Chapter: 2 - Inheritance Tax Mitigation: The Basics

The main charges and definitions

2.1.2

(a) Transfers of value and chargeable transfers
IHT is charged on the value transferred by a ‘chargeable transfer’ (IHTA 1984 s1), which is a ‘transfer of value’ made by an individual except an ‘exempt transfer’ (IHTA 1984 s2(1): see 2.1.5 and 2.2). A transfer of value is a disposition made by a person which causes the value of his estate immediately after the disposition to be less than the value immediately before it (IHTA 1984 s3(1)) but, in this, no account is taken of ‘excluded property’ (IHTA 1984 s3(2)).

(b) Excluded property
Excluded property is, generally, (i) property situated outside the UK owned by someone domiciled outside the UK, both under the general law and for IHT purposes (IHTA 1984 s6(1)); (ii) a reversionary interest (except where owned by the settlor or his spouse/civil partner) to the type of life interest in a settlement which is taxed as if the beneficiary owned the underlying property - a so-called 'estate' interest in possession (IHTA 1984 s48(1)); and (iii) property in a settlement situated outside the UK where the settlement was made by someone domiciled outside the UK for IHT purposes when made (IHTA 1984 s48(3)). Categories (i) and (iii) represent the territorial limitation on the operation of IHT: see 2.12.

TAX TIP: An individual who is prospectively entitled under a settlement, that is on the death of the current beneficiary who has a qualifying interest in possession, could give away his interest under the settlement (called a ‘reversionary interest’) with no IHT consequences (even if he were to die the following day, ie as excluded property he will not have made a PET).  Nor indeed will there be any CGT implications, assuming that the settlement has always been UK resident and he did not acquire his interest for value (TCGA 1992 s76).

(c) Potentially exempt transfers and chargeable transfers
Accordingly, the tax looks for chargeable transfers, whether made during lifetime or on death, and taxes them. However, there is a significant category of lifetime chargeable transfers, as PETs, which are transfers of value (of whatever amount) made by an individual to another individual, or into a trust for a disabled person, which are assumed to be exempt when made and do not become chargeable except in the event of the transferor’s death within seven years (IHTA 1984 s3A). Such treatment was, before 22 March 2006, also extended to a gift into trust in which an individual had a right to income (interest in possession) – called a ‘qualifying interest in possession’, the legislative expression for an 'estate' interest in possession - or into a favoured accumulation and maintenance trust for children (see 2.3.3(c)).

In the case of a chargeable lifetime transfer, whether immediately chargeable, eg a gift into trust (generally, of whatever kind on or after 22 March 2006) or a PET which becomes chargeable by reason of death within seven years, the rate of tax charged will be 40% unless the amount of the chargeable transfer falls within the transferor’s nil-rate band (£325,000 for 2009/10), in which case the rate will be 0%. The rate of IHT on an immediately chargeable lifetime transfer is 20% to the extent that it exceeds the nil-rate band as reduced by chargeable transfers made within the previous seven years (IHTA 1984 s7). If death follows within seven years of this new chargeable transfer the rate is increased to 40%, with a credit for any tax already paid. The nil-rate band is given according to the order of gifts within a seven year period. In the case of gifts made on the same day it is allocated pro rata.

Example 2.1
For the last five years Belinda has made gifts of £3,000 per annum to a favourite God-daughter, effectively using her £3,000 annual exemption in each year.  Otherwise she has made gifts as follows:
• on 1 July 2004 £125,000 to her son (with no chargeable transfers in the seven years before that).  This was a PET and even if Belinda dies within the next seven years will not attract IHT;
• on 1 March 2006 £250,000 into an accumulation and maintenance settlement for her grandchildren.  Again, this was a PET when made.  Provided that Belinda  dies at a time when the nil-rate band is no less than £375,000 (the sum of the gift to the son and the gift to the A&M trust) there will be no further IHT to pay; and
• on 1 January 2008 £75,000 to her daughter.  This was also a PET, but should Belinda die when the combined total of that plus chargeable transfers made in the previous seven years exceeds the then nil-rate band, for example on 1 November 2009 (tax year 2009/10, when the nil-rate band is £325,000), the excess viz £125,000 will attract IHT at 40% of £50,000, whether the IHT is paid by Belinda’s daughter or by Belinda’s executors.. 

TAX TRAP: A PET which becomes chargeable on death within seven years may trigger IHT which could have been avoided if there is a surviving spouse/civil partner, by letting the value in excess of the nil-rate band fall into exempt residue and having the survivor make a PET in the hope of survival for seven years. The moral: always when planning a PET consider the impact of death within the following seven years.