A Comprehensive Guide to UK Inheritance Tax

Introduction to Inheritance Tax (IHT)

Modern-day Inheritance Tax (IHT), also known as IHT, dates back to 1894. It replaced several different taxes on estates, including the 1796 tax used to fund the war against Napoleon. It’s deeply embedded in UK tax legislation and is not expected to disappear soon. Discussions of a potential overhaul in the near future have been circulating.

In the tax year 2020-2021, 3.73% of all UK deaths resulted in Inheritance Tax (IHT) being paid, slightly down from previous years due to various tax reliefs. HMRC collected £7.1 billion in IHT receipts during the tax year 2022-2023, and this figure is increasing annually. Between April and December 2023 alone, HMRC collected £5.7 billion, £400 million more than the same period in the previous year. Over the past five years, the UK government has raised approximately £33 billion from IHT, funding public services and addressing budgetary needs.

As a UK resident, after paying your 12.5% national insurance, most of your income will be taxed at 20%, 40%, or even 45%. Investment profits are taxed further; if there’s any leftover, your loved ones will pay another 40% on your death.

This guide aims to provide a high-level understanding of IHT and planning strategies to minimise this tax. By grasping these concepts, you can leave more wealth to your loved ones and less to HMRC, thereby enhancing your financial planning and potentially increasing the legacy you leave behind.

What Is Inheritance Tax?

“Inheritance Tax; it is, broadly speaking, a voluntary levy paid by those who distrust their heirs more than they dislike the Inland Revenue” is a famous quote by Roy Jenkins. IHT is a tax on the cumulative value of an individual’s estate on death, gifts within seven years before their death, and certain lifetime gifts. Reasonable funeral costs, debts, or any tax due can be deducted from the estate value.

IHT is charged at the following rates:

– 0% on the estate below the current £325,000 nil rate band (NRB)

– 20% on any chargeable lifetime transfers (gifts into certain trusts)

– 40% on the estate over the NRB (reduced to 36% if over 10% of your net estate is left to charity)

At 40%, the UK has the fourth most aggressive inheritance tax in the world, followed by France (45%), South Korea (50%), and Japan at a whopping 55%.

IHT is, however, one of the only optional taxes. If you own nothing on your death or in the seven years leading up to it, there’s nothing to tax. Having no assets in the seven years before your death is probably not wise, and we have no idea when that day might be.

However, it’s important to note that IHT planning is a complex topic. Seeking guidance from a qualified and experienced financial planner is highly recommended. With their help, you can navigate the various allowances, exemptions, reliefs, and solutions offered by HMRC, making IHT planning a powerful tool in your financial strategy.

Who Does It Affect?

IHT is payable on worldwide assets for UK-domiciled and deemed-domicile individuals and on UK assets for non-domicile (non-doms). Your estate’s tax amount varies massively depending on your circumstances.

The main factors affecting the amount of tax due are:

– To whom you leave your wealth

– Yours and your beneficiaries’ domicile

– The value of your estate

– Your use of trusts

On death, your Legal Personal Representatives who administer your estate will be responsible for calculating and paying your IHT within six months of your death. One of the biggest misconceptions I see with British expats is that because they live outside the UK, they assume their estate would not be liable for UK IHT if they were to die. Unfortunately, this could not be further from the truth!

There are three main personal taxes: income, gains, and inheritance. Generally, residency determines your income and capital gains tax, whereas domicile determines your inheritance tax. However, for UK residents, domicile can also play a big part in their income and capital gains tax.

What Exactly Is Domicile?

Domicile, in the context of IHT, refers to the country that a person considers their permanent home or where they have a substantial connection. It’s a bit like your ‘home base’ for tax purposes. Understanding and potentially changing your domicile status is crucial for IHT planning because it determines whether your worldwide estate is subject to UK IHT. If you are UK-domiciled or deemed domiciled, your global assets are liable for IHT. If you are non-domiciled in the UK, only your UK assets are subject to IHT.

Types of Domicile

Domicile of Origin

This is acquired at birth and is usually the father’s if the parents are married and the mother’s if not.

Deemed Domicile

Long-term residents of the UK will be treated as deemed domiciled for all tax purposes, including IHT, if they have been residents for 15 out of the last 20 tax years. This means that even if you acquired a domicile of choice outside the UK, if you return to the UK for one out of two years, you will automatically revert to a UK domicile for tax purposes.

Non-Domicile

Non-dom is the term given to anyone the UK considers not domiciled in the UK.

Domicile of Choice

This is more challenging to acquire than you may think. HMRC looks for positive action to become a citizen of your new home with the intention to stay there permanently. HMRC will take the following into account:

– Physically living in the new country

– Expressing an intent to stay forever

– Acquiring citizenship or nationality on top of permanent residency

– Becoming employed or starting a business

– Getting on the electoral roll

– Making a valid will and burial arrangements

– Having friends and family there.

But what most people forget is that HMRC will also expect you to cut ties to the UK. This includes transferring pensions, closing bank accounts, not renewing your UK passport, and relinquishing business interests. Even if an individual manages to go through all this, they will still be deemed UK-domiciled by HMRC for three years after acquiring their new domicile of choice.

Do I Pay Inheritance Tax (IHT) On My Worldwide Estate?

The answer is yes for people seen to be domiciled in the UK. However, IHT is very much an optional tax! Regardless of whether you plan to reduce your liability, your estate will naturally benefit from various available allowances, reliefs and exemptions, as explained below:

Allowances

Upon someone’s death, their estate is valued, and any of the above exemptions are deducted, after that process comes additional allowances, such as the nil rate band and residence nil rate band, which reduce the liability even further.

Nil Rate Band (NRB): This is the amount someone can leave others before IHT is payable. The Nil-Rate Band (NRB) for Inheritance Tax (IHT) in the UK is the threshold above which the value of an estate is taxed at the standard IHT rate of 40%. This threshold has been a critical component of the UK’s tax system for many years. Historically, the NRB has seen various adjustments. It was set at £263,000 in 1996 and steadily increased until it reached £325,000 in the 2009-2010 tax year​.

Since 2009, the NRB has been frozen at £325,000, a policy extended multiple times. The most recent extension, announced in the Autumn Statement of November 2022, will keep the NRB frozen at this level until at least 2028​. This prolonged freeze has led to a growing number of estates becoming liable for IHT as property values and other asset prices have risen, pushing more estates above the threshold. Your available NRB may be reduced if you have made gifts during your lifetime and die within seven years of making the gifts.

Transferable NRB: In most cases, married couples have mirror wills, meaning they inherit 100% of their spouse’s assets without IHT. The tax is paid when they subsequently die. In any case, where someone dies and does not use their own NRB, their surviving spouse inherits the unused part.

Residence Nil Rate Band (RNRB): Introduced in 2007, this additional allowance of £175,000 each can be passed on tax-free. It is only available if the main family home is left to direct descendants and can also be transferred to a surviving spouse if not used on the first death. The RNRB is reduced to zero on estates valued over £2m on a £2 for £1 basis. This means that joint estates valued at over £2.35m will not benefit from this allowance.

Reliefs

On top of exemptions and allowances, there are also reliefs. There are several, including woodlands, postmortem, and agricultural reliefs. However, for the scope of this guide, I have picked out the two main reliefs:

Business Relief (BPR): This is a relief for transfers of business property owned for at least two years before death. It applies to certain types of businesses and doesn’t include companies that deal in land, property, or shares. It offers:

• 100% relief for unincorporated businesses (sole traders/partnerships) or shareholdings in unquoted or AIM shares
• 50% relief for controlling shareholdings in listed companies
• 50% relief for land, buildings, plant, or machinery used in a business controlled by the person who died

There’s no relief for the person inheriting any of the above if the business property is subject to a binding contract for sale on the owner’s death.

Quick Succession Relief: This relief is available if you inherit wealth and die within five years. It reduces the IHT liability on your estate because the IHT is paid on the estate you have just received, stopping the same wealth from being taxed twice.

Exemptions

Spousal Exemption: This is unlimited, assuming both people are UK-domiciled. If the receiving spouse is non-domiciled, the allowance is limited to £325,000 (including the deceased NRB) unless they elect to be treated as a UK domicile. The election is irrevocable unless they leave the UK, where it falls away after four complete tax years. The election must be made within two years of death.

Gifts for National Benefit: Wealth left to museums, libraries, and charities registered with the Charities Commission is not included in the deceased’s estate.

Education and Maintenance: Maintenance payments to a spouse or children until they reach 18 or full-time employment are unlimited.

UK Political Parties: Gifts to these are unlimited if they have two elected MPs or over 150,000 votes.

Exemptions During Lifetime Only

Annual Exemption: £3,000 per tax year can be gifted to anyone (doubled if the previous year’s exemption is not used).

Small Gifts: Gifts of £250 per person each tax year to an unlimited number of people. This cannot be in addition to the above.

Normal Expenditure from Income: You can give someone any amount of money as long as it’s regular. It doesn’t have to be the same amount but must come from income (not capital) and not affect your standard of living.

Marriage / Civil Partnership: You can give £5,000 to your children, £2,500 to your grandchildren, and £1,000 to anyone else for their wedding.

Planning to Minimise IHT Liability

Deliberate planning to minimise your liability can often involve gifting wealth, using trusts, utilising pensions, applying a deed of variation, or insuring against your liability. Usually, combining some or all the above will yield the most success.

Gifting

Gifting assets to loved ones is the simplest way to reduce your estate size and, therefore, IHT liability. Assets can be gifted directly or into a trust.

Potentially Exempt Transfers (PETs)

Potentially Exempt Transfers (PETs) are gifts made by an individual during their lifetime that may become exempt from Inheritance Tax (IHT) if the donor survives for seven years after making the gift. PETs are a way to reduce the value of an individual’s estate, thereby lowering the IHT liability.

Chargeable Lifetime Transfers (CLTs)

Chargeable Lifetime Transfers (CLTs) are gifts made during an individual’s lifetime that do not qualify as PETs and are subject to immediate IHT if they exceed the available nil-rate band. These are typically gifts into trusts, excluding absolute and bare trusts.

Combining PETs and CLTs can get complicated, and expert advice should be sought. Gifting into trusts can involve immediate and deferred tax implications.

Gifts With Reservation (GWR)

Gifts where the donor retains an interest are included in the estate for IHT purposes.

Pre-Owned Asset Tax (POAT)

This income tax charge applies to assets that have circumvented the GWR rule.

Wills

A valid will allows for tax-efficient wealth distribution, minimising IHT.

Deed of Variation

Beneficiaries can alter an estate to minimise IHT liability, often used by financially comfortable individuals who inherit from their parents and wish to avoid increasing their own IHT liability.

Trust Planning

Various trusts (Bare, Discretionary, Excluded Property Trusts, Loan Trusts, Discounted Gift Trusts) offer different tax benefits and complexities.

Pensions

SIPPs, QROPs, and QNUPS are generally outside someone’s estate for IHT, making them powerful planning tools.

Life Insurance

Life insurance can cover IHT liabilities, retain control of assets, and provide peace of mind.

Case Study

Example Scenario: British Expat in the Middle East and UK IHT Liability

Background

Consider John, a British national who has lived in Dubai, UAE, for the past 10 years. John moved to Dubai for work and has since established a successful business there. He owns property in Dubai, has a bank account, and has integrated into the local community. Despite his long-term residence in Dubai, John remains liable for UK Inheritance Tax (IHT) because he is still considered domiciled in the UK.

John’s Situation

Domicile of Origin: John was born in the UK to British parents, acquiring a UK domicile of origin at birth.

Residency: John has been a resident of Dubai for 10 years, where he owns property and has business interests.

Intentions: Although John enjoys living in Dubai, he has not taken definitive steps to change his domicile. He maintains strong ties to the UK, including family connections, a UK bank account, and occasional visits.

Assets: John’s assets include his Dubai property, significant savings in a Dubai bank, and investments in the UK. His total estate is valued at £2.5 million.

Domicile Considerations

Even though John has been living abroad for a decade, his UK domicile of origin remains significant because he needs to take adequate steps to establish a domicile of choice in the UAE. The following factors contribute to his continued UK domicile status:

Lack of Permanent Commitment: John has yet to express or demonstrate a clear intent to remain in the UAE permanently.

Ongoing UK Ties: He retains strong connections to the UK, including family, bank accounts, and occasional visits.

No Domicile of Choice: John has yet to acquire UAE citizenship or take other definitive steps to establish a domicile of choice outside the UK.

IHT Implications

As a UK-domiciled individual, John’s worldwide assets are subject to UK IHT upon his death. This means that both his Dubai property and UK investments will be considered when calculating his IHT liability.

Calculating John’s IHT

Let’s assume John’s total estate is valued at £2.5 million, which includes:

– Dubai property: £1.5 million

– UK investments: £750,000

– Savings in Dubai: £250,000

John’s estate will be subject to the following IHT calculations:

– Nil-Rate Band (NRB): £325,000

– Residence Nil-Rate Band (RNRB): Not applicable as his main residence is not in the UK

– Taxable Estate: £2.5 million – £325,000 (NRB) = £2.175 million

– IHT Bill: 40% of £2.175 million = £870,000

Planning Strategies for John

To minimise his IHT liability, John could consider several planning strategies:

1. Changing Domicile: John could take steps to establish a domicile of choice outside the UK by acquiring citizenship in another country, closing UK bank accounts, and making a will in the UAE. Becoming a UAE citizen is almost impossible so anyone with a UK domicile of origin living in the UAE would be liable to UK IHT on their worldwide estate.
2. Gifting Assets: John could make gifts to his family, utilising the Potentially Exempt Transfers (PETs) to reduce the size of his estate, provided he survives for seven years after making the gifts.
3. Trusts: Establishing trusts can help manage and distribute his assets tax-efficiently, potentially reducing his IHT liability.
4. Life Insurance: Taking out a life insurance policy written in trust to cover the IHT liability can ensure that his estate does not need to sell assets to pay the tax.

By implementing these strategies, John can reduce the IHT burden on his estate and ensure more wealth is passed on to his beneficiaries rather than to HMRC. Consulting with a qualified financial planner or tax advisor is essential to tailor these strategies to his specific circumstances.

Summary

Inheritance Tax (IHT) is a complex and often misunderstood aspect of financial planning that can significantly impact the wealth passed on to loved ones. This complexity arises from various factors, including domicile rules, lifetime gifts, exemptions, and trusts, all of which have specific conditions and implications.

Understanding IHT Complexity

Domicile Rules: Determining an individual’s domicile is crucial for IHT liability, affecting whether their worldwide assets are subject to UK IHT. The rules surrounding domicile are intricate and involve assessing the individual’s intentions and connections to the UK, making expert advice indispensable.

Lifetime Gifts: Managing Potentially Exempt Transfers (PETs) and Chargeable Lifetime Transfers (CLTs) requires careful planning. PETs can become exempt if the donor survives seven years, but CLTs may incur immediate IHT charges. Both strategies need to be implemented correctly to minimise tax liabilities.

Exemptions and Reliefs: IHT exemptions, such as the annual gift exemption and spousal exemption, provide opportunities to reduce taxable estate value. The Residence Nil-Rate Band (RNRB) also allows for further relief when passing the primary residence to direct descendants, but its conditions are complex.

Trusts: Using trusts to manage and protect assets can be effective for IHT planning. However, different types of trusts (e.g., discretionary trusts) come with specific tax rules and administrative responsibilities that require professional guidance.

Importance of Professional Advice

Tailored Strategies: Professional advisors can develop tailored IHT strategies based on individual circumstances. This includes optimising exemptions, planning lifetime gifts, and setting up trusts to ensure maximum tax efficiency.

Avoiding Pitfalls: Without expert advice, individuals may inadvertently increase their IHT liability through poorly executed planning. Mistakes such as failing to survive the seven-year period for PETs or improperly structuring gifts and trusts can have significant financial consequences.

Maximising Wealth Transfer: Engaging with financial advisors helps ensure that loved ones inherit more of the individual’s wealth. Advisors provide guidance on reducing the taxable estate, utilising reliefs effectively, and avoiding common pitfalls, thereby preserving more assets for beneficiaries.

Navigating Legislative Changes: IHT rules and thresholds are subject to change, as evidenced by the recent freezing of the NRB until 2028. Staying informed about legislative changes and adjusting planning strategies accordingly is essential, and professional advisors are well-equipped to provide this ongoing support.

Conclusion

Given the intricacies of IHT and its significant impact on wealth transfer, taking professional advice is crucial. Advisors offer invaluable expertise in navigating domicile rules, managing lifetime gifts, utilising exemptions, and setting up trusts. Doing so, they help individuals optimise their estate planning, ensuring that more wealth is passed on to their loved ones rather than being lost to taxation.

Consult a qualified financial planner or tax advisor for further details and personalised advice.