Streamlining inheritance tax? Better late than never

For too long we have been living with a tax which does not do what it says on the tin. It is not a tax on the inheritances received by a person, but on certain lifetime and death transfers made by a person. Worse, the current effect of the tax is far removed from its original policy intention. Even worse, IHT can be hideously complex, almost capricious, in the way it can catch out unsuspecting families.

When introduced in 1975, the capital transfer tax was intended to tax only the wealthiest individuals. As chancellor, Denis Healey threatened at the time that the aim was to squeeze the rich until their pips squeaked. This policy approach continued when capital transfer tax became inheritance tax in 1986. In the course of the following 32 years, while wealthier families have learned how careful planning can help mitigate or eliminate the effects of IHT, it has become a major worry for ordinary people up and down the UK.

This policy drift coupled with a major shift in the tax base demographic are two of the principal reasons behind repeated calls for a root-and-branch review of the way IHT operates. On the face of it, therefore, the current review should be welcomed and we should be eagerly awaiting publication of the terms of reference. I fear, however, that the reality may be different. 

While the chancellor's letter to the OTS was driven by a wish "to ensure that the system is fit for purpose and makes the experience of those who interact with it as smooth as possible", he goes on to emphasise that the "review should include a focus on the technical and administrative issues".

Key Points

• The proposed IHT simplification seems to be led by a concern for administrative convenience rather than the desire to overhaul the tax
• The tax, which once fell on the wealthiest families, now often falls on those of average wealth
• Philip Hammond’s request to the OTS was specific about fixing distortions in the terms of the tax

The OTS is well known for its bravery in putting forward dramatic and well-thought-through proposals for reform, but the chancellor’s carefully chosen words suggest that he is encouraging the OTS to think inside the box, not outside it.

Of course, anything which can be done to simplify the tax and its administration would be welcome.

Simpler disclosure

As the scope of IHT has increased, so has its complexity. At the same time, some exemptions such as the annual exemption, the marriage exemption and the small gifts exemption have not kept pace with inflation. The effect of all of this is that many parents worry that, after a lifetime of prudence and careful saving, the taxman may become one of the greatest beneficiaries of their estates on their deaths.

It is often almost impossible to undertake effective IHT planning shortly before a charge on death occurs. But taking action early, and planning for the distribution of assets or maximising the reliefs available, could mean that IHT is fully mitigated and that the next generation benefits from the full value of an estate. Interestingly, the chancellor seems open to the idea of making routine estate planning easier, with simpler disclosure processes.

A good example of the need for simpler processes is the main residence nil rate band (RNRB). This is being phased in from April 2017, and the ability to claim this additional allowance should not be assumed. There are complex rules to consider, including conditions regarding who inherits the property and downsizing, as well as a tapering of the allowance for those with estates worth in excess of £2m. By any standards, RNRB is a fine example of a simple piece of political willpower getting bogged down in administrative practicalities.

The chancellor is also keen for the OTS to look at "whether the current framework causes any distortions to taxpayers’ decisions surrounding transfers, investments and other relevant transactions". Undoubtedly it does.

As IHT law currently stands, individuals who are retired with wealth in excess of the nil rate band (or double the nil rate band for couples) should consider putting a plan in place to deal with IHT. Often, children with parents in that position can formulate an IHT plan together with them so that, with straightforward actions, tax planning can be mitigated. 

Pension planning

Nevertheless, the desire of many parents to help their children onto the housing ladder now means they face a conundrum. While they would like to do more to help their children by providing money towards the mortgage deposit, their assets are illiquid. At first sight, this is where the pensions freedoms might have come into play. Undoubtedly, more people are drawing money out of their pension plans for diverse purposes, including inter-generational wealth planning.

However, many people are realising that individuals who die before the age of 75 can pass on the pension fund tax-free, without any restrictions. When someone dies over the age of 75, the fund can be withdrawn in stages and taxed at the beneficiaries’ marginal income tax rates, rather than being subject to an immediate 55 per cent tax charge. Suddenly, the undrawn value of a pension plan becomes an attractive asset for those worried about inheritance tax.

Those familiar with inheritance tax will know that none of these criticisms are new. So why should the chancellor invite the OTS to review IHT now, especially when Brexit leaves parliament with so little time to debate any significant tax proposals?

The clue is to be found in these words in the chancellor's letter to the OTS: "Also look at how current gift rules interact with the wider IHT system".

If calls for reforming IHT have for years been piling up like straws on the back of the proverbial camel, then HMRC's recent letters to major donors to the Brexit campaign represent the straw which broke the camel’s back.

In those letters, HMRC pointed out that Brexit campaign gifts did not qualify for any inheritance tax exemption, so were chargeable lifetime transfers with tax payable immediately. Defending those letters, the chancellor promised to consider whether a change of law was necessary (although he expressed a reluctance to backdate any such change).

So there we have it. It seems that one of the improbable effects of Brexit has been to usher in a review of IHT.

Anything which can be done to create a tax based on 21st-century policy aims, to simplify the legislation, to reduce the need for ordinary families to have to engage in complex tax planning, and to reduce the burden of administration will be welcome. While I very much doubt that we will see the fundamental review which is necessary, it is good to travel hopefully. When the terms of reference are published I will be scrutinising them in detail.

George Bull is a senior tax partner at RSM