The fact that transfers of value are considered in chronological order for IHT can give rise to some unfortunate results, as Canada Life's Paul Thompson demonstrates...
Widow Twankey had two sons: twins called Reggie and Ronnie. Unfortunately, their mother had recently died unexpectedly as a result of a tragic accident in the laundry room where she worked.
Reggie was the tearaway son, so this left Ronnie with the task of obtaining probate on his mother’s estate. Initially, he was quite relaxed about this. Widow Twankey’s possessions totalled £300,000, so Ronnie was confident there would be no inheritance tax (IHT) to pay on it.
Widow Twankey’s estate had no benefit from the transferable nil rate band provisions, since her husband had utilised all of his nil rate band on his death many years ago. However, Ronnie knew the current nil rate band was £325,000, significantly above the value of the estate.
A Ronnie and Reggie tale to share with clients
Unfortunately, Ronnie’s confidence proved to be misplaced.
Just over five years ago, Reggie the tearaway decided to leave home. This was not particularly noteworthy, as he was in his mid-thirties at the time. What was rather unusual, however, was the agreement he negotiated between his mother and twin brother.
He suggested that, since he was leaving home, he should receive his share of the inheritance now, in return for being left out of his mother’s will. After much discussion between the three of them, it was agreed he would receive £250,000 which, fortunately, his mother was able to raise fairly easily.
As Widow Twankey was relatively generous to her sons at birthdays and Christmas, she had already used up her annual exemptions for both that tax year and the previous one. With this in mind, the £250,000 she gave to Reggie was a potentially exempt transfer (PET), meaning no IHT was payable at the time.
As agreed, Widow Twankey changed her will so that the sole beneficiary was Ronnie, who faithfully decided to stay at home and look after his mother. After her death, he went to his adviser for assistance with the estate, and was visibly shocked when he was told there would be a considerable liability on the estate. Instead of receiving the £300,000 free of IHT he was expecting, he would be receiving only £210,000, which was less than his brother had received all those years ago.
When asked to explain the figures, the adviser correctly pointed out that the £250,000 gift to Reggie was only potentially exempt, not unconditionally exempt. The potential for the gift to be fully exempt would be realised only if Widow Twankey had survived for seven years or more.
As it turned out, she failed to survive long enough, meaning the potential for the gift becoming a fully exempt transfer was not realised. Thus, it had become a chargeable transfer. There was still no tax payable on it, since it fell wholly within the nil rate band.
However, it did mean the nil rate band available to the £300,000 estate was only £325,000 – £250,000 = £75,000, resulting in £300,000 – £75,000 = £225,000 being taxable at 40%. This meant that £225,000 x 40% = £90,000 IHT had to be paid to HMRC, leaving only £210,000 for poor Ronnie.
But Ronnie thought he had detected a flaw in the adviser’s arithmetic. He had been doing some research into IHT on the internet, and he knew there was something called taper relief. He knew that, where a gift was made during lifetime and the donor died within seven years, the relief was available at a rate that depended on the date of death.
He seemed to recall the relief was nil in the event of death within the first three years after the gift, but then 20%, 40%, 60% and 80% relief was available in the event of death in years four, five, six and seven respectively.
Since his mother had died in year six, shouldn’t relief be granted to reduce the IHT by 60%? This would mean a liability of £36,000 instead of £90,000, leaving £264,000 for Ronnie, a much more equitable result.
Ronnie was very encouraged when his adviser agreed that taper relief would apply in these circumstances. However, his face fell when the adviser went on to say that the relief applied to the tax payable on the PET, not the tax payable on the estate. As the PET was wholly within the nil rate band, the IHT payable on it was nil, meaning that the benefit of taper relief was also nil.
Ronnie saw it as little consolation when the adviser pointed out to him that the key words as far as IHT is concerned are “forward planning”.
Had Ronnie approached his adviser when the gift to Reggie was being made, very cost-effective life insurance cover could have been arranged under a suitable trust so that, if Widow Twankey had died in the following seven years, £90,000 could have been paid to Ronnie IHT-free, thus mitigating the effect of the tax payable on the estate.
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