Mercury Institute of Management Pte Ltd Lecturer : T. P. L. Raj FCCA ACMA raj@tplraj.

com INHERITANCE TAX (PART 1)

ACCA Fundamentals Stage (June 2013 PT/FT) Paper F6 :Taxation (UK) FA 2012

The scope of inheritance tax Inheritance tax (IHT) is paid on the value of a persons estate when they die, but it also applies to certain lifetime transfers of assets. If IHT did not apply to lifetime transfers it would be very easy for a person to avoid tax by giving away all of their assets just before they died. As far as Paper F6 is concerned the terms transfer and gift can be taken to mean the same thing. The person making a transfer is known as the donor, while the person receiving the transfer is known as the donee. Unlike capital gains tax where, for example, a principal private residence is exempt, all of a persons estate is generally chargeable to IHT. A person who is domiciled in the UK is liable to IHT in respect of their worldwide assets. As far as Paper F6 is concerned people will always be domiciled in the UK. Transfers of value During a persons lifetime IHT can only arise if a transfer of value is made. A transfer of value is defined as any gratuitous disposition made by a person that results in a diminution in value of that persons estate. There are two important terms in this definition: Gratuitous: Poor business deals, for example, are not normally transfers of value because there is no gratuitous intent. Diminution in value: Normally there will be no difference between the diminution in value of the donors estate and the increase in value of the donees estate. However, in some cases it may be necessary to compare the value of the donors estate before the transfer, and the value after the transfer in order to compute the diminution in value. This will usually be the case where unquoted shares are concerned. Shares forming part of a controlling shareholding will be valued higher than shares forming part of a minority shareholding. As far as Paper F6 is concerned a transfer of value will always be a gift of assets. A gift made during a persons lifetime may be either potentially exempt or chargeable. Potentially exempt transfers Any transfer that is made to another individual is a potentially exempt transfer (PET). A PET only becomes chargeable if the donor dies within seven years of making the gift. If the donor survives for seven years then the PET becomes exempt and can be completely ignored. Hence such a transfer has the potential to be exempt. If the donor dies within seven years of making a PET then it becomes chargeable. Tax will be charged according to the rates and allowances applicable to the tax year in which the donor dies. However, the value of a PET is fixed at the time that the gift is made. Chargeable lifetime transfers Any transfer that is made to a trust is a chargeable lifetime transfer (CLT). There is no legal definition of what a trust is, but essentially a trust arises where a person transfers assets to people (the trustees) to hold for the benefit of other people (the beneficiaries). For example, parents may not want to make an outright gift of assets to their young children. Instead, assets can be put into a trust with the trust being controlled by trustees until the children are older. Unlike a PET, a CLT is immediately charged to IHT based on the rates and allowances applicable to the tax year in which the CLT is made. An additional tax liability may then arise if the donor dies within seven years of making the gift. Just as for a PET, the value of a CLT is fixed at the time that the gift is made, but the additional tax liability is calculated using the rates and allowances applicable to the tax year in which the donor dies.

Mercury Institute of Management Pte Ltd Lecturer : T. P. L. Raj FCCA ACMA raj@tplraj.com

ACCA Fundamentals Stage (June 2013 PT/FT) Paper F6 :Taxation (UK) FA 2012

Rates of tax IHT is payable once a persons cumulative chargeable transfers over a seven-year period exceed a nil rate band. For the tax year 201112 the nil rate band is 325,000. The rate of IHT payable as a result of a persons death is 40%. This is the rate that is charged on a persons estate at death, on PETs that become chargeable as a result of death within seven years, and is also the rate used to see if any additional tax is payable on CLTs made within seven years of death. The rate of IHT payable on CLTs at the time they are made is 20% (half the death rate). This is the lifetime rate. The tax rates information that will be given in the tax rates and allowances section of the June and December 2012 exam papers is as follows: 1 325,000 Excess Nil 40% 20%

Death rate Lifetime rate

Where nil rate bands are required for previous years then these will be given to you within the question. Nil Rate Bands 6 April 2012 to 5 April 2013 6 April 2011 to 5 April 2012 6 April 2010 to 5 April 2011 6 April 2009 to 5 April 2010 6 April 2008 to 5 April 2009 6 April 2007 to 5 April 2008 6 April 2006 to 5 April 2007 6 April 2005 to 5 April 2006 6 April 2004 to 5 April 2005 6 April 2003 to 5 April 2004 6 April 2002 to 5 April 2003 6 April 2001 to 5 April 2002 6 April 2000 to 5 April 2001 6 April 1999 to 5 April 2000 6 April 1998 to 5 April 1999 6 April 1997 to 5 April 1998 325,000 325,000 325,000 325,000 312,000 300,000 285,000 275,000 263,000 255,000 250,000 242,000 234,000 231,000 223,000 215,000

Taper relief It would be somewhat unfair if a donor did not quite live for seven years after making a gift with the result that the gift was fully chargeable to IHT. Therefore, taper relief reduces the amount of tax payable where a donor lives for more than three years, but less than seven years, after making a gift. The reduction is as follows: Years before death Over 3 but less than 4 years Over 4 but less than 5 years Over 5 but less than 6 years Over 6 but less than 7 years Percentage reduction % 20 40 60 80

Although taper relief reduces the amount of tax payable, it does not reduce the value of a gift for cumulation purposes. The taper relief table will be given in the tax rates and allowances section of the exam paper.

Mercury Institute of Management Pte Ltd Lecturer : T. P. L. Raj FCCA ACMA raj@tplraj.com

ACCA Fundamentals Stage (June 2013 PT/FT) Paper F6 :Taxation (UK) FA 2012

Transfer of a spouses unused nil rate band Any unused nil rate band on a persons death can be transferred to their surviving spouse (or registered civil partner). The nil rate band will often not be fully used on the death of the first spouse because any assets left to the surviving spouse are exempt from IHT (see the following section on transfers to spouses). A claim for the transfer of any unused nil rate band is made by the personal representatives who are looking after the estate of the second spouse to die. The amount that can be claimed is based on the proportion of the nil rate band not used when the first spouse died. Even though the first spouse may have died several years ago when the nil rate band was much lower, the amount that can be claimed on the death of the second spouse is calculated using the current limit of 325,000. Exemptions Transfers to spouses Gifts to spouses (and registered civil partners) are exempt from IHT. This exemption applies both to lifetime gifts and on death. There are a number of other exemptions that only apply to lifetime gifts. Small gifts exemption Gifts up to 250 per person in any one tax year are exempt. If a gift is more than 250 then the small gifts exemption cannot be used, although it is possible to use the exemption any number of times by making gifts to different donees. Annual exemption Each tax year a person has an annual exemption of 3,000. If the whole of the annual exemption is not used in any tax year then the balance is carried forward to the following year. However, the exemption for the current year must be used first, and any unused brought forward exemption cannot be carried forward a second time. Therefore, the maximum amount of annual exemptions available in any tax year is 6,000 (3,000 x 2). Normal expenditure out of income IHT is not intended to apply to gifts of income. Therefore a gift is exempt if it is made as part of a persons normal expenditure out of income, provided the gift does not affect that persons standard of living. To count as normal, gifts must be habitual. Therefore, regular annual gifts of 2,500 made by a person with an annual income of 100,000 would probably be exempt. A one-off gift of 70,000 made by the same person would probably not be, and would instead be a PET or a CLT. Gifts in consideration of marriage This exemption covers gifts made in consideration of a couple getting married or registering a civil partnership. The amount of exemption depends on the relationship of the donor to the donee (who must be one of the two persons getting married): 5,000 if the gift if made a by a parent. 2,500 if the gift is made by a grandparent or by one of the couple getting married to the other. 1,000 if the gift is made by anyone else.

Mercury Institute of Management Pte Ltd Lecturer : T. P. L. Raj FCCA ACMA raj@tplraj.com

ACCA Fundamentals Stage (June 2013 PT/FT) Paper F6 :Taxation (UK) FA 2012

Part 2 Tax liability on lifetime transfers When calculating the tax liability on lifetime transfers there are three aspects that are a bit more difficult to understand, and can therefore cause problems for students. CLT preceded by a PET that becomes chargeable The situation where a CLT is made before a PET is fairly straightforward, and has been covered in previous examples. However, where the sequence of gifts is reversed the IHT calculations are more complicated because the PET will use some or all of the nil rate band previously given to the CLT. Grossing up In all the examples so far concerning a CLT the trust (the donee) has paid any lifetime IHT that has arisen. The loss to the donors estate is therefore just the amount of the gift. However, the donor is primarily responsible for any lifetime IHT that arises on a CLT. In this case the loss to the donors estate is both the amount of the gift and the related tax liability. To correctly calculate the amount of IHT payable it is therefore necessary to gross up the net gift. Any available annual exemptions are deducted prior to grossing up, and it is only necessary to gross up the amount in excess of the nil rate band. When an IHT question involves a CLT then make sure you know who is paying the IHT. Grossing up is not necessary if the trust (the donee) pays. Seven-year cumulation period As far as Paper F6 is concerned the most difficult aspect to grasp is the seven-year cumulation period. What the seven-year cumulation period means is that when calculating the IHT on a lifetime transfer (either a PET becoming chargeable or a CLT) it is necessary to take account of any CLT made within the previous seven years despite it being made more than seven years before the date of the donors death. Only CLTs have to be taken into account, as PETs made more than seven years before the date of death are completely exempt. Advantages of lifetime transfers Lifetime transfers are the easiest way for a person to reduce their potential IHT liability. A PET is completely exempt after seven years. A CLT will not incur any additional IHT liability after seven years. Even if the donor does not survive for seven years, taper relief will reduce the amount of IHT payable after three years. The value of PETs and CLTs is fixed at the time they are made, so it can be beneficial to make gifts of assets that are expected to increase in value such as property or shares. Tax liability on death estate Until now the examples have simply given a figure for the value of a persons estate. However, it may be necessary to calculate it. A persons estate includes the value of everything which they own at the date of death such as property, shares, motor vehicles, cash and other investments. A persons estate also includes the proceeds from life assurance policies even though these proceeds will not be received until after the date of death. The actual market value of a life assurance policy at the date of death is irrelevant.

Mercury Institute of Management Pte Ltd Lecturer : T. P. L. Raj FCCA ACMA raj@tplraj.com

ACCA Fundamentals Stage (June 2013 PT/FT) Paper F6 :Taxation (UK) FA 2012

The following deductions are permitted: Funeral expenses Debts due by the deceased provided they were incurred for valuable consideration. Therefore, gambling debts cannot be deducted. Mortgages on property. This does not include endowment mortgages as these are repaid upon death by the life assurance element of the mortgage. Repayment mortgages and interest-only mortgages are deductible. Payment of inheritance tax Chargeable lifetime transfers The donor is primarily responsible for any IHT that has to be paid in respect of a CLT. However, a question may state that the donee is to instead pay the IHT. Remember that grossing up is only necessary where the donor pays the tax. The due date is the later of: 30 April following the end of the tax year in which the gift is made. Six months from the end of the month in which the gift is made. Therefore, if a CLT is made between 6 April and 30 September in a tax year then any IHT will be due on the following 30 April. If a CLT is made between 1 October and 5 April in a tax year then any IHT will be due six months from the end of the month in which the gift is made. The donee is always responsible for any additional IHT that becomes payable as a result of the death of the donor within seven years of making a CLT. The due date is six months after the end of the month in which the donor died. Potentially exempt transfers The donee is always responsible for any additional IHT that becomes payable as a result of the death of the donor within seven years of making a PET. The due date is six months after the end of the month in which the donor died. Death estate The personal representatives of the deceaseds estate are responsible for any IHT that is payable. The due date is six months after the end of the month in which death occurred. However, the personal representatives are required to pay the IHT when they deliver their account of the estate assets to HM Revenue & Customs, and this may be earlier than the due date. Where part of the estate is left to a spouse then this part will be exempt and will not bear any of the IHT liability. Where a specific gift is left to a beneficiary then this gift will not normally bear any IHT. The IHT is therefore usually paid out of the non-exempt residue of the estate.