08 July 2019

The Office of Tax Simplification (OTS) has published its second report into possible reforms of inheritance tax. The report focusses on three key areas:

  1. Interactions of inheritance tax (IHT) with capital gains tax (CGT)
  2. Agricultural property relief and Business property relief (APR and BPR)
  3. Lifetime gifts

1. Interaction of IHT and CGT

A key theme of the report is the unification of the treatment of assets for CGT (and in some cases income tax) and their treatment for IHT. We explore this key message below.

Current position

When a person inherits an asset, that asset is ‘rebased’ at the date of death for CGT purposes. The person inheriting the asset takes it at the market value at the date of death. This is known as capital gains uplift. If the person who inherited that asset then sells it, any gains or losses are calculated from that rebased value rather than the acquisition value of the deceased. If the asset also attracts a relief (most commonly APR or BPR) or exemption (most commonly spouse exemption) from IHT on death then this can mean that there is neither CGT nor IHT payable.

If a person gives an asset away during their lifetime, this is a potentially exempt transfer for IHT. If they survive more than seven years then no IHT is payable on the value of that asset. If the asset attracts a relief from IHT then no IHT is payable even if they die within seven years. For CGT, if a person gives an asset away then there may be CGT payable on any gains that have accrued during their period of ownership. Sometimes it may be possible for holdover relief to be claimed on a gift of an asset where IHT is or, would be but for a relief, chargeable. This is often seen with the gift of APR or BPR assets. It means that the person to whom the asset is given, takes it on at the base cost of the person who has given it to them.

The perceived problem

The downside of making a lifetime gift is that the recipient is likely to take the asset at a lower base cost than if they had waited and inherited the asset. The OTS have observed that this can mean that taxpayers delay passing business or agricultural assets to the detriment of the business or farm.

Although the OTS don’t mention it, they may also be concerned about 'death-bed planning' (where one spouse is on their death-bed, the other gives assets to the dying-spouse, knowing that they will receive them back shortly afterwards, but with a CGT uplift).

The suggested solution

The OTS suggest that the treatment of gifts made during lifetime and those made on death are unified. They propose that the uplift on death is removed and is replaced with 'no gain, no loss'. A person inheriting an asset, where a relief or exemption applies, would not take at the market value at the date of death, but instead take the asset at the base cost of the person who left it to them. This would apply where there was no IHT payable on that asset such as where a relief applied or where the beneficiary was exempt (such as a spouse).

For instance, a father leaves his farmland and farming business to his daughter. Currently, APR/BPR would likely be available on the farmland and business and there would be CGT uplift on death. With the OTS proposal, APR/BPR would apply but the daughter would inherit at her father’s base cost. There would be no immediate tax. But if she sold, there would be CGT payable on any gains since her father acquired the farm/asset rather than from when she inherited it.

The wrinkles

The OTS acknowledge that the proposal does have some wrinkles which need to be ironed out:

  1. Where a proportion of an asset is inherited by two or more beneficiaries with a split of exempt and non-exempt beneficiaries, how is the uplift for part and no uplift for the other part to be dealt with? (i.e. a mother leaves an asset to her husband and son in equal shares. The share passing to her husband would not receive uplift as it would pass spouse exempt with no IHT due, but the share passing to her son would receive the uplift as IHT would be due on his share.) The OTS suggestions range from deeming a proportion of the eventual gains as not chargeable, applying no gain no loss to part of the asset, or increasing the base cost to reflect the proportion of the asset which was subject to IHT.
  2. Where a proportion of an estate is inherited by a spouse or civil partner but it is not specified which assets pass to them, it would need to be recorded which items went to them on a no gain, no loss basis, and which passed to non-exempt beneficiaries and were rebased.

2. Trading businesses (including furnished holiday lets) 

Again the OTS note the discrepancy between the treatment of trading businesses for CGT and IHT.

They suggest:

  1. Increasing the threshold of trading activity necessary for BPR to match that used for the CGT reliefs of holdover and entrepreneurs’ relief. This would be a significant change meaning that the test for BPR on death would no longer be “wholly or mainly” (i.e. above 50% trading) but instead there would need to be a “substantial trading activity” (which HMRC guidance indicates is 80% or more trading).
  2. Reviewing whether it is correct that if an individual holds non-controlling shares of a trading company (i.e. 50% or less) indirectly (for instance by way of a holding company) that the assets are likely to be treated as investments whereas if they were held directly they would be eligible for BPR. Further review of holding company and LLP structures to ensure they work as intended.
  3. Aligning the treatment of furnished holiday lets for IHT with income tax and CGT for trading meaning that, provided conditions were met, it may be that holiday lets would be classed as trading for IHT too and that BPR could be claimed.
  4. Reviewing the position of farmhouses where the farmer moves out a few months before death (for instance for medical care).

3. Lifetime gifts and other recommendations 

The final, eye-catching, proposal from the OTS is that the existing seven-year rule for gifts is replaced with a five-year rule. The OTS justify this on the grounds of the difficult record-keeping requirements that executors otherwise face.

However, this proposal is counter-balanced by the removal of 'taper relief'. Currently 'taper relief' (for gifts above the nil-rate band) steps the rate of IHT down( from 40 per cent) to 32 per cent after three years, 24 per cent after four years, 16 per cent after five years, eight per cent after six years and zero per cent after seven years. The OTS note that taper relief is complex and very little IHT is in fact raised for gifts between five and seven years old. Acknowledging that their proposals will create a cliff-edge, they propose that gifts up to five years are charged at 40 per cent and gifts from five years and one day onwards at zero per cent.

The OTS also recommend technical changes so that the current requirement to keep records for up to 14 years is removed.

Other recommendations include:

  1. Lifetime gifts – the report summarises the current exemptions and thresholds for lifetime gifts and suggests that they are replaced with a personal gift allowance. They also suggest a review of how gifts out of income are dealt with. Finally, it recommends that the burden of IHT on lifetime gifts be moved from the recipient to the estate of the person who makes the gift.
  2. Life assurance – suggestion that policies are inheritance tax free on death whether or not they are written into trust.
  3. Pre-owned asset charge (POAT) – suggests that the government reviews this legislation, whether it is still necessary, and if it is, whether it actually does what is intended.
  4. Spouse exemption – notes that any extension to cohabitees would be a decision for government to make.
  5. Residence nil rate band (RNRB) – the report notes that the relief is complex. It suggests some alternatives (including its abolition) but shies away from suggesting changes occur now as the allowance is only 2 years old and 'more time is needed to evaluate its effectiveness before recommendations can be made on how to simplify it'.
  6. Trusts – with the HMRC consultation on trust taxation ongoing (responses have been received and we await the conclusions), OTS make no suggestions in relation to IHT for trusts and merely note some of the difficult areas.
  7. Charities (reduction of IHT rate to 36 per cent where 10 per cent or more of a person’s net estate is given to charity) – As with RNRB, the report notes that this provision in its early days and makes no suggestions for changes. It notes that the exemption for gifts to charities is well known and understood.

4. Burges Salmon Comment 

The OTS consultation on inheritance tax received over 3,000 representations, expressing a wide variety of (often contradictory) views. Faced with such a wide range of opinion, the OTS has done particularly well to synthesise a series of proposals so comprehensively. Admittedly it has ducked tackling some of the more difficult questions (wider reform of IHT; trusts; charities; the residence nil-rate band). But it hasn’t shied away from eye-catching proposals, notably the amendment of the seven year rule and the potential loss of CGT uplift. The proposals on business and agricultural property will create winners and losers, but there is some sense in aligning these rules with the definitions used for other taxes. Fortunately the proposals here are not as stringent as some feared they might be (for instance abolishing or restricting these reliefs altogether). A number of the proposed technical changes are sensible and will make life easier for settlors, executors and trustees.

It is important, of course, to remember that the OTS is independent of government, so it does not necessarily follow that the government will accept these recommendations. With little Parliamentary time (and a new Prime Minister imminent) it may be that the proposals are kicked into the long-grass. However, in our opinion, if the next Prime Minister wants to be seen to be 'doing something' about IHT – perhaps to counter-balance an image of favouring 'the rich', then these proposals could well be an easy-win.

Consequently, in our view, these proposals are – barring a General Election intervening - more likely than not to be implemented (in substantial part) in the next 12-18 months.

What action to take?

Given the uncertainties (both as to what and whether this happens), it would be tempting to wait and see before taking precipitate action. However, opportunities may be gained by taking action now. Although it is impossible to be definitive about these, we would tentatively note the following:

  • If you make a gift now and survive (say) four years, it seems likely that any new five year rule may have transitional rules. If so then you may still get taper relief (which you wouldn’t had you waited). And you will have started the clock earlier. If there are no transitional rules then you are still no worse off than waiting.
  • If you make a gift now and survive five years (expiring after a new five year rule comes in), it is possible that you may benefit from the new five year rule. It might be the case (although we think unlikely) that you would have been better to wait for the new five year rule and then make the gift – but given that any change may take 12-18 months to implement, you may well be better starting the clock ticking earlier anyway.
  • If you have a business which is more than 50 per cent, but less than 80 per cent trading you should review the position carefully. It may be that the business can be restructured. Or it may be (but this is difficult to judge) that there are transitional provisions for any gift made prior to any change.
  • If you have been delaying making gifts in order to get a CGT uplift on death, it looks likely that this uplift may well go. It would seem sensible to progress with any gifts that you were thinking of making in this case.

Obviously careful advice should be taken about your particular situation as each case is likely to throw up particular issues.

What next?

The government has acknowledged receipt of the report and will respond substantively in due course. It shall be interesting to see that response when it comes and more general industry and public response to these proposals.

This article was written by John Barnett and Andrew Kerr. For more information, please contact one of the authors.

Key contact

Headshot John Barnett

John Barnett Partner

  • Head of Partnerships
  • Private Client Services
  • Tax

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