Inheritance tax – lifetime gifting

Introduction

Death duties have been with us for centuries, in the guise of Estate Duty, Capital Transfer Tax and now Inheritance Tax (IHT). The combination of frozen thresholds and rising property prices have meant more estates than ever are likely to face an IHT bill.

This briefing provides an overview on how gifts can be made during lifetime; the criteria that needs to be followed to be effective and the order in which gifts should be made. Supporting calculations are included to show the learning points in practice.

Core considerations

IHT is a tax on the transfer of assets on certain lifetime gifts or on death. Most assets will be chargeable to IHT unless they are specifically exempt.
IHT is only charged on the part of an estate that is the above the tax-free allowance (called the Nil Rate Band) of £325,000. There is also a Main Residence Nil Rate Band of £175,000 which is available to anyone who owns a main residence which is passed onto their direct descendants.
There are various ways to mitigate IHT, including reducing the size of an estate whilst alive by making gifts. However, to have this effect, gifts need to comply with certain criteria.
There are two types of gifts or transfers that can be made during lifetime: Chargeable Lifetime Transfers or Potentially Exempt Transfers.
The rate of IHT reduces if gifts are made and the individual making the gift survives between three and seven years – this is known as Taper Relief.
No IHT is payable on gifts between spouses/civil partners as long as both parties are domiciled in the UK.

Lifetime gifts
Gifting Principles
Gifts with reservation of benefit
Associated operations
Potentially Exempt Transfers (PET)
Chargeable Lifetime Transfers (CLT)
How PETs and CLTs interact with each other – the order of gifting

Lifetime gifts

Inheritance Tax (IHT) is a tax on the transfer of assets on certain lifetime gifts or on death. This is normally any gift made by someone that results in them suffering a decrease in the value of their estate. The measure of a gift for IHT purposes is always the loss to the donor’s estate and not the amount gained by the recipient.

For gifts made during lifetime, generally once the individual survives seven years after having made the gift, the value will not be counted as part of their estate on death and will be exempt from IHT. The two main lifetime gifts are; Potentially Exempt Transfers (PETs) and Chargeable Lifetime Transfers (CLTs).

In some cases, it may be necessary to look back 14 years from the date of death, depending on multiple gifts that have been made and if they were a mixture of PET’s and CLT’s.

The primary determinant of an individual’s liability to IHT is the individual’s domicile. For those domiciled in the UK, IHT applies to all worldwide assets. For those domiciled abroad (non-UK domiciles), the tax usually applies only to assets situated in the UK.

Gifting Principles

Some gifts are completely exempt from IHT whether they are made during lifetime or on death and others are exempt only if made during lifetime. The person making the gift is the donor or transferor and the recipient is the donee or transferee.

There can be benefits to gifting money and property to others during an individual’s lifetime. Gifting can reduce IHT, however, to have this effect, gifts need to comply with certain criteria.

Any gift that is exempt from IHT will not be included in the calculations when working out whether any IHT is due.

Gift with Reservation of Benefit

Gift with reservation rules were introduced in 1986 so that gifting to reduce the value of an estate that did not result in the transferor’s situation effectively changing were made ineffective. Where a gift is made it is important to ensure that there is no GWR consideration which could effectively invalidate the IHT planning.

An individual must have given up all rights to the asset otherwise it will be classed as a Gift with Reservation of Benefit. If at the time of the transferor’s death, a gift is subject to a reservation of benefit, the value of that gift will be treated as part of their estate for IHT purposes. It will be treated as if the gift was never made, notwithstanding the legal ownership may have passed from the deceased to the recipient of the gift, during their lifetime.

For example, if parents gifted their house to their children but continued to live in it. In these circumstances the general situation has not changed apart from legal ownership. If the property stopped being subject to the GWR rules (so, in the case of the house, the parents stopped living in the house) then at that point the GWR rules stopped being applicable and the parents are treated as having made a gift at that point.

Where a gift has been made into trust, if the settlor is a potential beneficiary of the trust then, even if the settlor never benefits from the trust, the action will create a GWR and so, in all likelihood, make the planning ineffective for IHT purposes.

The GWR provisions do not normally apply if the gift made is exempt under normal rules. This includes transfers between spouses or civil partners, small gifts up to £250, gifts on consideration of marriage or a civil partnership and gifts to charities.

Double tax charge regulations are in place to make sure that there are not two sets of tax applied – for example tax arising because of a failed PET or chargeable lifetime transfer also becoming chargeable a second time on the transferor’s death. In these circumstances only one (the highest) tax charge applies.

Associated Operations

The associated operations rules exist to prevent IHT from being avoided by splitting a single transfer into a two or more transactions, in order to reduce IHT. HMRC will link these transactions and regard them as a single transfer.

For example, Mr and Mrs Wilson each take out a whole of life policy under discretionary trust. Neither Mr nor Mrs Wilson are potential beneficiaries under the trusts for the policies taken out on their own lives. However, Mrs Wilson is a potential beneficiary of the trust for Mr Wilson’s policy and Mr Wilson is a potential beneficiary of the trust for Mrs Wilson’s policy. Individually, neither Mr nor Mrs Wilson retains any benefit under the policy they have each effected, but they have been made a potential beneficiary under the trust of the policy effected by the other. Due to the reciprocal arrangement both policies may well be subject to the GWR provisions.

Potentially Exempt Transfers (PET)

A PET is where a gift has been made from one individual to another. An everyday example is where a parent makes a cash gift to a child (that is not otherwise exempt). Once made the gift will form part of the beneficiary’s estate for IHT purposes on death, bankruptcy and divorce.

When PETS are made, the individual must survive for seven years after making the gift for it to be exempt. So, if the individual survives for seven years, the PET escapes IHT altogether and will never be brought into the IHT calculation. The seven year rule doesn’t apply to gifts where the individual has reserved a benefit.

A PET is only potentially exempt, so if the individual dies within seven years of having made the gift, it fails and becomes chargeable, known as a Chargeable Transfer (CT) for IHT purposes. This means that it will be included in the individual’s IHT calculation.

Taper Relief can reduce the amount of tax to pay if the cumulative value of any gifts made within the seven years prior to death exceeds the IHT allowance of £325,000. IHT is payable at the following rates on any gifts given in excess of this during the seven years before death, as follows:

Gift made	Taper Relief
Less than 3 years	100% of the IHT payable on the gifts
3-4 years	80% of the IHT payable on the gifts
4-5 years	60% of the IHT payable on the gifts
5-6 years	40% of the IHT payable on the gifts
6-7 years	20% of the IHT payable on the gifts

Example of IHT on death where PETs have been made

Amanda gifted £500,000 to her niece Georgia 8 years ago and a further £500,000 to her nephew Harry last year. The total gifts equal £1,000,000. The gifts are PETs, so unlimited amounts can be given and provided Amanda lives for seven years there will be no IHT consequences. Each gift will have its own seven-year period, starting on the date the gift was made. However unfortunately Amanda died this year.

We know that that the first PET, to Georgia has dropped out of the estate as Amanda made it more than 7 years ago.
The second PET to Harry, was made last year therefore, this PET will fail and become chargeable.
This will use the £325,000 nil rate band, leaving £175,000 of this PET chargeable to IHT at 40% = £70,000.
The gift does not qualify for Taper Relief* as Amanda died within one year of making the gift.
There will also be no nil rate band remaining for the rest of Amanda’s estate on death which will be liable for IHT at 40%.
If the gift to Harry was made four years ago, taper relief will reduce the IHT payable to 60%. Therefore, £70,000 x 60% = £42,000 IHT payable. Again, there is no nil rate band remaining for the rest of Amanda’s estate on death - therefore the remainder of her estate will be liable for IHT at 40%

Chargeable Lifetime Transfers (CLTs)

Gifts such as transfers into discretionary trusts are CLT‘s. The individual who gifts assets into the trust is called the Settlor or Donor.

A CLT is a gift made during a settlor’s lifetime which is immediately chargeable to IHT. This does not necessarily mean that there will be IHT to pay but it does have to be assessed to see if a charge to IHT will arise. Each individual can gift up to £325,000 in a seven-year rolling period before an entry charge applies.

CLTs are cumulative and CLTs made in the previous seven years prior to the current CLT will reduce the amount of nil rate band available.

If the sum of CLTs in the seven period is below the nil rate band, there will be no IHT due immediately.
If the sum of CLTs in the seven-year period exceeds the nil rate band, then there will be a charge to IHT on the excess, known as ‘an Entry Charge’. The charge is at the lifetime rate of 20%, which is half of the death rate.

The liability to IHT on the CLT rests with the settlor, although the settlor and trustees can agree between them as to who pays. The amount of the transfer must be grossed up if the settlor pays the tax, as this is regarded as a further gift and is a transfer of value. The tax must be grossed-up to value the loss to their estate. This gives an effective rate of 25%. 

With CLTs, because the trust assets are not included in the taxable estate of any of the beneficiaries, the trust itself will be assessed to IHT every 10 years. This is known as the periodic charge. In addition, an IHT exit charge is calculated when capital (not income) is distributed to a beneficiary.

If the donor survives for seven years from the date of gift, there will be no further IHT payable, however, there is no refund of any IHT paid during life.

If an individual dies within seven years of making a CLT, it will be brought into the IHT calculation and tax will be recalculated at the full death rate (40%). As with PETs, taper relief can reduce the amount of IHT payable on death, if the settlor dies within 7 years of making a CLT.

Example calculations of IHT on death where CLT’s have been made

Two years ago Angus gifts £162,500 to a discretionary trust, and last year Angus gifts £200,000 to another discretionary trust. The total gifts equal £362,500. The gifts are CLTs, so if the accumulation of CLTs in the seven years exceeds the nil rate band of £325,000, there will be an entry charge of 20% on the excess (half the death rate). The gifts were made a year apart. When each trust is created, it needs to be assessed to see if an entry charge applies:

For Angus’ first trust, any entry charge would be determined by checking for CLTs in the preceding seven years - none were made. This means that there is no entry charge and that there is a full nil rate band available to the trust at the 10-year point.
For Angus’ second trust, as there was a CLT in the previous year and this used £162,500 of the available nil rate band, only £162,500 of the nil rate band is available to the second trust (full nil rate band of £325,000 less previous CLT of £162,500 = £162,500).
As this CLT is £200,000, the amount over £162,500 (£37,500) will be subject to an entry charge of 20% = £7,500.

Unfortunately, Angus dies a year after creating the second discretionary trust. This means both CLTs are in the seven years preceding death.

The first CLT has already used £162,500 of the nil rate band, of £325,000.
The second CLT has used the remaining £162,500 of the nil rate band and there was an entry charge on £37,500 of the £200,000 gift at the rate of 20% (half the death rate - £7,500).
On death, the IHT due on the CLT is recalculated at the rate of 40% (full death rate). The tax will be calculated at 40% on the £37,500 over the nil rate band = £15,000. The tax already paid at 20% (£7,500) for the entry charge, can be deducted from this and only the difference will be payable = £7,500 (£15,000 minus £7,500)
It is important to note that the nil rate band at the time of death will apply and if the CLT was made more than three years prior to death, the gift also benefits from taper relief.
If the IHT calculated on death is less than the tax already paid as an entry charge, there will be no refund of the tax paid.

How PETs and CLTs interact with each other – the order of gifting

Before making a lifetime gift, it is important to understand an individual’s gifting history. Gifts made in the previous seven years may affect the IHT payable on the current gift and, if the gift is made into trust, future IHT charges may apply, so making gifts in a specific order is important.

Two main considerations when planning the IHT position of gifts are the tax position whilst the individual is alive and the tax position after the individual has died.

For gifts made at the same time, usual planning would be to consider making CLTs before PETs. In this way there is no risk of a failed PET reducing the nil rate band available throughout the lifetime of the trust created by the CLT.

PETs before CLTs

There are two issues to consider: the entry charge on lifetime gifts into trust and the impact of death.

A CLT will be subject to an immediate charge to IHT at 20% where the value of the CLT, when added to any other CLTs made by the settlor in the preceding seven years, exceeds the IHT nil rate band. PETs can therefore be ignored in this accumulation at this point.

However, if in a seven-year period, an individual makes a PET, then a CLT and subsequently dies, the PET will become a chargeable transfer or ‘failed PET’. Both the failed PET and the CLT will be included in the IHT calculation of the individual.

In addition, if a PET has been made in the seven years leading up to the discretionary trust creation (which was a CLT), and subsequently fails becoming chargeable, this causes an impact to the trust when assessing for future periodic charges. This is because chargeable transfers in the seven years prior to the trust creation are added into the periodic charge computation.

For example

Six years ago Helen gifts her son Connor £100,000 to help him get on the property ladder. This gift to Connor will be a PET for £100,000. She subsequently sets up a discretionary gift trust three years later (this is her first gift into trust) for £300,000 so she can leave a legacy for future generations.

If Helen were to die now (after 6 years), the PET would become chargeable. This means that, at every ten-year point, instead of having 100% of the nil rate band throughout the lifetime of her discretionary trust, it will be reduced by £100,000. So, in this scenario, you can see that, instead of her discretionary trust having a full nil rate band at each 10th anniversary, it will now be reduced each time by £100,000, which means there is more chance of a periodic charge applying every ten years to the trust.

CLTs before PETs

Again, there are two issues to consider – lifetime gifts and the impact of death.

During lifetime, CLTs have no impact on PETs as they do not become chargeable unless the individual dies within seven years of making the PET. However, when calculating the IHT payable by the estate, failed PETs and CLTs made in the seven years before death are included.

If a PET is created after the set-up of a discretionary trust, this can expand the timeline for the CLT beyond the seven years and can potentially keep the CLT in the timeline for up to 14 years. Under the complex IHT rules, it states that if a PET fails and becomes chargeable from the date of that gift, you look back seven years and include any previous CLTs.

For example

If Helen sets up her discretionary gift trust first for £300,000, she expects this to drop out of her IHT cumulation after seven years. However, three years after setting up the trust, her son Connor decides to buy a house and Helen gifts him £100,000 to help him out - this cash gift is a PET.

The impact of the PET is that, instead of her £300,000 discretionary gift trust dropping out of her cumulation after seven years, it is now going to be included for the same length of time as the PET. This means it will not drop out of her IHT calculation for ten years.

There are implications either way when looking at the order of gifting. Considerations include:

The value of gifts.
The type of gift.
Succession of gifts and the order in which they are made.
The position if the donor dies within seven years of making the gift.

An individual should always utilise any exemptions, reliefs and allowances and then usual planning would be to consider making CLTs before PETs. In this way there is no risk of a failed PET reducing the nil rate band available throughout the lifetime of the trust created by the CLT.

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