Inheritance tax, part 2

The TX-UK syllabus requires a basic understanding of inheritance tax (IHT), and this
two-part article covers those aspects that you need to know. It is relevant to those of
you taking TX-UK in an exam in the period 1 June 2020 to 31 March 2021, and is based
on tax legislation as it applies to the tax year 2019–20 (Finance Act 2019).

The first part of the article covered the scope of IHT, transfers of value, rates of tax and
exemptions.

Tax liability on lifetime transfers

When calculating the tax liability on lifetime transfers, there are three aspects which are
a bit more difficult to understand and can therefore cause problems for students.

Chargeable lifetime transfer preceded by a potentially exempt transfer which

becomes chargeable

The situation where a chargeable lifetime transfer (CLT) is made before a potentially
exempt transfer (PET) is fairly straightforward, and was covered in the first part of the
article. 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.

EXAMPLE 18
Ali died on 3 March 2020. He had made the following lifetime gifts:

 1 August 2017 – A gift of £360,000 to his son.

 21 November 2018 – A gift of £240,000 to a trust.

These figures are after deducting available exemptions.

The nil rate band for the tax years 2017–18 and 2018–19 is £325,000.

IHT liabilities are:

Lifetime transfers

1 August 2017

Potentially exempt transfer 360,000

21 November 2018
( 2011-2018 GCT or PET chargeable? No NRB 325000
available)

Chargeable transfer 240,000

No lifetime IHT is payable because the CLT is less than the nil rate band for 2018–19.
Additional liabilities arising on death

1 August 2017
( 2010-2017 CLT or PET chargeable = GCT? No NRB 325000
available)

Potentially exempt transfer 360,000

IHT liability
325,000 at nil% 0
35,000 at 40% 14,000

14,000
 £

21 November 2018
( 2011-2018 GCT or PET chargeable? yes NRB 325000 –
360000 = 0 available)

Chargeable transfer 240,000

IHT liability 240,000 at 40% 96,000

IHT already paid 0

Additional liability 96,000

The nil rate band for 2019–20 of £325,000 has been fully utilised by the PET made on 1
August 2017.
Grossing up

So far, in all of the examples concerning a CLT, the trust (the donee) has paid any
lifetime IHT which has arisen. The loss to the donor’s estate is therefore just the amount
of the gift. However, the donor is primarily responsible for any lifetime IHT which arises
on a CLT. In this case, the loss to the donor’s 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.

EXAMPLE 19
On 17 June 2016, Annie made a gift of £406,000 to a trust. She (donor) paid the IHT
arising from the gift.

Annie has not made any other gifts since 6 April 2015.

The nil rate band for the tax year 2016–17 is £325,000.

The lifetime IHT liability is calculated as:

£ £

Value transferred 406,000

Annual exemptions
2016–17
2015–16 3,000
3,000

(6,000)
 £ £

Net chargeable transfer 400,000

IHT liability
325,000 at nil% 0
75,000 x 20/80 18,750

Gross chargeable transfer 418,750

The amount of lifetime IHT payable by Annie is £18,750. This figure can be checked by
calculating the IHT on the gross chargeable transfer of £418,750:

IHT liability
325,000 at nil% 0
93,750 at 20% 18,750

18,750

Once the gross chargeable transfer has been calculated, then this figure is used in all
subsequent calculations. CLTs are never re-grossed up on death, even if the nil rate
band is reallocated as a result of a PET becoming chargeable.

EXAMPLE 20
Continuing with example 19, Annie died on 12 March 2020.

Additional liability arising on death

17 June 2016 ( 2009-2016 CLT or PET chargeable? No NRB 325000 available)

Gross chargeable transfer 418,750

IHT liability
325,000 at nil% 0
93,750 at 40% 37,500

Taper relief reduction – 20% (7,500)

30,000

IHT already paid in lifetime (18,750)

Additional liability 11,250

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 TX-UK is concerned, the most difficult aspect to grasp is the seven year
cumulation period.

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 this CLT being made more than seven years before the date of the donor’s
death. Only CLTs have to be taken into account in this way, because PETs made more
than seven years before the date of death are completely exempt.

EXAMPLE 21
Nia died on 18 March 2020 leaving an estate valued at £450,000 (the residence nil rate
band is not available). She had made the following lifetime gifts:

 1 August 2011 – A gift of £200,000 to a trust.

 1 November 2017 – A gift of £280,000 to a trust.

These figures are after deducting available exemptions. In each case, the trust paid any
IHT arising from the gift.

The nil rate band for the tax years 2011–12 and 2017–18 is £325,000.

IHT liabilities are:

Lifetime transfers
1 August 2011

Chargeable transfer 200,000

No lifetime IHT is payable because the CLT is less than the nil rate band for 2011–12.
1 November 2017 ( 2010-2017 CLT or PET chargeable? No NRB 325000-200000
available)

Chargeable transfer 280,000

IHT liability
125,000 at nil% 0
155,000 at 20% 31,000

31,000

The CLT made on 1 August 2011 is within seven years of 1 November 2017, so it
utilises £200,000 of the nil rate band for 2017–18.

Additional liabilities arising on death

1 August 2011

Chargeable transfer 200,000

 £

There is no additional liability because this CLT was made more than seven years
before the date of Nia’s death on 18 March 2020.

1 November 2017

Chargeable transfer 280,000

IHT liability
125,000 at nil% 0
155,000 at 40% 62,000

IHT already paid (31,000)

 £

Additional liability 31,000

The CLT made on 1 August 2011 utilises £200,000 of the nil rate band for 2019–20 of
£325,000.

Death estate (2013 -2020 CLT or PET Chargeable? Yes, CLT = 280000, NRB =
325000 – 280000 = 45000)

Chargeable estate 450,000

IHT liability
45,000 at nil% 0
405,000 at 40% 162,000

162,000
  The CLT made on 1 August 2011 is not relevant when calculating the IHT on the
death estate because it was made more than seven years before the date of
Nia’s death on 18 March 2020.
 Therefore, only the CLT made on 1 November 2017 is taken into account, and
this utilises £280,000 of the nil rate band of £325,000.

EXAMPLE 22
The same situation as in example 21, except that on 1 November 2017 Nia made a
gift of £280,000 to her daughter rather than to a trust.

IHT liabilities are:

Lifetime transfers

1 August 2011

Chargeable transfer 200,000

No lifetime IHT is payable because the CLT is less than the nil rate band for 2011–12.

1 November 2017

Potentially exempt transfer 280,000

Additional liabilities arising on death

 £

1 August 2011

Chargeable transfer 200,000

1 November 2017 ( 2010-2017 CLT or PET chargeable? Yes,

CLT = 200,000 NRB 325000 -200,000 = 125000 available)

Potentially exempt transfer 280,000

IHT liability
125,000 at nil% 0
155,000 at 40% 62,000
 £

62,000

Death estate

Chargeable estate 450,000

IHT liability
45,000 at nil% 0
405,000 at 40% 162,000

162,000

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 which 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 person’s estate.
However, it may be necessary to calculate the value.

A person’s 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
person’s estate also includes the proceeds from life assurance policies even though
the 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.

Funds which have been invested in (and not withdrawn from) a pension fund are
outside of a person’s estate. Investing in a pension fund can therefore be a good
approach to reducing a person’s liability to IHT. However, it is possible to withdraw 25%
of a pension fund as a tax-free lump sum, and any such withdrawal will fall back into the
estate.

The following deductions are permitted:

 Funeral expenses
 Debts due by the deceased provided they can be legally enforced. Therefore,
gambling debts cannot be deducted, nor can debts which are unenforceable
because there is no written evidence.
 Mortgages on property. This does not include endowment mortgages because
these are repaid upon death by the life assurance element of the mortgage.
Repayment mortgages and interest-only mortgages are deductible.

EXAMPLE 23
Andy died on 31 December 2019. At the date of his death he owned the following
assets:
  A main residence valued at £425,000. This had an outstanding interest-only
mortgage of £180,000.
 Motor cars valued at £63,000.
 Ordinary shares in Herbert plc valued at £54,000.
 Building society deposits of £25,000.
 Investments in individual savings accounts valued at £22,000, savings
certificates from NS&I (National Savings and Investments) valued at £19,000 and
government securities (gilts) valued at £34,000.
 A life assurance policy on his own life. On 31 December 2019, the policy had an
open market value of £85,000 and proceeds of £100,000 were received following
Andy’s death.

During his lifetime, Andy had contributed into a personal pension scheme. The pension
fund was valued at £167,000 at the time of his death.

On 31 December 2019, Andy owed £700 in respect of credit card debts and he had also
verbally promised to pay the £800 legal fee of a friend. The cost of his funeral amounted
to £4,300.

The residence nil rate band is not available.

The IHT liability is:

Death estate

Property 425,000

Mortgage (180,000)
 £

245,000

Motor cars 63,000

Ordinary shares in Herbert plc

54,000

Building society deposits 25,000

Other investments (22,000 + 19,000 + 34,000) 75,000

Proceeds of life assurance policy 100,000

Pension fund 0
 £

562,000

Credit card debts (700)

Funeral expenses (4,300)

Chargeable estate 557,000

IHT liability
325,000 at nil% 0
232,000 at 40% 92,800

92,800

 The promise to pay the friend’s legal fee is not deductible because it is not legally
enforceable.
 Unlike capital gains tax, there is no exemption for motor cars, individual savings
accounts, saving certificates from NS&I or for government securities.
  The IHT liability on the life assurance policy could have easily been avoided if the
policy had been written into trust for the beneficiaries of Andy’s estate. The
proceeds would have then been paid direct to the beneficiaries, and not formed
part of Andy’s estate. However, this aspect is not examinable at TX-UK.
 The pension fund of £167,000 is outside of Andy’s estate.

Residence nil rate band

For residence nil rate band purposes, the value of the main residence is after deducting
any repayment mortgage or interest-only mortgage secured on that property.

If a main residence is valued at less than the available residence nil rate band, then the
residence nil rate band is reduced to the value of the residence.

EXAMPLE 24
Una died on 10 July 2019 leaving an estate valued at £625,000. Under the terms of her
will, Una’s estate was left to her children. The estate included a main residence valued
at £225,000 on which there was an outstanding interest-only mortgage of £130,000.

The IHT liability is:

Death estate

Chargeable estate 625,000

IHT liability
420,000 (325,000 + 95,000)
 £

at nil% 0
205,000 at 40% 82,000

82,000

The value of Una’s main residence is £95,000 (225,000 – 130,000), so the residence nil
rate band is restricted to this amount.

Payment of inheritance tax

Chargeable lifetime transfers

The donor is primarily responsible for any IHT which 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 which 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 which 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 deceased’s estate are responsible for any IHT
which 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 and Customs (HMRC), 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.

EXAMPLE 25
Alfred died on 15 December 2019. He had made the following lifetime gifts:

 20 November 2017 – A gift of £420,000 to a trust. Alfred paid the IHT arising
from this gift.
 8 August 2018 – A gift of £360,000 to his son.

These figures are after deducting available exemptions.

Alfred’s estate at 15 December 2019 was valued at £850,000. Under the terms of his
will, he left £250,000 to his wife, a specific legacy of £50,000 to his brother, and the
residue of the estate to his children (the residence nil rate band is not available).

The nil rate band for the tax years 2017–18 and 2018–19 is £325,000.

IHT liabilities are:

Lifetime transfers
20 November 2017

Net chargeable transfer 420,000

IHT liability
325,000 at nil% 0
95,000 x 20/80 23,750

Gross chargeable transfer 443,750

The due date for the IHT liability of £23,750 payable by Alfred was 31 May 2018.

8 August 2018

Potentially exempt transfer 360,000

The PET is initially ignored.

Additional liabilities arising on death

20 November 2017
 £

Gross chargeable transfer 443,750

IHT liability
325,000 at nil% 0
118,750 at 40% 47,500

IHT already paid (23,750)

Additional liability 23,750

The due date for the additional IHT liability of £23,750 payable by the trust is 30 June
2020.

8 August 2018
 £

Potentially exempt transfer 360,000

IHT liability 360,000 at 40% 144,000

 The CLT made on 20 November 2017 has fully utilised the nil rate band.
 The due date for the IHT liability of £144,000 payable by Alfred’s son is 30 June
2020.

Death estate

Value of estate 850,000

Spouse exemption (250,000)

Chargeable estate 600,000

 £

IHT liability 600,000 at 40% 240,000

 The due date for the IHT liability of £240,000 payable by the personal
representatives of Alfred’s estate is 30 June 2020.
 Alfred’s wife will inherit £250,000, his brother will inherit £50,000 and the children
will inherit the residue of the estate of £310,000 (850,000 – 250,000 – 50,000 –
240,000).

Basic inheritance tax planning

Make gifts early in life

Gifts should be made as early in life as possible so that there is a greater chance of the
donor surviving for seven years.

Gifts made just before death will be of little or no IHT benefit, and may result in a capital
gains tax liability (whereas transfers on death are exempt disposals).

Make use of the nil rate band

Gifts can be made to trusts up to the amount of the nil rate band every seven years
without incurring any immediate charge to IHT.

Gifts to trusts within seven years of each other will be subject to the seven year
cumulation period, whilst an immediate charge to IHT will arise if a gift exceeds the nil
rate band.

However, as far as TX-UK is concerned, there is no advantage to making gifts to a trust

on death. This will not save any IHT.

Skip a generation
When making gifts either during lifetime or on death, it can be beneficial to skip a
generation so that gifts are made to grandchildren rather than children. This avoids a
further charge to IHT when the children die. Gifts will then only be taxed once before
being inherited by the grandchildren, rather than twice.

Of course such planning depends on the children already having sufficient assets for
their financial needs.

Residence nil rate band

Given that the residence nil rate band is only available where inheritance is by direct
descendants, rearranging the terms of a will can save IHT.

EXAMPLE 26
Victor has an estate valued at £1,300,000, including a main residence valued at
£500,000. He has not made any lifetime gifts. Victor’s wife died on 17 May 2009 and all
of her estate was left to Victor. Under the terms of his will, Victor has left his main
residence to his brother, with the residue of the estate left to his children.

Currently, Victor’s estate will benefit from a nil rate band of £650,000 (325,000 +
325,000). The residence nil rate band is not available because the main residence will
not be inherited by a direct descendant.

Victor could amend the terms of his will so that his brother inherited £500,000 of other
assets, with the main residence being included within the residue. A residence nil rate
band of £300,000 (150,000 + 150,000) would then be available, saving IHT of £120,000
(300,000 at 40%).

There is no reason why Victor’s brother could not purchase the main residence from the
children following Victor’s death.

Capital gains tax (CGT)

Although the interaction of IHT and CGT is not examinable at TX-UK, the two taxes
could be examined within the same question and the information given could be
relevant to both taxes.

For a lifetime gift of unquoted shares, the IHT transfer of value will be based on the
diminution in value of the donor’s estate. In contrast, for CGT purposes the valuation will
be based on the market value of the shares gifted.
As far as tax planning is concerned, a lifetime gift can avoid or reduce the IHT that
would arise if assets were retained until death. However, the potential IHT saving must
be weighed against any immediate CGT cost. There are no CGT implications if assets
are retained until death, because transfers on death are exempt disposals. CGT is not
an issue if a cash gift is made.

EXAMPLE 27
On 20 June 2019, Craig made a gift to his grandson of a residential property valued at
£250,000. The gift of the property resulted in a chargeable gain of £145,000.

The value of the property is expected to increase to £300,000 by 31 December 2021,

and to £340,000 by 31 December 2026.

Craig is an additional rate taxpayer. He will not make any other disposals during the tax
year 2019–20, and he has not made any previous lifetime gifts. Craig has an estate
valued in excess of £2,000,000 for IHT purposes.

CGT liability
Craig’s CGT liability for 2019–20 is:

Chargeable gain 145,000

Annual exempt amount (12,000)

133,000
 £

Capital gains tax:

133,000 at 28% 37,240

Craig dies on 31 December 2026

The gift of the property is a PET. If Craig lives until 31 December 2026, then the PET
will be exempt because he will have survived for seven years. The IHT saving will be
£136,000 (£340,000 at 40%), so a lifetime gift would appear to be beneficial despite the
immediate CGT cost of £37,240.

Craig dies on 31 December 2021

If Craig were to die on 31 December 2021, the IHT saving (ignoring annual exemptions)
would be:

Value of house on
31 December 2021 300,000

Value of house on
(250,000)
20 October 2019
 £

Increase in value 50,000

IHT saved: 50,000 at 40% 20,000

Note that although there will be no IHT liability in respect of the PET, the PET will
reduce the amount of nil rate band available against Craig’s death estate.

The lifetime gift no longer appears to be beneficial because the immediate CGT cost of
£37,240 outweighs the IHT saving of £20,000.
Written by a member of the TX-UK examining team