Reform of inheritance tax: an end to heavy petting?

Inheritance tax (IHT) is probably the most controversial of the UK taxes and there are regular rumblings as to the possibility of reform. In the latest of such rumblings, the All-Party Parliamentary Group (APPG) for Inheritance and Intergenerational Fairness has just published a new report recommending a complete overhaul of the existing regime. The proposed changes would produce significant winners and losers, but could result in a simpler, and perhaps fairer, system.

It is worth emphasising at this stage that the APPG is an informal group of cross-party MPs and the report is no more than a summary of their views. The government may well give consideration to the recommendations (as in the case of the recent 'loan charge' review) but the proposed changes are not (yet, at any rate) government policy.

Key changes: individuals

The headline changes proposed by the report are as follows:

• Tax on all lifetime gifts and transfers on death at 10% (though see below)
• Annual lifetime gift allowance of £30,000
• Transferrable nil rate band of around £325,000 (residence nil rate band disappears)
• Spouse exemption and exemption for gifts to charity remain
• Business property relief (BPR) and agricultural property relief (APR) disappear (though instalment payment option available)
• All other reliefs / exemptions disappear (eg 'surplus income' exemption)
• No automatic capital gains tax (CGT) uplift on death

Perhaps the biggest difference under the proposed new regime would be the abolition of the concept of a 'PET', or potentially exempt transfer, and with it the scope for IHT planning by way of lifetime gifting. Under the existing regime, lifetime gifts made by individuals to other individuals are typically PETs and are, unless the donor reserves a benefit in what he or she gives away, subject to IHT only if the donor dies within seven years of making the gift. The new proposals suggest a flat rate of tax on all lifetime gifts (subject to the £30,000 annual exemption), regardless of how long the donor survives that gift. Arguably, the current seven year rule is rather arbitrary and it can certainly be criticised as 'regressive'. The well-off and well-advised can avoid IHT through the making of PETs, whereas the less affluent, whose net worth is typically represented to a large extent by the homes they live in, cannot. Certainly, an elimination of the seven year rule would reduce the administrative burden for executors, who currently have to consider all gifts made by the deceased in the seven (and occasionally 14) years prior to death.

Even with the elimination of PET-ing, the biggest losers under the proposed new regime would probably be family business owners and farmers, who would lose both the benefit of BPR / APR and the CGT uplift, which allows many businesses and farms to be passed on to the next generation with an increased base cost and without any tax being paid. The report acknowledges this but suggests that the 1% or 2% a year payable under the instalment option 'could generally be funded out of net income'. This may offer limited comfort to those who might be affected - if these proposals progress any further, there will surely be an outcry from such taxpayers.

What rate?

Arguably, the simplicity of the proposals is somewhat undermined by the suggestion that on death, a higher rate of 20% would apply where the value of the estate exceeds £2m. Any such higher rate on death would encourage lifetime giving by wealthier individuals, and create an opportunity for (at least a degree of) avoidance, contrary to one of the key aims of the proposed reform.

This aspect of the proposals also sits uneasily with the suggestion that certain anti-avoidance rules should be abolished. These rules are very poorly drafted and in many respects their abolition would be welcome, but their function is to deter arrangements under which (very broadly) property is given away but continues to be enjoyed by the donor. If the system continues to provide an incentive for the wealthy to make lifetime gifts, an unfortunate corollary of that is a probable continuing requirement for anti-avoidance measures regarding enjoyment by donors of property that has been given away.

There is a strong case for a flat rate of tax that is the same for transfers made in life or on death, so that the playing field really is level, and so that all complexities of the current IHT regime can be stripped away. As the report itself points out, the level of the flat rate needs to be competitive if the new regime is to be attractive to individuals from jurisdictions where there is no equivalent tax or where the rate of such tax is low.

Key changes: trusts

There are also significant proposed changes to the taxation of trusts:

• Gifts to trusts taxed at the same 10% flat rate (no nil rate bands)
• Assets of discretionary trusts subject to fixed rate tax charge annually and on exits (tax rate unstated)
• Assets of life interest trusts treated as belonging to the life tenant and taxed on his/her death

The reduced IHT 'entry charge' and effective reversal of the 2006 changes to the treatment of life interest trusts would remove significant impediments to the use of trusts as sensible asset protection vehicles, eg as a means of providing funds for the benefit of children and grandchildren without the beneficiaries gaining total control.

An unanswered question is how the new regime would deal with existing trusts. Presumably existing discretionary trusts would simply become subject to the new annual tax rather than the current decennial charge, but non-qualifying interest in possession trusts (ie those life interest trusts that are currently subject to the IHT regime for discretionary trusts) would pose greater difficulty. In some cases, it may be advantageous for such trusts to be moved out of the discretionary trust regime and for the underlying assets to be treated as forming part of the life tenant's estate (eg where minimal decennial charges have been paid to date / the life tenant is young), but in others it could result in gross unfairness. One possible option would be to allow trustees to make an election as to whether the trust should continue to be treated as a discretionary trust or should move into the new regime for life interest trusts.

International aspects

The international aspects of the proposals are the least well thought through. The discussion is rather confused, but the broad thrust of the proposals is that the territorial scope of IHT will be determined by reference to an individual's residence over a reference period, rather than his or her domicile.

It is suggested that 'foreigners' will be taxed in the same way as 'UK-born persons' once they have been UK resident for 10 out of the last 15 years. It is unclear why a 10 / 15 year test has been chosen, rather than the 15 / 20 year test that applies to the existing deemed domicile concept. The discrepancy makes no sense and it would surely be more logical for the IHT regime to remain broadly aligned with the income tax and CGT regimes.

There is also an indication that the current 'excluded property' regime for trusts created by non-UK domiciliaries may be removed in some circumstances where the trust has a UK resident beneficiary, but the report is vague and inconsistent about this.

What next?

It is clear that these proposals for reform are still in their infancy and that there is a great deal of detail that would need to be worked out. Equally, it is far from clear that any of the suggestions in the report will meet with favour from the government, although a report from a similarly constituted APPG in relation to the controversial 'loan charge' has proved influential. The report also suggest some 'piecemeal' reform options, such as eliminating the CGT uplift on death where no IHT is paid (clearly targeted at assets that currently benefit for BPR / APR). If there is no appetite for a complete overhaul, it may be that some of these smaller changes are adopted.

Recent changes to the UK's tax regime (particularly in relation to foreign domiciliaries and offshore trusts) have been rushed through, with inadequate consultation and seemingly insufficient time for the draftsman to produce effective legislation. Whatever approach is taken, it is essential that any changes are implemented with care and attention to detail – this must not be another botched job.

This piece was written by Catrin Harrison. For more information please contact catrin.harrison@crsblaw.com or +44 (0)20 7427 6514.