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Modern day Inheritance Tax, also known as IHT dates back to 1894, where it replaced several different taxes on people’s estate including the 1796 tax on estates which was used to fund the war on Napoleon.
It’s therefore safe to say it’s well imbedded in the tens of thousands of pages of UK tax legislation and not going anywhere. Rumours are also circulating that there of a massive overhaul looming in the not so distant future.
In the tax year 2017 – 2018, 3.9% of all UK deaths resulted in IHT being paid which was a fall from the previous year, most likely due to the introduction of a new allowance. HMRC collected GBP 5.2b in receipts during the tax year 2019 – 2020 which is a figure they are rapidly trying to increase.
So basically, as a UK resident most of the income you earn after you have paid your 12.5% national insurance will be taxed at 20%, 40% or even 45%, then if you invest it where any profit will be taxed some more and If there’s any left over, your loved ones will pay another 40% on your death.
This guide aims to give you some clarity at a high level to help you gain a basic understanding of some of the main components surrounding IHT and ideas on how to plan to minimise this rather unfair tax so you can leave more wealth to your loved ones and less to HMRC.
As always Expat Wealth Adviser is here to bring Knowledge, transparency and simplicity to the offshore financial services world. We are happy to answer any questions, give you a second opinion on any recommendations you have received or introduce you to one of our panel of IHT specialists.
“Inheritance Tax; it is, broadly speaking; a voluntary levy paid by those who distrust their heirs more than they dislike the Inland Revenue” is the famous quote by Roy Jenkins which, perfectly sums up this aggressive tax on the wealthy by the UK government.
The more technical term is that Inheritance Tax is a tax on the cumulative value of an individual’s estate on death, gifts within 7 years prior to their death and certain lifetime gifts.
Reasonable funeral costs, debts or any tax due can be deducted from the value of the estate along with excluded property.
IHT is charged at the following rates:
At 40% the UK has the 4th most aggressive inheritance tax in the world, closely followed by France (45%), South Korea (50%) and at the top is Japan at a whopping 55%.
IHT is however one of the only optional taxes as if you don’t own anything on your death or the 7 years leading up to it, there’s nothing to tax. Obviously having no assets in the 7 years prior to your death is probably not wise, not to forget the fact we have no idea when that day might be.
What would be wise however, would be to explore this complex topic with a qualified and experience financial planner as HMRC have some actually quite generous allowances, exemptions and reliefs not to mention other solutions like trusts, pensions and insurance which makes for some very powerful planning.
This is the country that a person treats as their permanent home, or lives in and has a substantial connection with. Unlike with many things to do with HMRC, the world of domicile can get very subjective.
There are several types of domicile, I have summarised the main 4 which will help HMRC to decide whether to tax your estate or not.
Domicile of Origin
This is acquired at birth and is usually that of the fathers if the parents are married, and the mothers if not.
Domicile of Choice
This is not as easy to acquire as you may think. HMRC look 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:
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 interest.
Even if an individual manages to go through the rigmarole of all this, they will still be deemed to be UK domicile by HMRC for 3 years after acquiring their new domicile of choice.
Deemed Domicile
Long term residents of the UK will be treated as deemed domicile for all tax purposes including IHT if they have been a resident for 15 out of the last 20 tax years
Anyone who acquired a UK domicile at birth whom returns back to the UK for 1 out of 2 years, will automatically revert back to UK domicile even if they managed to acquire a domicile of choice outside the UK.
Non – Domicile
Non-Dom is the term given to anyone that the UK consider to be not domicile in the UK.
How Can I Check My Domicile?
It used to be possible to ask HMRC for their opinion on your domicile however that’s service has now ceased. Some barristers or tax consultancy’s will offer this service however this is only their opinion.
In the worlds of HMRC, it’s up to you to prove you’re not domicile, not their job to prove you are.
Learn more about your domicile status here.
For people seen to be domicile UK the answer is yes, however, IHT is very much an optional tax! Regardless of whether you actually plan to reduce your liability or not your estate will naturally benefit from the various available exemptions, allowances and reliefs explained below:
Upon someone’s death their estate is valued and any of the above exemptions deducted. After that process comes additional allowances such as the nil rate band and residency nil rate band which reduce the liability even further.
On top of exceptions and allowances there are also reliefs. There are several including Woodlands, Post Mortem 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 2 years prior to death. Applies to certain types of businesses and doesn’t include companies that deal in land, property or shares in the main.
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 death of the owner.
Quick Succession Relief
This relief is available of you inherit wealth and then unfortunately die within 5 years. It basically reduces the IHT liability on your estate because of the IHT paid on the estate you have just received, therefore stopping the same wealth being taxed twice.
Deliberate planning to minimise your liability can often involve gifting wealth, using trusts, utilising pensions, applying a deed of variation, or simply Insuring against your liability.
Usually a combination of some or all of the above and below will mean the most success!
Gifting
Gifting assets to loved ones is arguably the simplest way to reduce your estate size and therefore IHT liability. Although, it’s not as simple as it sounds. In the eyes of HMRC a gift is where someone gets poorer and someone gets richer.
Imagine you gave someone £10, if you never get it back, you are seen to be £10 poorer and the lucky person you gave it to is £10 richer. Ignoring all available allowances mentioned above, In the eyes his is a transfer of value for IHT purposes which means as long as you survive 7 years it would not form part of your estate.
The 7-year rule is there to stop people giving all their world possessions and investments away in their final moments.
Now imagine you put the same £10 somewhere you and your beneficiary could reach it, so it was neither yours or theirs. This is where things start to get a little bit more complicated.
Combining PET’s and CLT’s gets rather complicated and expert advice should be sought.
Gifting is all well and good but…. was it really a gift!?
This is an income tax charge on any assets seen to have somehow successfully circumvented the GWR rule for inheritance tax. So, the donor still has access to an asset that’s would not be subject to IHT on death.
The taxable benefit deemed to be retained by the donor is the value of the asset multiplied by a prescribed rate of interest which is then added to their income tax liability for the year and charged to tax and the normal rates.
For example, if an asset is worth £200,000 and the rate of interest is 3%, the tax charge is based upon £6,000 (£200,000 x 3%)
However, there is an annual limit of £5,000. So, if the same asset is worth £150,000 there would be no POAT charge as £150,000 x 3% = £4,500.
Not only does a valid will allow the deceased to control their distribution of wealth, they have plenty of benefits including the ability to minimise IHT by allowing the estate to be administered in a more tax efficient way.
This could be by leaving more money to charity or another exempt beneficiary or even leaving all your money to your spouse which is not possible for estates over a certain value with the laws of intestacy.
A deed of variation is an IHT planning tool that allows beneficiaries to alter someone’s estate. This is not a tool for you to use unless you are the one inheriting, but could be used by anyone you leave your estate to if they all agree.
This is usually done by elderly people whom are financially comfortable whom inherit form their parents and do not want to increase their own IHT liability. A deed of variation used to skip a generation would solve this issue.
A deed of variation must be agreed and signed by all parties that are set to be financially worse off by the deed. An estate can only be varied once and has to be done within 2 years of death.
Now here’s where things get a little technical.
The purpose of these guides is to make a complicated subject simple so I will try and do just that by outlining a few popular types of trusts that can be used for the purposes of minimising someone’s tax IHT liability:
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With a DGT the donor gifts wealth into a trust subject to a provision of a pre-determined fixed payment back from the trust for the rest of their life.
These are only suitable for people whom have an IHT liability, are likely to live for another 7 years and are in a position to decide on a pre-determined amount of income from the trust each year.
A DGT can be set up as a Bare or Discretionary Trust and is the only type of trust that allows an immediate reduction in the value of your estate, therefore a reduced IHT liability whilst still being able to receive regular withdrawals.
The transfer of value seen to be lower than the amount gifted into the trust due to a discount that takes into account the fixed payment stream.
The transfer of value is therefore the total transfer into the trust minus the discount which is seen to be the amount needed to fund your pre-determined withdrawals. This is calculated by underwriters at the life company you have selected for this solution and may involve a medical examination.
Transfers into a Bare version are a PET which means the value of the part gifted is subject to the 7-year rule and after which outside the donor’s estate.
Transfers into all other versions (mainly Discretionary) are a CLT and subject to the 20% lifetime tax and the 40% death tax if the doner dies within 7 years minus the tax already paid.
The growth is outside the settlor’s estate and neither the GWR or POAT rules apply.
Once a DGT is set up it cannot be unwound so expert advice and careful budgeting should be done prior to setting it up.
SIPP’s, QROP’s and QNUPS are all generally outside someone’s estate for IHT as people’s beneficiaries inherit pensions which in most cases come with the same options the member had. The benefits are either tax free or subject to income tax depending on the treaty between the country the beneficiary is resident in and the country the pension is based in.
This makes pensions a very powerful IHT planning tool. It may be when someone reaches retirement and wants to live off their investments and pensions, they drawdown from their ISA’s and other investments first and try and keep the value of their pensions high so they can be passed onto to their beneficiaries free of IHT.
There are however some caveats to this which may cause the pension to be a transfer of value for IHT purposes I.e.:
This is a complex topic and expert advice is advised.
Life Insurance
Life insurance is a very popular solution for IHT. It doesn’t actually reduce your liability; it simply pays it.
The benefits are:
There are two types you can chose from:
Term Insurance
This type of policy pays out a fixed amount for a set number of years. A 7-year decreasing term policy is usually used to cover the value of the gift for 7 years whist the gift remains in the doners estate. This is called an Inter Vivos policy and usually has fixed premiums set at the start.
Whole of Life Insurance:
This type of policy lasts as long as you live and only pays out on death. The pay-out is simply used pay an IHT bill. This type of policy is more expensive as you are certain to use it. By holding the policy in a simple trust, the pay-out itself does not form part of your estate.
Bear in mind the premiums have to be maintained for the policy top remain in force and getting insured later in life can be expensive and sometimes impossible after health issues
Summary
IHT is one of the more complex areas of financial planning, however the more complexity usually means the more scope for planning. IHT is definitely one of those areas that a decent financial planner and a solid strategy can make a huge difference.
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