Introduction to Inheritance Tax

What it is and how it works

Inheritance tax (IHT) is a capital tax, charged according to the value of an asset rather than the income or gain generated by that asset.

Commonly thought of as a death tax, IHT is chargeable in more than one way and at more than one rate. The basis of charging IHT is the drop in value of a person’s assets when a gift or a transfer is made and this drop in value is then charged to tax.

UK domiciled persons are subject to IHT on their worldwide estates whilst non UK domiciled persons are only subjected to the charge on assets situated in the UK. IHT is charged on transfers above a value known as the Nil Rate Band (NRB), which for UK domiciled individuals is currently set at £325,000.

Charges during lifetime

Most lifetime gifts and transfers of value between individuals are ‘Potentially Exempt Transfers’ (PETs). They are potentially exempt in that they only become chargeable should the transferor die within seven years of the date of the transfer.

Chargeable Lifetime Transfers (CLTs) also exist, the main example being the creation of a trust [1]. To the extent that a CLT, along with the value of any PETs and CLTs made in the preceding seven years, exceeds the NRB the value is taxed at the lifetime rate of 20%. With reference to the creation of a trust this is commonly referred to as the entry charge.

The charge on death

On death, the value of a person’s estate along with the value of transfers made within the preceding seven years is combined and, to the extent that the NRB is exceeded, IHT is charged at 40%.

Where a lifetime transfer exceeds the NRB and becomes chargeable because of the death of the settlor, the tax rate is tapered downwards by reference to how many years the gift was survived by:

Number of years Less than 3 3-4 4-5 5-6 6-7
Tapering 0% 20% 40% 60% 80%
IHT charged at 40% 32% 24% 16% 8%

CLT’s becoming taxable on death qualify for relief for the lifetime tax suffered.

A number of exemptions and reliefs can apply to reduce the IHT charge, including:

Inter-spouse transactions

Transactions during lifetime or on death between UK domiciled spouses do not fall within the charge to IHT.

Political and charitable legacies

Assets left to qualifying political parties or charities are exempt from IHT.

In addition, where at least 10% of an estate is left to qualifying charities, the balance of the estate is taxed at a reduced rate of 36%.

Business Property Relief (BPR)

BPR offers relief from IHT on qualifying business interests and assets. Not all businesses qualify, but those that do can attract relief at either 50% or 100%.

Agricultural Property Relief (APR)

APR offers relief to qualifying agricultural business assets at either 50% or 100%. Significantly, only the agricultural value of the asset can be relieved from tax, not any development value (or similar) over and above the agricultural value.

The charge on trustees

As well as an entry charge on settlement of a trust, most trusts are subject to a system of IHT charges levied at ten yearly intervals and on assets leaving the trust (so called exit charges). Trustees can benefit from up to the whole of a settlor’s NRB by reference to the settlor’s seven year history at the point of creation, and both periodic and exit charges are levied on a sliding scale, but at no more than 6%.

The next step

If you would like to discuss inheritance tax then please contact one of the members of our team.

[1] Nearly all trusts settled during lifetime are now relevant property trusts, the creation of which is a CLT.