The proposed changes to discretionary trust taxation and the introduction of the settlement nil-rate band (NRB) mean that gifts made in the seven years before a discretionary trust is settled will not be taken into account when calculating periodic and exit charges. Trustees of new trusts would therefore no longer need to investigate the settlor’s gifting history.
However, there is still the need for executors to look at gifts made up to 14 years before a settlor’s death. In addition, taper relief is widely misunderstood. These factors combined mean that beneficiaries may be in for an unexpected inheritance tax (IHT) bill up to seven years after they have received a gift.
The 14-year rule
The 14-year rule is relevant when calculating IHT due on gifts that failed because the settlor died within seven years of making that gift.
A chargeable lifetime transfer (CLT) made up to 14 years before the death of the settlor can result in an IHT liability on a subsequent failed potentially exempt transfer (PET) or a second CLT.
A PET will always fall out of the equation after seven years, when it becomes exempt.
In effect there are two separate IHT calculations on death: the seven-year cumulation for assets owned by the settlor at death, with any tax payable by the executors; and the seven-year cumulation on gifts made within seven years of death, with any tax payable by the recipient of the relevant gift (which may be an individual or trustees).
Normally, if no lifetime tax was payable because a CLT was wholly within the available NRB then there would have been no extra tax to pay on death after the settlor survives seven years. However, if a second gift is made within seven years of a CLT and the settlor then dies within seven years of that second gift, the original CLT is taken into account to calculate any liability on the subsequent gift. This applies even though the original CLT was made more than seven years before the settlor’s death.
Calculating IHT on failed gifts
Each gift made in the seven years prior to death should be looked at in isolation when calculating any IHT liability, starting with the oldest gift.
The ‘available NRB’ for each failed gift is the standard NRB plus any transferable NRB, less gifts made in the previous seven years. Note that the transferable NRB is only available when calculating the IHT due following death – it is not available in lifetime when calculating IHT due on CLTs. An example of how this works is laid out in Box 1.
Taper Relief
Taper relief is misunderstood by many who believe it acts to reduce the total value of a gift. In fact, it only applies to reduce the tax due once the seven-year cumulation of gifts has exceeded the NRB, and only then if the settlor survives three years from the date of the gift.
Failed gifts that fall fully within the available NRB on death suffer no direct tax themselves, but other parts of the estate may be brought into a charge to IHT by a failed gift, effectively taxing the value of the failed gift in full.
Where at least a portion of a failed gift exceeds the available NRB, taper relief may be applied to reduce the tax payable. Taper relief means that if the donor survives for at least three years, a reduced percentage of the full death rate of
40 per cent will be used on the taxable portion of a failed gift. The rate at which IHT is applied is explained in Table 1, and an example of how this works is in Box 2.
Fall in value relief
There may be further relief where a PET becomes chargeable on death, the gifted property is still owned by the recipient and its value has fallen since the date of the gift. Where ‘fall in value relief’ is claimed, the failed PET will be valued at the market value on the donor’s death rather than the value at the time of the gift. If the donee has sold the property to an unconnected person prior to the donor’s death the value will be the market value at the date of sale.
Fall in value relief can be used in conjunction with taper relief. But it cannot be used when calculating the seven-year cumulation for calculating tax on subsequent gifts or on the death estate; the value at the time of the gift will apply in these circumstances. Relief must be claimed by the recipient of the gift, as the person liable for the tax.
Planning considerations
Where gifts near or above the NRB are being made over time, it is often worth considering a gifting strategy on a seven-year-and-one-day basis in order to avoid the impact of the 14-year rule.
When gifting over the NRB, bear in mind that tax falls on the beneficiary of the later gifts and taper relief is only available where the settlor survives at least three years.
Keeping clear records of lifetime gifts and where exemptions are used will be invaluable to executors.
Victoria Harman is a chartered financial planner at Hargreaves Lansdown
