were made (after of course having knocked off any exemptions). 

Tapering Relief is available if death follows at least three, but less than seven, years after the gift:

There is no benefit from Tapering Relief if the whole gift falls within the Nil-Rate Band, because no IHT is chargeable. However, even if death does follow within three years, making a PET could bring valuation advantages, as the taxable value is that on the date of the gift, not at the date of death.

Certain points need to be borne in mind with PETs, as outlined below.

(a) The Danger of Premature PETS

The effect of the legislation (IHTA 1984 s 7(1)) can easily go unnoticed. In particular, it can render the IHT effects of making a PET worse than if the assets concerned had been left in the transferor’s estate on death.

Example

Bertie made a gift of £500,000 to a discretionary trust on 1 September 2003. This was a chargeable transfer and IHT was paid accordingly. Five years later he made a PET of £200,000 to his daughter. Bertie died on 1 October 2010 with a fully chargeable estate of £800,000 (after the 2003 chargeable transfer had ceased to be taken into account).

IHT on the failed PET is £80,000, since the 2003 transfer constituted Bertie’s cumulative total in 2008 – and exceeded the Nil-Rate Band.

IHT in the death estate will be calculated by including the failed PET in the cumulative total, that is a chargeable total of £1m, producing a taxable amount of £675,000 after the Nil-Rate Band of £325,000 and a tax liability of £270,000.

By contrast, had the PET never been made and if instead Bertie’s daughter had taken a share of residue under the Will, with the consequence that a further £200,000 would form part of the death estate, tax on the enlarged estate of £800,000 would again be £270,000.

On these facts therefore extra IHT arising out of the PET is £80,000.

TAX TRAP:  This ‘7+7=14’ trap is easily overlooked. Even where the transferor of a chargeable transfer is likely to survive that transfer by seven years, caution should await their elapse before making a PET, to avoid the possibility of an unnecessary IHT liability.

(b) Falls in Value since Date of PET or Chargeable Lifetime Transfer

What happens where the asset given away falls in value following the gift, so that its value at the date of the transferor’s death within seven years is lower than its value at the date of the gift? There is a measure of relief: subject to conditions, the person liable to pay the tax on the PET or Chargeable Lifetime Transfer may claim that the lower value be taken, for purposes of calculating the IHT or additional IHT (IHTA 1984 s 131). It is the transferee who has the primary liability for the tax. There is no prescribed form and the claim is made simply by an informal letter.

However, note that this relief cannot apply where the asset given is a wasting asset, or to the extent that the fall in value occurs within the Nil-Rate Band. The latter may seem unfair, since it has the effect of pushing up the IHT liability on the rest of the estate by denying it part of the Nil-Rate Band, but the rule is apparently so drawn intentionally. However, this restriction seems to be the legitimate corollary of the principle that appreciation in value of the subject-matter of a PET which becomes chargeable escapes IHT. Where the transferee has sold the asset before the transferor’s death, the lower sale value may be taken into account instead of the market value at the date of death, provided that the sale has been made by the transferee or his spouse/civil partner in an arm’s length sale to an unconnected purchaser.

The eventuality can easily arise with development land where, for example, in the intervening period the development potential, secured typically by options, disappears.

TAX TRAP:  Do bear in mind the IHT downside of a fall in value of the subject-matter of a lifetime gift. The loss of the Nil-Rate Band on death to that extent could be an unwelcome twist.

(c) When does the Transfer of Value Take Place, to establish a PET?  At what Point does the Seven Year Period Start Running?

While this was not the specific issue in the Court of Session case Linlithgow & Anor v RCC [2010] CSIH, the decision established a point which is also relevant to that broader question. The point in the case was whether the gift had been made before 22 March 2006, following which gifts to accumulation and maintenance trusts were no longer PETs. The transfers in land were made on 15 March 2006, but were not recorded in the Register of Sasines until 10 October and 16 November 2006 respectively. HMRC argued as a result that the transfers of value were not PETs. However, the Court held (unsurprisingly) that a transfer of value for IHT purposes occurred when the gratuitous disposition of heritable subjects in Scotland was delivered to the transferee rather than when it was recorded in the Register of Sasines. 

HMRC’s arguments seem very odd (although perhaps the amounts at stake might have been large), certainly in the context of clear findings by the Court in, e.g., Re Rose [1949] Ch 78 with share transfers that it is the date of the transfer form, not the date of registration in the company’s books, which determines the date of transfer.  There is a clear distinction between the legal and (as relevant for tax purposes) the beneficial interest. That said, there may be cases, typically involving private companies, where the transfer of value will follow the date of the transfer form, for example where there are pre-emption rights (when it will not be until all potential purchasers of the shares have been eliminated) or perhaps where certain transfers of shares require board approval: even so, in either case, this may be before the date of registration.

(d) Ensure no Reservation of Benefit

If a benefit is reserved from the gift, the asset will not effectively leave the chargeable estate until such time (if ever) as the benefit ceases (FA 1986 s 102(3) and (4)). See 3.2.2.

(e) The Pre-Owned Assets Regime

The POA charge with effect from 2005/06 can catch successful attempts made since March 1986 to avoid the Reservation of Benefit rules. If a person has disposed of land or chattels – or contributed to their acquisition – and he occupies the land or possesses the chattels, there is, subject to some exemptions, an annual Income Tax charge on the benefit. A similar point applies in relation to ‘intangible’ property (life assurance policies and the like) owned by a trust from which the settlor can benefit. See 3.2.3.

(f) Other Taxes 

See elsewhere in this Chapter for the possible impact of Capital Gains Tax (CGT), Stamp Duty Land Tax (SDLT) and even Value Added Tax (VAT). 

The Spouse/Civil Partner Exemption

The Exemption is unlimited except where the donor is UK domiciled and the donee is or is deemed to be non-UK domiciled, in which case there is the (rather odd) historic limitation to £55,000, on a lifetime basis (IHTA 1984 s 18). The days of this £55,000 limitation in a case where the transferee spouse is EU domiciled may be numbered following a consultation launched by the European Commission in June 2010 (‘Inheritance Tax Hinders Freedom of Movement’). See 13.2 and, for domicile, 15.3 and 16.4.

As to transfers between spouses/civil partners, it has been traditionally axiomatic that on death (and you never know who is going to go first) each individual should own at least £325,000 (for 2010/11) of chargeable value to pass to a beneficiary other than the survivor. This can be achieved by careful Will drafting – see Chapter 18.  Otherwise the wastage of the Exemption could cost up to £130,000 (40% of the Nil-Rate Band for 2010/11). However, the advent of the Transferable Nil-Rate Band from 9 October 2007 (see 18.4.3) has made this unnecessary – and indeed, in the usual case, perhaps ill-advised.

The Annual Exemption

Gifts of £3,000 in a tax year are exempt (IHTA 1984 s 19). To the extent that the allowance in one year is unused, it can be carried forward for one year (only). This exemption is ‘per donor’ (whereas the £250 exemption is ‘per donee’). While it might not seem very much (and was raised from £2,000 as long ago as 1981), regular use can get £30,000 IHT-free out of the chargeable estate over a ten-year period – or £60,000 per married couple/ civil partnership.

HMRC Trusts and Estates interpret the statute (specifically, IHTA 1984 s 19(3A) in circumstances where more than one transfer of value is made in a particular tax year as follows: the Annual Exemption should be deducted from the first gift (not otherwise exempt), whether a PET or not: see IHT IHTM 14143 - Annual Exemption: Multiple Transfers. This is disadvantageous to taxpayers where the donor survives seven years and the Annual Exemption may be wasted on a gift which subsequently proves to be wholly exempt. The practical advice is in any year to make a chargeable transfer before a PET. Where more than £3,000 is given in any year, any unused balance from the preceding year may be used.

The Annual Exemption might be used to pay premiums on a life assurance policy written in trust for others or to make gifts in kind – a painting worth up to £3,000, for example. Alternatively, consider setting up a stakeholder pension for a child or grandchild: a payment of £2,880 (net of 20% Basic Rate tax in 2010/11, i.e., £3,600 gross) can be made for a minor beneficiary, although of course the benefits cannot be taken until (currently) age 55 (which many might consider an advantage).

In the case of a parental gift, there is no income to be caught by ITOIA 2005 s 624. However, somewhat strangely, s 624 will apply to the income from a £3,000 cash ISA set up from 6.4.01 for a 16 or 17 year old unmarried child of the donor.

TAX TIP: It is axiomatic that regular (and recorded) use should be made of the Annual Exemption. In the absence of other contenders for the gifts, stakeholder pensions might be thought quite a sensible thing to set up, within the Annual Exemption and/or the Normal Expenditure Out of Income Exemption (see 2.2.6).

The £250 Small Gifts Exemption

A gift of up to £250 (but no more) to any individual in a tax year is exempt (IHTA 1984 s 20). Note that this exemption cannot be used in conjunction with the £3,000 Annual Exemption (IHTM 14180). So a gift of £3,250 to a particular individual, in circumstances where the previous year’s Annual Exemption has been used and so cannot be carried forward (but with no other transfers of value in that tax year), will be covered by the Annual Exemption as to £3,000 and, as to £250, if not within the Normal Expenditure Out of Income Exemption, will be a PET.

TAX TIP: Consider the advantages of occasional or even annual £250 gifts to (say) God-children made during one’s lifetime rather than by Will – and the donor might even get the bonus of a thank you letter.

Normal Expenditure Out of Income

A transfer will be exempt only if (taking one year with another) it was made out of income, leaving the transferor with sufficient net income to maintain his usual standard of living, i.e., without resort to capital (IHTA 1984 s 21). HMRC used to argue that a pattern of expenditure of at least three years must be shown, though the Bennett decision in 1994 (see below) roundly disproved this. A pattern of giving should be started as early as possible. Records should be kept to back up any claim if necessary. The gifts must be made out of income (which, not surprisingly, does not include the proceeds of sale of shares: see Nadin v CIR [1997] SSCD 107 (SpC 102)).

Expenditure will of course include Income Tax and all regular expenditure of an income nature – as opposed to capital, e.g., extending the house. This exemption is quite extraordinarily useful and is generally underused. It is important to keep careful records, in the event that death falls within seven years after a gift in a series, in order to convince HMRC that that gift was exempt. Where the exemption is used over a number of years, it does not matter if in one of those years there was a deficit (out of which of course no gift can be made), so long as ‘taking one year with another’ there was a surplus and gifts were made out of that surplus.

Note the helpful principles set out in the leading case (by Lightman J in Bennett & Others v CIR [1995] STC 54):

• '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 need the recipient be the same on each occasion. The amount of the gift may be fixed by a formula, e.g., a percentage of earnings, or by reference to an ascertainable liability, e.g., the cost of nursing home fees, and the donees may be a general class, e.g., family members or needy friends; and
• tax planning does not disqualify the expenditure.

In Bennett, the deceased was the life tenant of her late husband’s Will Trust. The trustees had, on her instructions, paid to her three sons total income of some £28,000 in February 1989 and then £180,000 in February 1990, a few days before the deceased’s death. Nevertheless, applying the above criteria, Lightman J was satisfied that ‘normality of expenditure’ had been achieved. He said that the donor had had a single and continuing intention regarding the surplus trust income and that that intention was put into effect. The decision in this case is likely to prove helpful in situations where a life assurance policy has been written in trust and where the grantee of the policy has died unexpectedly having paid only one or a very limited number of the regular premiums which would have been due had he survived.

TAX TIP: As with the Annual Exemption, it is axiomatic that where the taxpayer does have post-tax income surplus to normal living requirements this extraordinarily valuable exemption is used. Clear records should be prepared each tax year to provide the necessary evidence in case of death within the following seven years, ideally in the form provided in Schedule 403 to the Inheritance Tax account form IHT 400.

The Marriage/Civil Partnership Exemption

Quite a bit of value can be extracted from the chargeable estate(s) when a son or daughter (or step-son or daughter) gets married or enters into a civil partnership (IHTA 1984 s 22). The exempt amounts depend on the relationship between donor and donee, as follows:

• £5,000 per parent;
• £2,500 for grandparents; and 
• £1,000 for all others. 

Gifts in kind as well as in cash are exempt, as are certain types of settled gift. The gift must be an outright gift to or for a party to the marriage/civil partnership: hence there is no exemption if the celebrations are called off.

The Charities Exemption

This exemption applies to gifts on death just as to lifetime gifts (IHTA 1984 s 23).  However, one advantage of lifetime gifts of course is the possibility of Gift Aid Income Tax relief, both Basic Rate recovery for the charity and Higher Rate relief for the donor. See 12.2 and 12.3.

Gifts of Shares to Employee Trusts

To secure the IHT exemption, the beneficiaries of the trust are restricted to a class defined by particular employment or type of employment and their relatives (IHTA 1984 s 28, with the conditions set out in s 86). Where there is a particular employment, the class must comprise all or most of the employees or the trust must be an approved profit-sharing scheme. Trustees must hold at least 50% of the company and no participator (broadly a shareholder with 5% or more) must be able to benefit.

Gifts for National Purposes

Gifts to the National Trust, etc., (including Government Departments!) are exempt (IHTA 1984 s 23: see IHTA 1984 Sch 3 for the list of bodies).

The above is an adapted extract from Hutton on Estate Planning 3rd Edition.

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