Neil MacGillivray: Simplifying IHT (Part 1) - The winners and losers

A year and a half after then-chancellor Philip Hammond wrote to the Office of Tax Simplification (OTS) asking it to review the UK's inheritance tax (IHT) system, the office's second report - entitled Simplifying the design of IHT - has finally been released.

The OTS's first report focused on feedback from its consultation and on ways of simplifying the administration of IHT. This new report, however, covers proposed changes to the tax itself and, while the changes are not as radical as many had predicted (if adopted), advisers need to be aware of the major impact they could it have on IHT planning.

The recommendation that grabbed the headlines was the proposed reduction in the period of time that gifts, made by an individual during their lifetime, may be taken into account when assessing IHT on death. For potential exempt transfers, the period would be reduced from seven to five years. For gifts deemed chargeable transfers (mainly gifts into trusts) during their lifetime, this would be reduced from 14 years to five years.

Neil MacGillivray: Simplifying IHT (Part 2) - Cutting through the complexities

The responses from the OTS consultation indicated the current seven and 14-year periods during which a lifetime gift may impact on IHT are too long. In particular, it can be difficult (indeed, sometimes impossible) for executors to obtain records going back that far - for example, it is not possible to obtain bank statements going back more than six years. It was also observed that the calculations in regard to chargeable transfers made within 14 years of death are too complex.

From a negative perspective, the report advocates removing taper relief. The supporting point made by the OTS was that very little IHT is raised on gifts made more than five years before the death of the donor. The seemingly obvious reasons for this, however, would be that any IHT due is reduced significantly by taper relief, and gifts may not have been taken into account due to the inability to find records that far back.

It was also apparent that the understanding of how taper relief worked was poor among the general public, in that many think it applies to the value of the gift, when in fact it relates only to the actual tax due.

When it comes to the current gift exemptions, they are seen as being complex and not well understood. The key issues are:

* the rules covering how each type of exemption applies;

* their interactions with each other; and

* the differing limits.

One of the examples given relates to the issue of ‘normal expenditure out of income' exemption, where it can require extensive record-keeping, and the scope of the exemption can be challenged by HMRC resulting in donor uncertainty.

Another important - and more positive - point made was that the exemptions have not kept pace with inflation. The annual exemption has been frozen at £3,000 since 1981; the small gifts exemption has been £250 since 1980; and the three exemption limits for gifts on marriage or civil partnership go all the way back to 1975.

The OTS believes the small gift exemption should remain but the limit be increased from £250 to £1,000 to reflect inflation. This would cut down dramatically the amount of record-keeping required by the donor and reflect more realistically the value of gifts made.

Normal expenditure

The recommendation for the annual gift, gifts on marriage or civil partnership and the normal expenditure out of income exemptions is that they should be replaced with a single annual personal gifts allowance. This would simplify matters considerably for both HMRC and donors. HMRC data shows a personal gift allowance of £25,000 would cover the value of 55% of all normal expenditure out of income claims. Based on HMRC 2015/16 data, only 261 such estates would have been worse off under these recommended changes.

Another possibility would be to put an annual limit on the amount of normal expenditure out of income that is exempt. This could simply be a fixed percentage of annual income, which would remove the need for the expenditure to be ‘regular' - a current requirement - which would provide more flexibility and, perhaps more importantly, certainty for donors. Those few individuals with large surplus incomes would, however, lose out. If this option was adopted, the annual gifts allowance would need to be lowered.

No matter how small any steps taken to simplify the tax system appear to be, they have to be a seen as a positive given the current position - though we will have to continue to accept there will still be winners and losers. The proposed reduction in the period of time it takes gifts to fall out of a donors' estate will benefit many but, for the few making large gifts, the loss of taper relief could prove costly.

The OTS report contained 11 recommendations overall and I will look at some of the remaining ones in my next blog.

Neil MacGillivray is head of technical support at James Hay

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