The OTS Second Report on the Design of IHT in a nutshell

The OTS recommends that the present array of gift exemptions should be consolidated; the £3,000 annual exemption, gifts on marriage and potentially the gifts out of surplus income (see 1.2 below) should be replaced with an overall personal gifts allowance.

Our comment: this is a welcome uncontroversial proposal. The level of this new allowance and the level of the small gifts exemption should also be reviewed.

The current rules require complex record keeping, including the need for the gift to be regular and for the donor’s lifestyle to be maintained.
The OTS suggests two options for replacement:

• Option 1: remove the requirement for expenditure to be regular and introduce a percentage of income limit;
• Option 2: replace the exemption with a higher personal gift allowance. The OTS suggests a personal gift allowance of £25,000 would cover 55% of all such expenditure out of income.

Our comment: this would be a major reform with winners and losers. Some wealthier taxpayers would lose a valuable relief. Either option would be simpler than the present arrangement.

The OTS points out that the seven year potentially exempt transfer (PET) period is too long and that records may be difficult for executors to obtain. It raises little tax. It recommends a reduced period of five years.

Our comment: this is an uncontroversial change that would make life simpler for taxpayers and presumably reduce the cost of term assurance for those covering the risk of death in the seven years.

However, the OTS also proposes abolishing taper relief, which reduces the amount of tax due on a gift on a sliding scale where over three years has passed since the gift was made. This is a very narrowly available relief as it is only in point where the lifetime gift exceeds the available nil rate band.

Our comment: as a general rule, in our experience, clients do not plan to use taper relief when making substantial gifts, although it is useful if it becomes available. This would therefore increase the cost of term assurance in the few relevant cases, as the amount covered does not decrease before it is eliminated. It will also result in a cliff edge for a taxpayer who dies one day before the five years has elapsed.

The OTS points out that where tax becomes payable on lifetime gifts made within the seven year PET period, the tax is borne by the donee and the nil rate band is allocated to lifetime gifts in the order they are made.

This is complex and is not well understood by taxpayers.

The OTS suggests two possible options:

• Reform option: IHT on lifetime gifts should be payable by the estate and the nil rate band should be allocated proportionately across lifetime gifts first;
• Amendment option: executors should be liable to pay the lifetime IHT only out of the assets they handle due to be distributed to the recipient of the gift; otherwise, the recipient of the gift should pay.

Our comment: this change only affects the collection of the tax rather than the overall amount of tax due so well planned estates should have no great concerns and the position may be improved where inadequate planning has been undertaken. Allocating the nil rate band proportionately may create uncertainty however as the available nil rate band, for example on a chargeable lifetime transfer into a trust, would be dependent on future gifts.

At present, there is a CGT uplift on death meaning that assets can be sold shortly after death without any CGT being due. If an asset is exempted or relieved from IHT, this means that no tax will arise in respect of that asset on death.

The OTS notes that this uplift discourages the passing of assets in lifetime to the next generation. It recommends addressing this by removing the CGT uplift where a relief or exemption applies, such as the spouse exemption, business property relief (BPR) and agricultural property relief (APR), and replacing it with a form of holdover relief. The recipient would then be treated as receiving the asset at historic base cost.

Our comment: this would be a major reform. The OTS is right that the present system distorts lifetime giving. The proposed reform is clever as the assets in question can still pass without payment of tax provided the asset is retained and not sold. That would be in line with the general purposes of APR and BPR. On the other hand, the potential amount of CGT eventually collected would very possibly increase. The proposal cannot really be said to be a simplification as such. It is nevertheless likely to prove an attractive idea to the Government as it can only increase the amount of tax ultimately collectible. It would reduce the flexibility of family wealth planning after death.

The report reviews the treatment of AIM shares and notes that in relation to third party investors in AIM shares BPR is not necessary to prevent the business being broken up. It does not, however, go on to make any recommendation on the BPR status of AIM shares, presumably because of the Government’s intention to increase investment in AIM.

The report points out the anomalies between the various taxes over what constitutes an investment rather than a business. The current IHT test is a wholly or mainly trading (over 50%) test. An equivalent test for CGT is a substantial (80/20%) test. The OTS invites the Government to consider whether or not it is appropriate for BPR to be set at a lower level.

Our comment: the policy basis for BPR is a tricky area that the OTS has understandably tiptoed around. The proposed tightening up of the definition of the amount of trading activity required will have a substantial effect on many diversely held estates, which would need to review their IHT status were the changes to be enacted.

There are also anomalies around:

• non-controlling shares in trading companies if held through a holding company where relief is unfairly lost; and
• the status of BPR for LLPs.

The recommendation is that the BPR treatment in these circumstances should be reviewed.

Our comment: both of these proposals are sensible and to be welcomed.

The report highlights the fact that there is a difference in treatment of FHLs for income tax and CGT on the one hand, where broadly they qualify as trades, compared to IHT where broadly they do not. The report invites the Government to consider aligning the treatment of IHT so that FHLs would qualify as trades.

Our comment: the current anomaly does not appear to be rational. For those involved in FHLs such a change would likely be very welcome. Case law in this area has proven just how difficult it is to achieve BPR.

The report is perhaps surprisingly light on proposals for APR. Its main area of concern is the treatment of farmhouses or cottages where, for example, the farmer has to move out because of medical circumstances thereby potentially losing relief. HMRC treats such situations on a case by case basis. The OTS argues that the eligibility tests should be clearer and more transparent without suggesting how that should be achieved.

This is the extra IHT relief designed to enable a family home to be passed on more easily. The OTS argues that the Residence Nil Rate Band (RNRB) is relatively new and more time is needed to evaluate its effectiveness before simplifications can be recommended.

Our comment: we are very disappointed by the OTS’s approach here, as the RNRB has quickly gained notoriety for being vastly over complex even for professionals. If ever there was an area of tax that needed urgent simplification, this is it. We can only hope the OTS will revisit this in the near future.

The OTS has not made any recommendation in light of the wider scale continuing review of trusts by HMRC. It did however highlight various issues it hopes that HMRC will consider further.

It is standard IHT planning to write such policies in trust to prevent the proceeds falling into the deceased’s estate and therefore into the scope of IHT. The OTS recommends a simplification that such policies are simply taken out of IHT without the need for the trust. As this is a trust matter, however, the OTS suggests it should be given further consideration as HMRC take that review forward.

The OTS points out that as with life assurance policies, it is anomalous that some pension policies are included in the estate while others are not. There are also issues where pensions are transferred between pension providers within two years of death where, unusually, HMRC considers there can be a transfer of value in certain circumstances giving rise to unexpected, and clearly anomalous liabilities. The OTS calls for further HMRC guidance without making further proposals.

These anti avoidance rules, which introduce an income tax charge in some circumstances, are described by the OTS as complex and not well known. The recommendation is that they are reviewed to consider whether they function as intended and whether they are still necessary.