Inheritance tax, the most recent of the capital taxes, has its origins in estate duty, first introduced in 1894. Under the original provisions tax was payable on the value of property on the death of the owner, and this tax, for obvious reasons, became known as “death duty”. This form of taxation remained little changed until its eventual repeal in 1976, when it was replaced by the capital transfer tax (CTT) provisions of the 1975 Finance Act. CTT extended the scope of estate duty to include transfers of value during life as well as on death.
Capital transfer tax was abolished in 1986 and replaced by inheritance tax (IHT), effectively removing a large proportion of lifetime transfers from taxation, thus, in a very broad sense, returning almost to the status quo of estate duty. However, this is not entirely the case as IHT is very much a tax in its own right.
The history of this important form of capital taxation remains significant. For one thing there is no specific inheritance tax legislation, government choosing to adopt the somewhat unusual expedient of utilising the 1984 Capital Transfer Tax Act, suitably adapted where necessary, and renamed the 1984 Inheritance Tax Act. Furthermore, many of the principles established by estate duty and capital transfer tax remain applicable to valuations for inheritance tax purposes.
Tax applies as ever to transfers on death but also to any transfers of value made within seven years of a person’s death. This type of transfer is known as a potentially exempt transfer, or PET, and will cover the large majority of transfers. A further category of transfers includes all those lifetime transfers which are not exempt — mainly trusts — and these are known as chargeable transfers. Inheritance tax applies to transfers made on or after March 18 1986 where there is an intention to confer a gratuitious benefit upon another.
The amount of tax payable depends upon the value of the estate on death or, in the case of gifts, the extent to which the value of the estate of the person making the transfer is reduced by the gift. This provision retains one of the important principles introduced with CTT (see later for details).
Tax is based on the total accumulation of all transfers made in the previous seven years. Tax rates for transfers on death were originally fixed in a steeply-ascending scale from 30% to 60% but, following the Budget this year, these have been simplified to a single rate of 40%. The first £110,000 is free of tax and it is reasonable to assume this “nil rate band” will be subject to annual review to ensure, at the very least, that the exempt amount rises in line with inflation. Chargeable lifetime transfers are charged at 20%. Tax is not payable on sales of property made at arm’s length.
Exemptions and reliefs
Apart from the new partial exemption afforded by the introduction of PET’s, the exemptions under IHT remain substantially the same as under previous legislation. These include transfers between husband and wife, gifts of up to £3,000 in one tax year, an unlimited number of gifts of up to £250 pa to individual recipients, wedding presents, gifts to charities and political parties (provided they had at least two MP’s elected at the last general election or one, plus at least 150,000 votes) and gifts made for the benefit of the public. Again the amounts of these exemptions are liable to alteration with each year’s budget.
Relief is also available for falls in value. If a property is sold within three years of death at a substantially lower price than the value on death, the sale price can be substituted for the value at death. There is also a reduction in the charge to tax where a person dies within four years of receipt of property under an earlier chargeable transfer. However, the most significant reliefs are available in respect of transfers involving business and agricultural property. Broadly speaking, subject to the satisfaction of a number of conditions, the value attributable to business or agricultural property will be reduced by up to 50%, ie for farms and businesses qualifying for the 50% reliefs the rate of IHT will effectively be 20%.
Potentially exempt transfers
The vast majority of lifetime transfers made between individuals now fall into the important category of potentially exempt transfers. No tax is payable on a PET provided the person making the transfer, the donor, survives for seven years. If the donor does die within this seven-year period, tax is payable but at a reduced rate in accordance with the following table:
Loss to donor principle and grossing-up
Often there is no difference between the value of the gift transferred and the loss to the donor, but there are cases where this will not be so, in particular the disposal of part of an interest.
Example 1 Simon owns three residential building plots each worth, individually, £5,000. However, their combined value is £25,000 because of development cost economics. Simon gives plot B to Samuel. The value of the gift is £5,000 but tax is payable on the loss in value to the donor’s estate which is £15,000. This amount is calculated by carrying out a “before and after” valuation.
The loss to donor principle gives rise to the need for “grossing-up”, another concept introduced with CTT. Tax is payable by either party to the transfer. If the person making the transfer pays the tax, the amount of tax paid is treated as part of the reduction in the value of the estate and as such is itself taxable. The grossed-up amount is found by the formula:
Example 2 George has already made chargeable gifts totalling £110,000 and now gives £10,000 to his friend, Cyril. At a tax rate of 20% what is the tax payable?
(a) If Cyril pays the Tax.
(b) If George pays the Tax.
(a) If Cyril pays the tax George’s estate is only reduced by the value of the gift, £10,000.
Tax is then payable on this sum @ 20% = £2,000
(b) If George pays the tax the value of his estate is reduced by the amount of the gift and the tax he pays:
Valuation
Generally, the value of the property transferred is: “The price it might reasonably be expected to fetch if sold in the open market at the time of the occasion which gives rise to the charge to tax.” (Finance Act 1975, section 38).
There is a long tradition of case law deriving from old estate duty cases defining, in more precise terms, what is meant by open market price and this applies equally to inheritance tax. In summary, when valuing for IHT the valuer should assume:
(a) that the sale is hypothetical — it is not necessary to assume an actual sale;
(b) that all preliminary arrangements for the sale have been made beforehand;
(c) that it is an open market sale with adequate publicity in the most appropriate fashion;
(d) that in the case of a large property the estate will be marketed in such a way as to ensure the highest possible return ie by prudent lotting;
(e) that it is assumed to be a sale between a willing seller and a willing buyer;
(f) that values will not be depressed by flooding the market; and
(g) that account will be taken of any special purchaser’s bid — such as that of a sitting tenant or an adjoining owner.
It is interesting to compare this last assumption with the definition of “open market value” set out in the Guidance Notes on the Valuation of Assets, prepared by the Assets Valuation Standards Committee and published by the RICS, which states that no account is to be taken of an additional bid by a special purchaser.
Tax planning
The changes introduced by the 1986 Finance Act have, if anything, increased the opportunities for planning financial affairs to reduce future tax liability.
This is a specialised field, particularly where the creation of trusts is concerned. However, there are some fairly obvious measures which property owners and their advisers should be prepared to take.
These include judicious use of the nil rate band and, as transfers between husband and wife are exempt, this could amount to relief, in the case of a married couple, on the first £220,000 of the value of their combined estate, especially valuable as the nil rate band is renewed every seven years when accumulations begin again.
In addition to this basic exemption, full use of all the other exemptions such as small gifts, wedding gifts etc is important (especially as these are available each year), as well as the agricultural and business reliefs where appropriate.
Finally, as any potentially exempt transfer may give rise to tax if death occurs within seven years, the possibility of insuring against any future liability should not be overlooked.