Yuliya Shved is a partner of LEXeFISCAL LLP, and an expert in International Tax Law, she is our resident Ask The Expert, and she's here today answering the question...
What is an inheritance tax (gift tax or alternative tax if relevant) in the UK? How does it work?
Inheritance tax (IHT) is charged on the ‘value transferred by a chargeable transfer’ (section 1, Inheritance Tax Act 1984). ‘A chargeable transfer’ may occur in cases of lifetime gifts (gifts made during your lifetime), gift between living persons, or on death.
Care should be given to the (deemed) domicile of the beneficiary:
An UK-domiciled individual is subject to IHT on their worldwide estate.
A non-UK domiciled individual are exempt from IHT on their non-UK assets.
Value of the estate
Nil-rate band (NRB)
1. up to £325,000*
2. everything above the £325,000 threshold left to the spouse, civil partner**, a charity or a community amateur sports club
Part of the estate above £325,000
(*) Finance Act 2021 provides that the nil rate band is frozen at £325,000 until April 2026.
(**) Any unused nil-rate band can be transferred to a surviving spouse or a civil partner so in certain circumstances you can effectively pool the allowances to double your NRB to £650,000.
To understand if the proceeds of your will are likely to incur an IHT liability, you need to put a value on your estate.
Start by listing everything you own (your assets) and figure out how much they are worth. Where the assets are owned jointly with someone then it is necessary to consider your share. If you're married, or in a civil partnership, the automatic assumption is a half share. Usually, pension savings and life insurance policies are excluded from your estate.
Once the total value has been calculated then it is necessary to calculate everything you owe (your liabilities).
Then you should subtract everything you owe, from everything you own, to get to a net current value for your estate.
So, if you leave behind an estate worth £600,000 then the IHT charged will be £110,000, assuming no other reliefs or allowances are available. That's 40% of £275,000, which is the difference between the total value of your estate and the NRB, i.e., £600,000 minus £325,000. The NRB will remain fixed at £325,000 until 2026.
Notice that the value of your estate is likely to increase over time, so you need to keep in mind that this could lead to greater tax exposure.
There are also various strategies that can be implemented that can help either reduce the value of the estate or increase the NRB in order to cut the level of exposure to taxation. Some of them are explored in more detail later in this post.
Who pays the IHT to HMRC and when?
Usually, if you have a will there will be an ‘executor’, the person responsible for dealing with your estate upon your death. This is known as probate. He is obliged to pay IHT bill to HMRC from the funds generated from the estate.
Your beneficiaries (the people who inherit your estate) do not normally pay tax on things they inherit. That said there may be IHT to pay tax on gifts received prior to your death. They may also have related taxes to pay, for example, if they get rental income from a house or other asset left to them in a will.
Rules on giving gifts
Anything you leave in your will or when you die does not count as a gift but is a part of your estate and will be used to work out if IHT needs to be paid. One of the options to reduce the size of your estate and potential IHT bill is to give away or gift your assets. This can help improve the finances of beneficiaries, but requires planning ahead as gifts are split in 2 ways:
tax-free immediately, or exempt gifts.
For example, there’s no IHT to pay on gifts between spouses or civil partners. There’s also no IHT to pay on any gifts you give to charities or political parties.
Every tax year, you can give away to one or to several people a total of £3,000 worth of gifts without IHT charge (‘annual exemption’). You can carry any unused annual exemption forward to the next tax year - but only for one tax year.
If you have children getting married then you can give gifts worth up to £5,000. For grandparents, it's £2,500 and for other people £1,000. You can give as many gifts of up to £250 per person as you want each tax year, as long as you have not used another allowance on the same person.
Another interesting option is to give away surplus income that you don't need. The key to this is you need to demonstrate that you have more income than is necessary to maintain your current lifestyle. This means making regular gifts as part of your regular spending. These are known as ‘normal expenditure out of income’.
drop out of your estate after a period of time, typically 7 years
Gifts that don't meet the tax-free gifting criteria are classified as ‘potentially exempt transfers’ (PET). This means that IHT is not payable now but could be at some time in the future. PETs that become chargeable to IHT in this way are commonly referred to as ‘failed PETs’.
No tax is due on gifts if you live for 7 years after the giving - unless the gift is part of a trust. If you pass away within the 7 years then the gift is subject to IHT. This is known as the 7-year rule.
Gifts given in the 3 years before your death are taxed at 40%. Gifts given 3 to 7 years before your death are taxed on a sliding scale known as ‘taper relief’.
It works as follows:
Years between gift and death
Rate of tax on the gift
3 - 4 years
4 - 5 years
5 - 6 years
6 - 7 years
Certain business transfers are eligible for up to 100% Business Property Relief. Farmers also receive very generous IHT breaks known as Agricultural Property Relief.