Inheritance Tax: PETs and CLTs 5th November 2014

Posted in: Inheritance Tax

I have to admit I have something of a love hate relationship with inheritance tax (IHT). On the one hand I hate what inheritance tax has become. It was meant as a tax on the very rich, however, as anyone with a modest house in certain parts of the country knows it is now catching the average family.

IHT seemed to work reasonably well at one time, then house prices started to rocket and the nil rate band which kept those houses out of the clutches of the taxman didn’t. Under Gordon Brown’s chancellorship the nil rate band crept up at a snail’s pace.

The Conservatives didn’t fare much better. They promised they would put the nil rate band up to £1m for an individual and £2m for a couple, but did they? No, its remained fixed at £325,000 for the last several years now.

Okay, I know if you’re a couple you can now transfer your nil rate band to your spouse when you die, effectively having £650,000 tax free to leave behind. Even so, after taking the family home into consideration and some savings for your retirement there’s still a good chance that your estate will be paying inheritance tax when you pass on.

On the other hand, as a system of taxation I can see the intuitive logic in it. The set of rules have a certain elegance about them and as subject of study it’s really quite pleasing.

So I both love and hate it.

It’s often been said that IHT is the easiest tax to avoid as all you need to do is gift your wealth away to the next generation before you die. However, even if you can’t gift away the family home (because you’re still living in it), you might be able to gift some of your wealth away and that’s what this post will be focusing on.

From this point on, any reference to a spouse or marriage applies equally to a civil partner or civil partnership.

First, let’s take a quick look at some exempt transfers.

  1. Gifts to spouse: Any transfer to a UK domiciled spouse, either during an individual’s lifetime or on death, is completely exempt from IHT. For a non-UK domiciled spouse the story is different. Up until 5 April 2013, only the first £55,000 was exempt. This was to stop the spouse acquiring the wealth from the death estate and disappearing back to wherever s/he came from, at which point HMRC would have lost any chance of taxing it further.
    From 6 April 2013, the exempt amount was increased from £55,000 to the level of the prevailing nil rate band. Additionally, a non-UK domiciled spouse can now elect to become UK domiciled for IHT purposes only. This will have the adverse effect of making their worldwide assets subject to IHT in the UK.
  2. Gifts to charities: These are completely exempt, with no monetary limit, as are gifts to political parties, housing associations and national heritage bodies.
  3. Small gifts: Any gift of £250 or less to a specific donee in the tax year is exempt. Note, this does not mean the first £250 is exempt. If £750 is gifted and ultimately becomes subject to IHT, the tax is levied on the whole £750, not the excess.
    There’s no limit to the number of donees in any tax year.
  4. Gifts on marriage: Gifts of up to £5,000 to children are exempt; gifts of up to £2,500 to grandchildren (or remoter ancestors) are also exempt. Wedding gifts of up to £1,000 can be made anybody. Only one gift can count as exempt, so a father could give £5,000 to his daughter and claim an exemption, but could not give a further £1,000 to his son-in-law.
    Only the excess would be taxable should any of the gifts ultimately be subjected to IHT.
  5. Normal expenditure out of income: Normal here means habitual or regular. A gift of any amount is exempt, provided it leaves the donor sufficient income to live on  and does not diminish the his/her standard of living.
  6. Annual exemption:  There is an annual exemption of £3,000. It only applies to lifetime transfers (not transfers on death). Any unused annual exemption can be carried forward one year only, giving a maximum of £6,000 that can be used in any one year. Note that a gift on marriage would not diminish the amount available for the annual exemption, as they are two separate exemptions.

Now we come to the more interesting types of gifts: PETs and CLTs.

Potentially Exempt Transfers (PETs)

A gift by one individual to another during their lifetime is a potentially exempt transfer. It’s potentially exempt because, provided the individual making the transfer survives for 7 years after the date of the transfer, the transfer will be completely exempt IHT.

If, however, the individual dies before the 7th anniversary of the gift, then the gift will become subject to IHT. The tax is payable by the donee (recipient).

Before 22 March 2006, gifts by an individual to anything other than a discretionary trust used to be treated as a PET, but Gordon Brown decided he didn’t like trusts as they were being used for tax avoidance (he should have put the nil rate band up), so he decided to tax them. From this point on, gifts to trusts are now taxable.

Here’s an example.

Geraldine gifts £160,000 to her daughter in July 2006. In August 2012, Geraldine makes a further gift of £220,000 to her son. Geraldine dies in September 2014.

What happens to the gifts on death? First, the PET made to her daughter in 2006 is over 8 years before Geraldine died, so is not taxable. We might think we need only concern ourselves with the gift to her son in 2012 and that it will be covered by her nil rate band, however, that is not the case. We need to look back 7 years from the date of the last transfer.

PET (August 2012) 214,000
Nil rate band (at death) 325,000
Less: chargeable transfers in previous 7 years (154,000)
Nil rate band remaining (171,000)
Taxable on death 43,000
IHT @ 40% (paid by son) 17,200

Why £154,000 and £214,000 in the above example? Because of the annual exemption, which is applied to lifetime transfers. Given Geraldine had not made any other gifts, at the time she made both gifts she had the annual exemption (for the current year) and the previous year’s annual exemption that was carried forward.

There is something called Taper Relief that can reduce the IHT liability in these circumstances, but it does not apply in this situation as Geraldine died so soon after making the gift to her son.

Chargeable Lifetime Transfers (CLTs)

If a lifetime transfer is not a PET it must be a chargeable lifetime transfer. The most common CLTs are those made to trusts. Just as with the PETs above, the value of the CLT can be reduced by the annual exemption.

A gift to a company (if truly a gift) is also a CLT.

An example of a CLT.

Helen sets up a discretionary trust and transfers £400,000 in October 2012. Helen had made no other gifts up to that point.

Gift to discretionary trust (Oct 2012) 394,000
Less: nil rate band (at time of transfer) (325,000)
Chargeable to IHT 69,000
IHT @ 20% (payable by trustees) 13,800

Again, it’s £394,000 because we have two years of annual exemption we can take off the value of the transfer.

Note the IHT rate here is 20% as it’s a chargeable lifetime transfer. There are a number of factors that can affect this rate.

If the donor pays the IHT charge, this is considered a further gift and the IHT charge on the CLT is grossed up to be 20/80 ths or 25%.

Further, just as with PETs, if the donor dies within 7 years there is an additional IHT charge. Consideration is given for any previous amounts charged to IHT.

The example for the CLT charge is a very simplified scenario. As with PETs, we must take into consideration any lifetime transfers that occurred in the 7 years prior to making the CLT, as this will reduce the amount of any nil band available.

[Update: There is now an additional nil rate band being phased in from April 2017 that will apply to the family home. Each individual will have an extra £175,000 to offset against their home. Beginning April 2017, there will be an extra £100,000 and this will be increased by £25,000 each year until it reaches £175,000.]