Beware IHT pitfalls

In the first in a series of articles from Canada Life’s technical team, Paul Thompson, tax & estate planning consultant, looks at some of the most common IHT planning complications.

On the face of it, inheritance tax (IHT) is pretty simple: make chargeable transfers, either during lifetime or on death and, if the total over seven years exceeds the nil rate band (NRB), tax is payable.

There are, however, exemptions and reliefs that are taken into account and, if they are used properly, the impact of the tax can be minimised or even eliminated. But care must be exercised, since there are a number of pitfalls waiting to trap the unwary. Here we look at the most commonly encountered snags and misunderstandings.

Taper relief

Many people are well aware of taper relief. If you make an outright gift to an individual, for example, which falls outside any available exemptions (e.g. spouse, £3,000 annual), it will still be potentially exempt. If you manage to survive for the next seven years, the potential for it to become fully exempt will be realised and there will be no IHT, no matter how large the gift.

However, if you die within seven years, it will become a chargeable transfer and will form the bottom slice of your estate. Any tax which becomes payable will be reduced by taper relief if you die more than three years but less than seven years from the date of the gift on a sliding scale.

What must be remembered, though, is that taper relief applies to the tax payable on the gift, not to the amount of the gift. This means that, if there is no tax payable on the gift, there will be no benefit from taper relief.

Transferable nil rate bands

Alistair Darling introduced the concept of transferable NRBs in the October 2007 pre-Budget report. They are a useful tool to ensure that both NRBs available to a married or civil partnership couple are fully utilised, although couples always had the opportunity to exploit both NRBs before October 2007 with a bit of forward planning.

Nevertheless, clients who are widowed and then subsequently remarry could now have the ability to enjoy the benefit of three, or even four, NRBs. However, such a favourable position will only be exploited to the full with some degree of forward planning. Without this, the full benefit of transferable NRBs will not be utilised.

Discretionary will trusts

Many married clients (or those in a civil partnership) may well believe that discretionary will trusts (DWTs) are no longer necessary, given that the unused proportion of the NRB on first death can now be transferred and used on the second death. But is this really true? As can be seen from the case study on this page, there are sound tax reasons why a DWT can be very useful, particularly now that the IHT NRB has been frozen until April 2015.

Case study

Andrew and Brenda were married in the early 1970s. Two children, Charlie and David, were born soon afterwards. After Andrew’s death in 2007, Brenda marries Edward, a divorcee.

2002 PET

Firstly, let’s consider Andrew’s 2002 potentially exempt transfer (PET) of £120,000. Since he died within seven years of this PET, the potential for it to become fully exempt was not realised. On his death in 2007, therefore, the PET became a chargeable transfer and formed the bottom slice of Andrew’s estate. At the date of Andrew’s death, the NRB was £300,000, but this had to be reduced by £120,000 to take account of the failed PET.

But what about taper relief? As Andrew died more than five years but less than six years from the PET, shouldn’t the £120,000 figure be reduced by 60%, leaving more NRB in Andrew’s estate? Unfortunately, this is not how taper relief works. It acts on the tax payable, not the amount of the gift.

Since the whole £120,000 falls within the £300,000 NRB, the tax payable on it is nil and, as we all know, reducing nil by 60% still leaves nil. What this means is that no clients ever benefit from taper relief unless they make a PET (or a CLT – chargeable lifetime transfer) in excess of the NRB and then subsequently die more than three but less than seven years later. So no tax, no taper.