IHT Exemptions

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    Exemptions

    In this article we are going to look at inheritance tax exemptions which occur when making gifts either during the testator’s lifetime or under a will. This article will make sure that you understand how these exemptions work and what tax advantages they give to a testator in terms of mitigating their tax liability under their estate.

    The starting point is being able to recognise under what Act there are provisions for inheritance tax exemptions available to any client. The source of these exemptions is found under sections 18-29 of the Inheritance Tax Act 1984 (1). Let us consider the inheritance tax exemptions for a testator and also examine how these exemptions can be used to make sure you can mitigate the client’s tax liability against their estate effectively.

    What is often forgotten and is of major importance, is that exemptions from tax do not all arise on death. Should a testator have an inheritance tax issue there are ways which the testator can, in his or her lifetime, begin the process of mitigating inheritance tax liability.

    The first is the most obvious and is the most well known exemption. This is where transfers are made between spouses and civil partners and is otherwise known as ‘the spousal exemption’ (2). This section states: “to the extent that the value transferred is attributable to property which becomes comprised in the estate of the transferor’s spouse or civil partner.” This means all gifts between spouses and civil partners are exempt in terms of inheritance tax.

    The above would work where gifts are made both during a testator’s lifetime and at death, in terms of transfers made between spouses and civil partners and would therefore be exempt from tax. It is important, however, to remember that this gift needs to be made completely to the spouse or the civil partner. For example, if gifted to a mother during her lifetime and then on to a spouse, this will not attract the spouse exemption.

    Also you will need to remember the treatment with regard to trusts differ in terms of the spousal exemption. Immediate post death interest trusts will benefit from the spousal exemption rule as these trusts will be seen as a gift under the Inheritance Act.

    While the life tenant is a spouse of the trust and remains alive there will be no adverse tax problems on first death, in other words this attracts a full spouse exemption.

    If this is compared with the older style trusts being the ‘interest in possession’ trusts which unlike the immediate post death interest trusts these are not seen as gifts made between spouses. The ‘interest in possession’ trusts are usually made to a number of beneficiaries only one of which being a spouse. However, this would loose the exemption simply because these gifts are to a number of beneficiaries and, therefore, unlike the ‘immediate post death interest’ the ‘interest in possession’ trusts will loose the benefit of the spousal exemption.

    For those testators who have a spouse or civil partner who are not domiciled within the United Kingdom, you will need to remember these spouses/civil partners are limited in the sense that only the first fifty five thousand pounds (£55,000.00) are exempt from inheritance tax. Anything over this amount will be liable to inheritance tax.

    The question has often been raised that the spouse exemption should exist for long term cohabiting couples, as they have the same relationship but without the inheritance tax benefits. The following point was raised in the case of Executor of Holland deceased v IRC (2003) (3). The court considered the above point of should long term cohabiting partners qualify for spousal relief, or something similar in terms of tax relief. The main facts examined were the length of time of the cohabitation. The court examined the differences between long term cohabitation and married couples and whether both should be viewed in the same manner. It was held the differences in both styles of relationships to be viewed as follows: The bond of marriage referred, “to being a commitment of mutual rights and obligations which related to maintenance throughout their lives and death”. However, when the court examined the bond between long term co-habitees it was held this did not provide such love ties hence special tax relief provisions is only available between spouses and civil partners.

    The next type of exemption with regard to inheritance tax liability transfers we will examine is those which are made to charities. These types of transfers are given under section 23 of the Inheritance Act 1984 (4). The amount a testator can give to a charity is unlimited. This relief used to be limited to United Kingdom based charities only, however, in the case of Persche v Finanzamt Ludenscheid (2009) (5), the European Court found that this limitation was too restrictive, due to the exemption only being applied to UK based charities and they held it to be a direct breach of European law.

    The outcome was the British government had to extend the principle of exemption to incorporate European charities.

    This principle of exemption to gifts made in life and death also extends to gifts made to political parties, as they are also seen to be exempt in terms of inheritance tax. The most important point of political party gifts is there are strict guidelines as to who qualifies based on the definition of what is ‘a political party’.

    To determine whether a political party qualifies for this exemption one of the two following factors need to be satisfied. The first is whether the party has at least two members elected to the House of Commons in the last general election. The second is have they had one member of its party receive 150,000 votes in the last election. This means that more obscure political parties need to meet the above requirements to ensure that the gift will be eligible for exemption under the Inheritance Tax Act (6).

    There are also other institutes which qualify for similar relief in terms of gifts made under a will. These are national bodies and non-profiting-making. The Inheritance Tax Act 1984 (7) contains a list of museums, art galleries, universities, libraries, local authorities and government departments which would qualify in schedule 13 of the Act. Non-profit making organisations are generally described as covering areas which are either historic or scientific, important land and buildings and will also be
    eligible for this exemption.

    There is also a yearly inheritance tax allowance exemption which the testator should take full benefit of, which can be used either in life or on death. The Inheritance Tax Act 1984 under section 19 (8), provides an annual exemption of three thousand pounds (£3,000.00). This exemption is available alongside all the other exemptions which we have so far looked at in this article.

    This exemption can be rolled over from the past year in that a whole or part of any unused yearly exemption can be rolled over, but this can only be up to a maximum two years worth of allowance. The best way of looking at this is see how this works in an example. If ‘A’ transfers nothing in year one, six thousand pounds (£6,000.00) of relief will be available on the following year. If only four thousand pounds (£4,000.00) is transferred in year two this will leave a balance of two thousand pounds (£2,000.00) of the annual relief left to be used.

    The annual exemption must be allocated to the first transfer in any tax year even though that transfer would otherwise be potentially exempt.

    This means it is more tax efficient to make a life time chargeable transfer early in the tax year than a potentially exempt transfer.

    For example:

    Richard has not made any transfers in 2011/2012 and he gives to Jeannifer three hundred and thirty one thousand pounds (£331,000.00) in a discretionary trust. Providing that he survives 7 years and receives no benefit from the trust this will be fully tax exempt.

    The above example is a gift of Nil Rate Band and the two yearly exemptions which makes the total of three hundred and thirty one thousand pounds, tax free providing the settlor lives for 7 years.

    Another great tip for any Will Writer who encounters clients who have a tax liability is to use pilot trusts to put their annual allowance into trust. This could reduce their Inheritance tax liability as illustrated below:-

    Richard and Jeannifer have been married 20 years and have two children who are 14 and 16 years old. They are both in their mid 50’s with an estate worth seven hundred and fifty thousand pounds (£750,000.00). Wally the Will Writer suggests that they each create a pilot trust to put there annual allowance into for the benefit of their children. Wally explains if they do this for a period of 10 years they could mitigate tax liability on their combined estate potentially taking sixty thousand pounds (£60,000.00) out of their combined estate. This would prove to be a great strategy for reducing tax liability.

    The above example illustrates that many individuals each year loose their annual allowances by not using this relief and therefore miss an opportunity to mitigate tax liability on their individual estates.

    In addition to the annual exemption, the testator also has the power to make outright gifts which can be up to a maximum of £250 per donee. These will be exempt see section 20 of Inheritance Tax Act 1984 (9). The important part to remember is this exemption does not apply to the first part of a gift which exceeds £250. For example, a donor who gives three people £250 each does not pay any tax and does not use up any of the £3,000 exemption, but if £600 is given to one donee, £600 of the £3,000 exemption is used up (10).

    There are also gifts which can be made if certain events arise, this particular event is a gift which is made with regard to a relative who is going to marry. The amounts which can be given are listed under section 22 of the Inheritance Act 1984 (11) and this allows the following individuals to make gifts of the amounts below:

    a) £5,000 if made by a parent of one of the parties to the marriage;
    b) £2,500 if made by a remoter ancestor of one of the parties or by a party to the prospective marriage; and
    c) £1,000 in any other case.

    Remember the limit applies to each marriage, not to each donee so the parent cannot give away more than the maximum allowed under section 22 of the Inheritance Act 1984.

    Furthermore, there is an exemption contained within section 154 of the Inheritance Tax Act1984 (12), which applies only to a member of the armed forces. This relief is only applicable to those who die or suffer an incident which leads to their death whilst they are on active service against an enemy or any other war like situation. If this situation occurs and that person dies, then their estate will attract no inheritance tax liability. In this case, and to qualify for such an exemption, the executors will need to obtain a certificate from the Ministry of Defence or the Secretary of State which would highlight any of the following conditions:-

    a) A wound which was inflicted, or an accident occurring or a disease contracted while on active service; or

    b) A disease contracted at some previous time, the death being due to or hastened by the aggravation of the disease, during active service.

    The main proof for this exemption is to ensure the certificate is obtained to certify the testator suffered one of the above circumstances. You can look up this principle which was upheld in the case of Barty-King v Ministry of Defence (1979) (13), this case showed that individual who died 27 years later of cancer showed that the cancer was a direct link to the wounds received whilst in active service.

    Conclusion

    We have seen from this article that there are a number of inheritance tax exemptions available for a testator in both life and death and most of these are not presently being effectively used by individuals during their life. Should a testator simply makes some small gifts during his or her lifetime this can go towards mitigating or even eradicating their inheritance tax liability.

    In some cases where there is an inheritance tax liability, the use of these exemptions by making gifts either to individuals, charities or organisations can create a tax effective will. This could give a double advantage of benefiting some part of society or even go towards a cause which the testator strongly believes in rather than leaving funds to be absorbed by the Inland Revenue.

    1 http://www.legislation.gov.uk/ukpga/1984/51/contents
    2 The Inheritance Act 1984, Section 18, http://www.legislation.gov.uk/ukpga/1984/51/section/18
    3 Holland v Inland Revenue Commissioners [2003] S.T.C. (S.C.D.) 43 [2003] W.T.L.R. 207 Sp Comm
    4 http://www.legislation.gov.uk/ukpga/1984/51/section/23
    5 Persche v Finanazamt Ludenscheid (C-318/07) [2009] P.T.S.R. 915; [2005] W.T.L.R. 1077 Sp Comm
    6 Wills, Administration and Taxation Law and Practice, Sweet & Maxwell, John Barlow, Lesley King and Anthony King
    7 Inheritance Tax Act 1984, sections 24-27
    8 http://www.legislation.gov.uk/ukpga/1984/51/section/19
    9 http://www.legislation.gov.uk/ukpga/1984/51/section/20
    10 Wills, Administration and Taxation Law and Practice, Sweet & Maxwell, John Barlow, Lesley King and Anthony King
    11 http://www.legislation.gov.uk/ukpga/1984/51/section/22
    12 http://www.legislation.gov.uk/ukpga/1984/51/section/154
    13 Barty-King v Ministry of Defence [1979] 2 All E.R. 80; [1979] S.T.C. 218 QBD

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    Matt Walkden Will Writer

    About Matt Walkden

    I am a Professional Will Writer and I offer a small number of other products that complement my Will Writing such as Lasting Power of Attorneys (LPA’s), Fixed Price Estate Administration, often called Probate and some Property Products such as changing a family home from Joint owners to Tenants in Common.

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