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OTS inheritance tax review - simplification or a significant overhaul?

Posted: 19/07/2019

On 5 July 2019, the Office for Tax Simplification (OTS) published its second report ‘Simplifying the design of inheritance tax’.

Penningtons Manches Cooper prepared a detailed submission to the OTS last year and we are particularly interested to read its recommendations. While we welcome the aim of simplifying the inheritance tax (IHT) regime, we are concerned the proposed price of such simplification would be the reform or abolition of important IHT exemptions and reliefs. The recommendations are wide-ranging and could significantly alter parts of the IHT and capital gains tax (CGT) regime if introduced.

We are also disappointed that the OTS has failed to address some of the areas for review we recommended, including the complex ‘residential nil rate band’; the taxation of trusts; the lack of IHT exemptions for cohabitants; and an immediate increase in value of some of the smaller lifetime allowances which have not changed for many years.

A summary of the main recommendations is as follows:

The window for lifetime gifts reduces from seven to five years and taper relief is abolished
Currently, if an individual survives for more than seven years after a lifetime gift is made, there is no tax payable on it (subject to anti-avoidance provisions) or IHT impact for the individual’s estate following their death. The OTS suggests this seven year period should be reduced to five years. This is welcome as it reduces administration (less record keeping) and shortens the time period after which lifetime gifts fall away for IHT purposes. Such advantageous changes are, however, offset by a recommendation to abolish taper relief.  This relief reduces IHT payments on a lifetime gift where death occurs between three and seven years after it is made. Combined together, these two proposals create a ‘cliff edge’ scenario: gifts made over five years before death are exempt from IHT but, with the loss of taper relief, those made five years less one day before death could potentially be subject to IHT at 40%.

New personal gift allowance
The report recommends that a new personal gift allowance is created to replace the smaller current annual lifetime gift exemption and exemptions for gifts on marriage or civil partnerships. We welcome plans for tax simplicity and acknowledge their amalgamation will make these allowances easier to understand and use. The report, however, does not suggest a definitive value for the new personal gift allowance. We urge that it represents a fair amalgamation of the combined values for those allowances it replaces. We also strongly recommend (contrary to the report’s suggestion) the new personal gift allowance should be available to ‘carry-over’ into the next tax year where it is unused in the preceding one. The loss of this ‘carry-over’ would penalise those who infrequently make lifetime gifts and require individuals to give greater thought to their lifetime planning to maximise use of available reliefs.

Reformation or abolition of normal expenditure out of income rules
IHT is a tax on capital, not on income. The current rules allow surplus income to be gifted by an individual on a regular basis, provided that individual is left with sufficient funds to maintain their normal standard of living and will not have to resort to spending capital. Where this relief is used, IHT charges are not incurred even if the person fails to survive seven years. We are concerned that the loss of this relief, or a restriction on its value, will be particularly disadvantageous to those who use it to make substantial gifts from disposable income.

Capital gains tax changes
The report suggests that the automatic long-standing and well understood CGT uplift on death be removed where a relief or exemption for IHT applies. It is suggested that a beneficiary should instead be treated as acquiring the asset at the deceased person's original acquisition cost. The impact of this would be very serious. Currently an estate may, for example, claim valuable IHT exemptions for specified business assets such as shares at death. At the same time, these assets are revalued for CGT purposes (the CGT ‘uplift on death’). If they are subsequently sold by beneficiaries, their market value is that at the date of death, not at acquisition. A substantial CGT saving is achieved. Importantly also, there is certainty as to CGT treatment with the current rules. If this recommendation is implemented, it would create potentially long periods of uncertainty whilst the availability of an IHT relief is agreed (or not) with HMRC. It may force estates and beneficiaries to forego an IHT relief in favour of a CGT uplift. We strongly oppose this change. 

Use of the original acquisition cost of an asset for CGT valuation purposes will require additional record keeping, particularly where an asset has been owned for a considerable period of time. We are surprised that the report recommends this for CGT purposes as it rejects it, for example, for IHT purposes: one of the key reasons given for the reduction of the IHT lifetime gift exemption. These two recommendations are inconsistent: those for IHT reduce record keeping while those for CGT increase it. Administrative simplicity should not be applied selectively but considered equally for all reforms. To promote the report’s stated aim of tax simplicity and to be consistent with its other recommendations, the proposed changes to the CGT uplift on death should also be rejected.

Additional reforms
Other issues raised in the report, include:

  • the relationship between IHT business property relief (BPR) and CGT entrepreneurial and hold-over reliefs and how trading activity is defined differently (perhaps illogically);
  • BPR and its application to shares that are traded on the Alternative Investment Market – suggesting the scope of BPR may be narrowed;
  • altering the responsibility for the payment of IHT on lifetime gifts from the recipient to the estate on death;
  • the eligibility of a farmhouse for agricultural property relief in certain sensitive cases, such as where a farmer needs to leave the home due to medical reasons – as things currently stand this can lead to loss of IHT relief;
  • death benefit payments from term life insurance should be free from IHT even if the policy is not written in trust;
  • the relevance of ‘pre-owned asset tax’ (POAT) which is overly complex.

Not included in the report
We are disappointed that the OTS has failed to address some of the concerns we raised in our submission last year. In particular:

  • residential nil rate band: the OTS has not recommended a review of the complex ‘residential nil rate band’ available on death where a home is left to a child or descendants. The stated reason for this is that more time is needed to judge its effectiveness;
  • IHT anomalies for trusts: these are recognised in the report, but no recommendations are made. The OTS says that HMRC’s ongoing review of the taxation of trusts should address both IHT and wider trust taxation issues;
  • cohabitants: the report does not adequately address our concerns that cohabitants do not benefit from the same favourable IHT exemptions on death as spouses, which can cause considerable hardship;
  • lifetime allowances: an immediate increase in value of some of the smaller lifetime allowances would also have been welcome, as they have not changed for many years.

The Government has committed to review and consult on the OTS's findings but in the current political climate it is difficult to predict which, if any, will be implemented and when. We always recommend you regularly review your tax planning affairs and the publication of this report is a timely reminder to do so. Up to date legal advice is key to successful planning and the complexities of the current IHT regime should not deter you. Please speak to the head of our private client and tax team, Clare Archer, or your normal Penningtons Manches Cooper contact if you have any questions or concerns about the report or wider tax planning issues.

The OTS report - key recommendations at a glance:

  • aim is to simplify and streamline the IHT regime;
  • the recommendations are wide-ranging and could significantly alter parts of the IHT and CGT regimes if introduced;
  • more lifetime gifts fall outside the IHT regime: the time period during which they are subject to IHT between the date of the gift and death falling from seven to five years;
  • loss of taper relief which reduces IHT payable on a lifetime gift between three and seven years after death;
  • new personal gift allowance recommended but with no ‘carry-over’ to the next tax year. No figures suggested for the allowance;
  • ability to make lifetime gifts out of income should be reformed or abolished. This will be particularly disadvantageous to those who make substantial gifts from disposable income;
  • reforms to CGT uplift on death of particular concern and opposed by us. This will potentially increase CGT payments when an asset is sold after death, leading to greater tax uncertainty and administrative complexity;
  • report fails to address some of the issues we made in our original submission such as changes to the ‘residential nil rate band’ and ongoing inconsistencies between the IHT treatment on death of cohabitants compared to spouses, which can lead to considerable hardship for the former;
  • no timetable for implementation and difficult to predict which, if any, of the recommendations, will be adopted as government policy.

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