Inheritance Tax

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1 Introduction

To be within the scope of Inheritance Tax (IHT) there must be a transfer of value of chargeable property by a chargeable person.

Transfer of Value

IHT is a cumulative donor-based tax. For it to arise, an individual must make a transfer of value with gratuitous intent; i.e. a gift or a sale at undervalue which results in the reduction of the donor's estate and there was an intention of a gift.

This is known as the 'loss to the donor' or the 'diminution in value' principle and applies to both:

• lifetime transfers

• the wealth a person leaves when they die (their death estate)

Chargeable Property

All property to which the donor is beneficially entitled.

Chargeable person

• An individual who is a long-term UK resident is chargeable on transfers of worldwide assets.

A long-term resident means that the individual has been UK resident for at least 10 of the 20 tax years prior to the tax year of the transfer.

• An individual who is not a long-term UK resident is taxed on transfers of UK assets only.

2 Exemptions on Lifetime Transfers and in the Death Estate

Transfers between spouses (husband and wife/civil partners) are always exempt.

3 Exemptions on Lifetime Transfers only

There are three types of lifetime transfer:

Potentially exempt transfers (PETs); This is a gift by an individual to another individual

• At the time the PET is made no IHT is chargeable.

• If the donor lives for at least seven years, the gift becomes exempt and no further IHT is charged.

• If the donor dies within seven years, then the PET becomes chargeable.

Chargeable lifetime transfers (CLTs) – for the TX exam this will always be a transfer into a trust.

IHT is chargeable on a CLT both:

• at the time the gift is made (at lifetime rates), and

• at the time of death (at death rates) if the donor dies within seven years

The following exemptions are available against lifetime transfers:

• Normal expenditure out of income:

  IHT is a capital tax; i.e. a tax on capital transfers. For this exemption, the donor must show a regular pattern of giving, make the gift out of excess income and must leave themselves with enough income to retain their normal standard of living.

• Small gifts exemption:

  Transfers of value of up to £250 per donee per tax year are exempt. Note that unlike some other exemptions, it cannot be used to exempt part of a larger gift; i.e. if the £250 limit is exceeded, the exemption does not apply.

• Marriage exemption:

  Transfers of value in consideration of marriage/civil partnership (i.e. a wedding present) is exempt up to certain limits:

  • For each of the parents to the bride or groom, £5,000.

  • For remoter ancestors (e.g. grandparents) and for the parties to the marriage (i.e. from the groom to the bride), £2,500.

  • For anyone else (e.g. from an aunt to a nephew), £1,000.

• Annual exemption (AE):

  The first £3,000 of the value of transfers each tax year is exempt. Any unused AE is carried forward a maximum of one tax year for use after that year’s own AE.

  The exemption is allocated to gifts on a strict chronological basis; i.e. to the first gift in the tax year, even if that gift is a PET and never becomes chargeable.

These exemptions are considered in order, so the annual exemption(s) are deducted from the transfer of value last to compute the amount of the PET/Net CLT.

4 Potentially Exempt Transfers (PET)

A PET is a lifetime gift made by an individual to another individual.

PETs are only chargeable if the donor dies within 7 years, therefore, although it uses up any available exemptions, there is no IHT liability at the date of the gift.

5 Chargeable Lifetime Transfer (CLT)

A CLT is a transfer made in lifetime into a trust.

With a CLT there is an immediate charge to tax on the net CLT (i.e. the amount net of exemptions), subject to the availability of the nil rate band (NRB). The NRB used to increase every year, but has been frozen at £325,000 since 2009/10.

The amount of tax that may be payable on the net CLT is based on the cumulative amount of transfers made by the donor over a 7 year period; i.e. the NRB is only given in full once every 7 years.

6 Calculating Lifetime IHT (CLTs only)

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When calculating IHT it is important to work through the three stages methodically:

Stage 1 – transfer value (PET/CLT):

• Identify the type of gift – exempt or PET or CLT

• Check for any lifetime exemptions and apply any that are relevant (AE last)

• The resulting figure is the PET or net CLT

Stage 2 – lifetime IHT (CLTs only)

• Identify the NRB at the date of the transfer (£325,000)

• Reduce the NRB by any chargeable transfers within the 7 years prior to this transfer (ignore PETs)

• If there is any NRB remaining, then that amount of the net CLT is taxed at 0%, but IHT will be due on any excess.

Stage 3 – Death

• If the donor dies within 7 years, then any lifetime gifts (PETs and gross CLTs) become chargeable; PETs for the first time and there may be additional tax to pay on CLTs.

• In addition, any assets the deceased owned at the date of death will be listed in the death estate and also charged to IHT.

STAGE 1: Transfers

STAGE 2: Lifetime IHT (CLTs only)

The Nil Rate Band (NRB) is the amount that can be gifted without incurring any IHT liability.

The NRB in the tax year of the gift should be used.

The NRB for 2025/26 is £325,000. If you need the NRB for a previous tax year, it will be given to you in the question.

The NRB must be reduced by the gross chargeable transfers (GCTs) made in the previous seven years. During the donor’s lifetime GCTs only include CLTs, not PETs.

The rate of tax on lifetime gifts not covered by the available NRB is 20%.

• If the trustees agree to pay the IHT: 20%

• If the question is silent, or it states that the donor pays the IHT:

  • The amount not covered by the NRB is treated as being net of tax at 20%.

  • The tax paid by the donor is therefore calculated at 20/80 (or 25%).

The gross chargeable transfer (GCT) which will be carried forward to reduce the NRB for the next 7 years is:

• If the trustees pay the tax, the GCT = net CLT

• If the donor pays the tax, then as the loss to the donor is the gift AND the tax, then the GCT = net CLT plus the tax.

The tax payable on a lifetime gift is due the later of:

• six months from the end of the month of the gift; and

• 30 April following the end of the tax year of the gift.

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STAGE 3: Death

On the death of the donor, there is no IHT to pay on lifetime gifts (gross CLTs and PETs) made more than 7 years prior to the date of death, but gross CLTs will still reduce the NRB until they are 7 years old.

However, any lifetime gifts (gross CLTs and PETs) made within 7 years prior to the date of death become chargeable.

• PETs become chargeable for the first time

• Additional tax may be due on CLTs.

The rate of IHT on death is 40% (subject to the availability of the NRB at the date of death).

Taper relief may be available to reduce the death tax (on gross CLTs and PETs) if there is at least 3 years between the date of the gift and the date of death.

Any death tax (after taper relief) due on a CLT can then be reduced by any lifetime IHT paid (either by the trustees or the donor). Note that the death tax can only be reduced as far as nil; (i.e. no refunds).

In addition, the death estate is charged to IHT at 40%.

Calculating death tax on lifetime gifts within 7 years prior to death

Death tax is calculated on each gift separately, in chronological order, as follows:

1. Identify all gifts (gross CLTs and PETs) within the seven years prior to death.

2. Start with the first gift in that 7 year period (gross CLT or PET).

3. Calculate the NRB available: start with the NRB at the date of death, and then reduce it by any chargeable transfers in the 7 years prior to the date of the gift.

   Remember that PETs made more than 7 years prior to death are not chargeable.

4. Calculate the death tax at 40% on the excess over the available NRB.

5. Calculate and deduct any taper relief available (see below).

6. For CLTs, deduct any lifetime IHT paid. NO REFUNDS.

7. If required, state who will pay and the due date for payment.

The tax payable on lifetime gifts as a result of the death of the donor is due within six months of the end of the month of death and is always paid by the donee (the trustees or the recipient of the PET).

Taper Relief

If the donor does not survive for 7 years following the gift but does survive for at least 3 years, any IHT payable on death (gross CLTs and PETs) is reduced by taper relief. The IHT is first calculated at 40% and then reduced as follows:

Time from transfer to date of death Relief/reduction

This table is provided in the examination.

7 The Death Estate

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The death estate comprises all assets held on death at their open market value (MV) at that date (known as the probate value) less certain liabilities.

Any funds held in a pension fund should not be included in the death estate.

Note 1:

If a property in the estate is mortgaged, the mortgage will reduce the property value if it is a repayment or interest only mortgage. Endowment mortgages are not deducted as they are repaid on death by the life assurance part of that mortgage.

Note 2:

The estate should also include the proceeds of any life assurance policy on the deceased’s life (as it will pay out on death). If the life assurance policy is on someone else's life (e.g. the deceased's spouse), then include the market value of the policy at the date of death (as it has not paid out).

Note 3:

The value of the estate will be reduced by any legally enforceable debts due at that date; e.g. credit card bills. Not gambling debts or verbal promises to pay.

Procedure to calculate IHT on the death estate:

1. Calculate lifetime IHT and death IHT on all gifts within seven years of death.

2. Calculate the gross chargeable estate value.

3. Calculate the amount of residence nil rate band (RNRB) available, if applicable (see below).

4. Calculate the amount of NRB available after deducting the value of GCTs (all PETS and CLTs) in the 7 years prior to the date of death.

5. Calculate the death tax on the excess at 40%.

6. If required, state who will pay and the due date for payment

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Additional Residence Nil Rate Band (as applicable to TX)

The residence nil rate band (RNRB) applies where a “main” residence is held within the death estate and is inherited by DIRECT descendants (children/grandchildren). The examiner has stated that a question will make it clear if the residence nil rate band is available. Therefore, you should assume that the residence nil rate band is only available if there is mention of a main residence.

The RNRB was introduced for deaths on or after 6 April 2017 (2017/18) and for 2025/26 is £175,000. If you need the RNRB for a previous tax year, it will be given to you in the question.

The value of the main residence for this purpose is after deducting any repayment mortgage or interest-only mortgage secured on that property.

If a main residence (after deduction of mortgage) is valued at less than the available residence nil rate band, then the residence nil rate band is reduced to the value of the residence.

Transfer of unused nil rate bands

Note that any transfer of RNRB and/or the NRB can only be done once both spouses are dead.

Any unused proportion of the RNRB on the death of the first spouse/civil partner can be transferred for use against the death estate of the second spouse/civil partner. The transfer is available even when the spouse/civil partner died prior to the introduction of the RNRB (i.e. prior to 6 April 2017), in which case, the unused proportion of the RNRB will be 100%. This enhanced RNRB can never exceed twice the current RNRB, therefore a maximum of £350,000.

Any unused proportion of the NRB on the death of the first spouse/civil partner can be transferred for use by the second spouse/civil partner on their death. This enhanced NRB can never exceed twice the current NRB, therefore a maximum of £650,000.

Note that the enhanced NRB is used throughout Stage 3, therefore on lifetime gifts before any remainder is applied to the death estate.

You may encounter a full IHT exam question in Section C as follows, however IHT is more likely to come up in the exam as a smaller part question than a full question.

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8 IHT Planning

As the Chargeable Estate of the taxpayer is charged at 40% above the nil rate bands it is sensible for a taxpayer to think carefully about succession planning to minimise what may be a significant IHT liability arising upon his or her death. Thus, making lifetime transfers is the easiest way an individual may reduce the IHT liability that would otherwise arise upon death. This of course assumes that the individual has both the capacity and willingness to make such gifts during lifetime.

If an individual makes regular lifetime gifts to others out of his excess income these transfers will be exempt as normal expenditure out of income. In addition, the taxpayer has an annual exemption of £3,000 available each year and may also be able to take advantage of the marriage exemption.

Other gifts to individuals will be PETs:

• no immediate IHT liability will arise, and these transfers will only become chargeable if the donor dies within 7 years of having made them.

• if the individual dies within 7 years the value of the transfer is “frozen” at the time of the transfer; i.e. any increase in value is ignored for IHT purposes. It is therefore beneficial to make lifetime gifts of those assets that are likely to increase in value over time.

• if the donor survives for at least 3 years then any IHT payable is reduced by taper relief.

When gifts are made in lifetime the taxpayer must also consider any CGT implications of those gifts. A chargeable gain arises on a chargeable disposal of a chargeable asset by a chargeable person. A gift is a chargeable disposal with a gain being computed based on the market value of the asset gifted. If the asset is of course an exempt asset, such as cash, a car, or an exempt chattel, then no gain will arise.

If the asset is a chargeable asset, then there will still be no CGT liability if the net gains for a tax year are covered by the AEA of the taxpayer. If gains would exceed the AEA then reliefs may be available to exempt or defer the gains from chargeability, for example the availability of private residence relief to exempt a gain or gift relief to defer a gain.

These planning issues are further explored in later chapters.

In choosing which assets should go to which beneficiary upon death it is also important to ensure that the taxpayer takes advantage, wherever possible, of exempt transfers to a spouse or civil partner and makes best use of the residence nil rate band by ensuring that a main residence, if not gifted to a spouse/civil partner is gifted to a direct descendant rather than to a beneficiary for whom the residence nil rate band is not available; e.g. a nephew.