There’s no tax quite like it. Inheritance Tax (IHT) feels like the most controversial of all UK taxes and the most talked about. But it makes up less than one percent of tax receipts. Fewer than one in twenty deaths result in a tax charge. Over the next few years, couples will be able to gift up to £1m without paying any IHT.
It doesn’t raise much revenue for HMRC. It affects only a few wealthy individuals. What’s the big deal?
In this post, I’m going to share some of my views on Inheritance Tax. The great news for you readers is that the Office for Tax Simplification is looking for your views too. In a rather new, and I think excellent step, they have set up a short online survey which you can (and should) fill out, sharing your views on IHT (this is the link: https://www.surveymonkey.co.uk/r/SQTNNMT). If you are so inclined, you can respond to the call to evidence, which closes on 8 June 2018 (https://www.gov.uk/government/consultations/inheritance-tax-review-call-for-evidence-and-survey).
My view on Inheritance Tax
In summary, I think that Inheritance Tax needs reform. It is too complicated. Has too many loopholes and exemptions. It has no defined purpose or underlying principle. And it is poorly understood by the greater public – both through poor communication and due to its complexity.
Before I go into more detail, let’s have a quick look at the history of IHT in the UK.
A short history of UK Inheritance Tax
1984 Estate Duty
The concept of modern Inheritance Tax as we see it today dates back to 1894. Back then, the Government at the time created a levy on the land estates to pay off a burgeoning deficit caused (in part) by several centuries of increasingly expensive wars.
This tax, however, was a replacement for a number of (and complicated) levies dating back to the 17th century. These were mainly brought in to fund our involvement in the Napoleonic Wars.
In promoting the 1984 reforms, Sir William Harcourt, the Chancellor of the Exchequer, noted:
The whole system is admittedly difficult and complicated. The Death Duties have grown up piecemeal, and bear traces of their fragmentary origin. They have never been established upon any general principles, and they present an extraordinary specimen of tessellated legislation. Various measures have been made at different times to redress some of their inequalities. Here a patch and there a patch, but each successive modification has only left confusion worse compounded.
The Estate Duty continued for about 50 years, with various tweaks until 1949. In 1949 Sir Stafford Cripps scrapped the legacy and succession duties. In his 1949 budget speech he also railed against the complexity and unfairness of the Estate Duty:
The Legacy and Succession Duties also have the drawback that they impose a proportionately heavier burden on the small than on the large estate. For example, an estate of £6,000, passing wholly to brothers and sisters, pays a total charge of 3 per cent. Estate Duty and 10 per cent. Legacy and Succession Duties, equivalent to a rate of nearly 13 per cent., or 10 per cent over the Estate Duty rate; whereas, at the other extreme, an estate of £3 million would pay only 2½ per cent. over the rate of Estate Duty. It is, no doubt, because of this unequal incidence of the duty that testators, in fact, leave about two-thirds of the total legacies and bequests free of duty, and in all such cases the Legacy and Succession Duties merely become a wholly illogical, extra Estate Duty, falling upon the residue.
Over time, the Estate Duty was tweaked, becoming increasingly progressive over time.
1975 Capital Transfer Tax
In 1975 Dennis Healey and the Labour Party scrapped Estate Duty and replaced it with the Capital Transfer Tax. The idea behind the change was that to try to shut loopholes that meant very large estates were avoiding paying inheritance taxes.
The Inheritance Tax (1986)
The current modern-day Inheritance Tax dates back to Nigel Lawson’s reforms in the mid-80s. He scrapped some of the taxes on lifetime gifting brought in under the Capital Transfer Tax. He also increased the three-year rule on transfers before death to the, now infamous, seven-year rule. In introducing the new Inheritance Tax Lord Lawson decried the unfairness of the Capital Transfer Tax:
My last proposal in this section concerns capital transfer tax which, ever since its introduction by the Labour Government in 1974, has been a thorn in the side of those owning and running family businesses, and as such has had a damaging effect on risk taking and enterprise within a particularly important sector of the economy.
There have been some tweaks over the years. The most notable being the introduction of the Residential Nil Rate Band (RNRB) by George Osborne in 2015. The idea behind that being it was unfair for children to pay tax on their family home.
In short, we’ve come almost 150 years without being able to successfully create a fair or simple inheritance tax. Despite the repeated efforts of several governments and chancellors of all stripes.
The reasons why Inheritance Tax needs reform
I think there are 5 broad reasons why Inheritance Tax needs reform.
1. There’s no defined purpose for Inheritance Tax
The original Estate Duties introduced to fund overseas wars. Over time the reason we still keep an Inheritance Tax has changed. The most oft-cited reason is for redistribution: so that the rich don’t get richer. Instead, sharing some of that wealth for the benefit of all.
But the rationale or underlying principles behind IHT aren’t particularly clear. Redistribution alone is more helpful in designing the tax, but not really for defining why it should exist in the first place.
To illustrate with a tax that has a very clear purpose: Value Added Tax (VAT) has a clear underlying principle. It is a contribution towards the shared services and infrastructure provided by a government that facilitated the good or service to be created. Whether you agree or not with that concept, it’s pretty clear. And the method by which you capture it – taking a proportional cut of the value of goods commensurate with the value of the state provided environment – is intuitively simple.
And this is why we’ve muddled along with a tax that seems unfair and overly complex. We don’t know what we want to achieve with it. As with all things in life, if you don’t know what your aim is you end up flapping about. Much like a lying politician being grilled by Jeremy Paxman.
2. Inheritance Tax fails at the only purpose its supposed to achieve
Even with the purpose, we are left with, redistribution, Inheritance Tax, utterly fails. It’s widely acknowledged that IHT is not paid by the super-rich. Without wanting to pick on somebody, when the late Duke of Westminster passed away, almost no inheritance tax was paid on his estate.
If the purpose of IHT truly is to prevent the perpetuation and concentration of wealth, then it surely fails when the very richest people will not pay a penny. The reality is that IHT is easily avoided with some planning. In fact, it’s arguably negligent to have an accountant or financial planner who doesn’t help you think about some aspects of IHT planning.
Finally, IHT often hits those who just meet the threshold most. These people have spent their lives creating a financial nest egg for their family only to have it hugely taxed upon death.
3. Inheritance Tax is poorly understood
The biggest misconception with Inheritance Tax is that it is paid only on death. IHT is actually a tax on the transfer of value from one person to another. And it’s calculated based on the value of the loss to the transferor’s estate. This means, of course, that IHT can be payable when making gifts during your life.
However, it’s most common on death – the whole estate is bequeathed as the deceased no longer exists (remember, ghosts don’t need to own a house to be able to haunt it). The value of the estate is reduced to zero.
Part of the issue is that most lifetime gifts are exempt. There are a huge number of exemptions and loopholes. Most of those have been created because it seems unfair, and counter-productive, to punish people giving away their wealth during their lifetime.
4. The rules and exemptions are incredibly complex
Because we are trying to avoid punishing people for being good and gifting money, we had to come up with some exemptions. But to prevent those exemptions being abused we had to come up with exemptions to those exemptions (and in some cases exemptions to those exemptions to those exemptions, a double Quick Succession Relief being a potential example).
It also means that the rules you think are simple and universal aren’t. The most commonly known rule is the “seven-year rule” – any gifts made prior to seven years before death are not subject to IHT. But really it’s the “seven-year rule(ish) plus maybe the 14-year rule if it’s a PET”. The (ish) because taper relief reduces the IHT payable if the gift was more than three, but less than seven years, before death. The plus maybe the 14 year rule is because if you made a Chargeable Lifetime Transfer (called a CLT) prior to the seven years followed by a Potential Exempt Transfer (a gift that is exempt from IHT, the PET above) because you need to then look back seven years from the PET to assess whether the donor’s NRB should be reduced.
Starting to get a headache?
5. It is double taxation (?)
The most unpopular aspect of Inheritance Tax is that it is often thought to be double taxation. It is a tax on money taxed somewhere before. I don’t think this is strictly true (see Richard Murphy for a pithy take-down http://www.taxresearch.org.uk/Blog/2006/07/31/lets-be-clear-inheritance-tax-is-not-doube-taxation/).
But these concerns come in part because IHT is a completely different tax to all others. Firstly, its wealth based, rather than income based (like Income Tax, National Insurance). Secondly, its calculated differently to the only other pseudo-wealth tax, Capital Gains Tax (CGT). IHT is calculated as the loss in value to the estate. CGT is measured by the value of the asset. This difference is exasperated by how different assets are treated. Your main home is exempt from CGT, but not (subject to the RNRB) from IHT (not to mention Gifts with reservation of benefit).
Here’s what I would do
Before I start, I should say that I don’t think I have all the answers, and I fully expect (and hope) people will disagree with me. Here we go:
- Come up with a defined purpose for IHT: For example, I think a better purpose for IHT would be something like: “encouraging the transfer of assets between individuals so that greater value is achieved.” That is, if widowed Grandma Doris has a 5-bed townhouse, surely it would be better to gift it to her daughter and her grandchildren than it laying half-dormant. Likewise, Mr Albert of Albert & Sons may want to gift half of his company to his son so that he can continue building the business when Albert wants to retire.
- If we want IHT to redistribute, it actually has to redistribute: The super-wealthy can dodge IHT by making transfers into trust. In legal form, that means they no longer own the assets, but in substance they still do. In all other aspects of accounting, substance trumps form. As long as trusts exist, IHT can and will be dodged. Any IHT rules which don’t account for the trust-fund shuffle will be flawed from the start. Further, parking huge amounts of money into real estate should not be a force-shield against the principle of redistribution.
- Scrap IHT and merge it into CGT: This will eliminate the need for most of the painful probate process. CGT would become payable on death (subject to Nil-Gain-Nil-Loss or Hold-over relief) and most estates will continue to be exempt. Principal Private Residence relief would still be available, and applied on transfer to a spouse and, if desired, the RNRB could be added in for transfers to children. I would scrap the relief for AIM shares, which seems bizarre to me. BPR and APR would be scrap-able as Hold-over relief and Entrepreneurs’ Relief can be utilised. This would hopefully limit the number of lawyers and bankers buying farmland in Montgomeryshire.
- Avoid arbitrary rules as much as possible: Moving IHT into the CGT regime would remove the need for lots of the rules and exemptions. But we must avoid creating arbitrary rules like the “seven years rule” – why seven years and not eight? six?
- Whatever we do, keep it simple: IHT is just too damn complicated. When things get complicated it goes wrong. People get confused. People get angry. Angry and confused people are dangerous (Donald Trump?) Any new system or reform must be simple to understand and easy to communicate. That won’t suit the accountancy and legal firms. But that’s probably a good thing (says the Chartered Accountant…)
I hope you found the post interesting. I’d encourage you to take the short survey by the Office for Tax Simplification (here’s the link again: https://www.surveymonkey.co.uk/r/SQTNNMT).
I’d love to know your thoughts. Should we reform Inheritance Tax? Would you scrap it altogether? If you were in charge, what changes would you make?
All the best,
Young FI Guy