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Inheritance tax changes – manoeuvring through the hurdles and protecting future legacy

Back in 2007, the Conservatives promised a £1 million inheritance tax allowance. In April 2017 this starts to take effect. It will only be £1million for married couples and civil partners; those who are single or divorced will be limited to £500,000.

It will be 2020 before the new tax giveaway reaches the million and it is hedged about with some complex conditions. This will mean a rethink on forward financial planning for anyone concerned to minimise the impact of this most dreaded of taxes.

Inheritance tax is currently 40% on estates over the basic tax-free allowance of £325,000. Married couples and civil partners can pass any unused allowance to each other after a death.

In 2017-18 the possible allowance rises to £425,000, then by £25,000 steps to reach £500,000 in 2020-21. A couple with a £1 million family home will then be able to pass it on free of tax. But those with other valuable assets may not qualify. In calculating whether the new allowance, known as the ‘residence nil-rate-band’ (RNRB), can be added to the existing and automatic ‘nil-rate-band’ (NRB), the whole estate is valued. If it is over £2 million, the RNRB is reduced by £1 for every £2 excess, so that estates worth more than £2.35 million get no RNRB.

For anyone needing to sell their property to ‘downsize’, but who might be deterred by potentially losing the new enhanced tax relief, special rules can preserve RNRB, but are highly complex. The new regime will bring opportunities. The estate must include a home that the deceased has lived in, but this does not have to be the main ‘family home’ and if there is more than one property in the estate, a family can nominate one for the relief.

That home must be “closely inherited” - left to a direct or lineal descendant, which means family members and their spouses, and includes stepchildren, adopted or foster children, and grandchildren. Any RNRB that is not used, on a first death in a couple, can be transferred to a surviving spouse or civil partner.

Assets and property left in trust will qualify if the only beneficiaries are direct descendants who will have at least a life interest.

But there are pitfalls. Transferring an unused RNRB between spouses will not help if the survivor’s estate becomes too valuable to qualify. Couples who are not married to each other might think that each other’s children would qualify, but they will not be “stepchildren” of each other and there will be no RNRB. Nor do gifts between an unmarried couple themselves get the new relief.

The £2 million cut off is valued for RNRB purposes before deducting any business or agricultural property reliefs.

The new regime also throws up significant new issues on the drafting of Wills, particularly in relation to trusts and estate planning.

For a husband and wife, there are the options of leaving outright or leaving in trust. All now depends on how the trust is worded when the second person dies. “A lot of spouses will leave everything to each other and on the second estate it all bunches up and it could be over £2 million,” notes Anthony Nixon, one of Irwin Mitchell’s Private Wealth senior inheritance tax specialists.

One option is NRB (nil-rate-band) discretionary trusts which were well used until 2007, as a way of not adding to the value of the survivor’s estate. The value of an estate can be reduced through either gifting or spending. But a giver must have full mental capacity – those with power of attorney cannot make gifts without an expensive court application.

Anthony adds: “The changes in taxation of pensions, and on death benefits payable from pensions, may mean it is worth spending down other capital and leaving pensions intact. Attractive as pension flexi-drawdown can be, it may be better to spend capital which you know would be taxed at 40% on death and which might also take you over the £2 million cut-off point for RNRB.”

April’s changes may also affect offshore trusts. They could cause many trusts to be treated as having ‘UK situs’ assets or to have UK domiciled settlors for the first time. There are no reporting exemption thresholds for trusts where there is an offshore element.

That means a full report must be made to HM Revenue & Customs when a capital distribution (or ‘proportionate charge’) is made from the trust, on each 10-year anniversary of the trust’s original creation (or ‘periodic charge’) and on the trust’s termination.

The assets held in the trust are re-valued at the ten-year anniversary and this determines the rate for any capital distributions in the subsequent ten years. The rate of tax is a maximum of 6% of the value of the UK situs assets. The full calculation can be quite complex and care should be taken.

The IHT nil rate band is determined by looking at all capital distributions in the ten year period. This is to discourage trustees from making large distributions prior to a ten year anniversary to avoid or significantly reduce the tax charge. There may be circumstances whereby it is favourable to wind up a trust prior to the ten year anniversary; occasionally it could be beneficial to wind a trust up in the three months following an anniversary.

IHT returns reporting an anniversary or distribution must be made within six months of the end of the month in which the event occurred, via tax form IHT100.

Voluntary late returns have penalties from £100 to £3000, but for returns requested by HMRC which uncover concealed information the penalty starts at £1,000 and can rise to the value of the tax due.

March 2017

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Anthony Nixon