Take advantage of the seven-year rule
If not exempt, an outright gift falls into one of two categories, depending the type of gift and to whom it’s made. These categories are Potentially Exempt Transfers (PETs) and Chargeable Lifetime Transfers (CLTs).
Inheritance Tax exemptions can be achieved by means of making certain exempt transfers, which apply in a number of cases including wedding gifts, life assurance premiums, gifts to your family and charitable giving.
If appropriate, you can transfer some of your assets while you’re alive – these are known as lifetime transfers. Whilst we are all free to do this whenever we want, it is important to be aware of the potential implications of such gifts with regard to Inheritance Tax. The two main types of non-exempt transfers are ‘potentially exempt transfers’ and ‘chargeable lifetime transfers’.
Potentially exempt transfers and chargeable lifetime transfers
Potentially exempt transfers are lifetime gifts made directly to other individuals, which includes gifts to Bare Trusts. A similar lifetime gift made to most other types of trust is a chargeable lifetime transfer. These rules apply to non-exempt transfers: gifts to a spouse are exempt, so are not subject to Inheritance Tax.
Where a potentially exempt transfer fails to satisfy the conditions to remain exempt – because the person who made the gift died within seven years – its value will form part of their estate. Survival for at least seven years, on the other hand, ensures full exemption from Inheritance Tax. Chargeable lifetime transfers are not conditionally exempt from Inheritance Tax. If they are covered by the ‘nil-rate band’ (NRB) and the transferor survives at least seven years, they will not attract a tax liability, but they could still impact on other chargeable transfers.
Chargeable lifetime transfers that exceed the available NRB when they are made result in a lifetime Inheritance Tax liability. Failure to survive for seven years results in the value of the chargeable lifetime transfers being included in the estate. If the chargeable lifetime transfers are subject to further Inheritance Tax on death, a credit is given for any lifetime Inheritance Tax paid.
Following a gift to an individual or a Bare Trust (a basic trust in which the beneficiary has the absolute right to the capital and assets within the trust, as well as the income generated from these assets), there are two potential outcomes: survival for seven years or more, and death before then. The former results in the potentially exempt transfer becoming fully exempt and no longer figuring in the Inheritance Tax assessment. In other case, the amount transferred less any Inheritance Tax exemptions is ‘notionally’ returned to the estate.
Anyone utilising potentially exempt transfers for tax migration purposes, therefore, should consider the consequences of failing to survive for seven years. Such an assessment will involve balancing the likelihood of surviving for seven years against the tax consequences of death within that period.
Failure to survive for the required seven-year period results in the full value of the potentially exempt transfers being notionally included within the estate; survival beyond then means nothing is included. It is taper relief which reduces the Inheritance Tax liability (not the value transferred) on the failed potentially exempt transfers if they exceed the nil-rate band after the full value has been returned to the estate.
The value of the potentially exempt transfers is never tapered so the gift uses up some or all of the nil-rate band for the full seven years with no tapering. The recipient of the failed potentially exempt transfers is liable for the Inheritance Tax due on the gift itself and benefits from any taper relief if the gift exceeds the nil-rate band.
Lifetime transfers are dealt with in chronological order upon death; earlier transfers are dealt with in priority to later ones, all of which are considered before the death estate. If a lifetime transfer is subject to Inheritance Tax because the NRB is not sufficient to cover it, the next step is to determine whether taper relief can reduce the tax bill for the recipient of the potentially exempt transfers.
The amount of Inheritance Tax payable on a gift that exceeds the nil-rate band is not static over the seven years prior to death. Rather, it is reduced according to a sliding scale dependent on the passage of time from the giving of the gift to the individual’s death.
No relief is available if death is within three years of the lifetime transfer. For survival for between three and seven years, taper relief at the following rates is available.
The tax treatment of chargeable lifetime transfers has some similarities to potentially exempt transfers but with a number of differences. When a chargeable lifetime transfer is made, it is assessed against the donor’s NRB. If there is an excess above the NRB, it is taxed at 20% if the recipient pays the tax or 25% if the donor pays the tax.
The same seven-year rule that applies to potentially exempt transfers then applies. Failure to survive to the end of this period results in Inheritance Tax becoming due on the chargeable lifetime transfers, payable by the recipient. The tax rate is the usual 40% on amounts in excess of the NRB, but taper relief can reduce the tax bill, and credit is given for any lifetime tax paid.
Gift of capital
The seven-year rules that apply to potentially exempt transfers and chargeable lifetime transfers could increase the Inheritance Tax bill for those who fail to survive for long enough after making a gift of capital.
If Inheritance Tax is due in respect of a failed potentially exempt transfer, it is payable by the recipient. If Inheritance Tax is due in respect of a chargeable lifetime transfer on death, it is payable by the trustees. Any remaining Inheritance Tax is payable by the estate.
The Inheritance Tax difference can be calculated and covered by a level or decreasing term assurance policy written in an appropriate trust for the benefit of whoever will be affected by the Inheritance Tax liability and in order to keep the proceeds out of the settlor’s Inheritance Tax estate. Which is more suitable and the level of cover required will depend on the circumstances. If the potentially exempt transfers or chargeable lifetime transfers are within the NRB, taper relief will not apply.
However, this does not mean that no cover is required. Death within seven years will result in the full value of the transfer being included in the estate, with the knock-on effect that other estate assets up to the value of the potentially exempt transfers or chargeable lifetime transfers could suffer tax that they would have avoided had the donor survived for seven years.
A seven-year level term policy could be the most appropriate type of policy in this situation. Any additional Inheritance Tax is payable by the estate, so a trust for the benefit of the estate legatees will normally be required.
Where the potentially exempt transfers or chargeable lifetime transfers exceed the NRB, the tapered Inheritance Tax liability that will result from death after the potentially exempt transfers or chargeable lifetime transfers are made can be estimated.
‘Gift inter vivos’
A special form of ‘gift inter vivos’ (a life assurance policy that provides a lump sum to cover the potential Inheritance Tax liability that could arise if the donor of a gift dies within seven years of making the gift) is put in place (written in an appropriate trust) to cover the gradually declining tax liability that may fall on the recipient of the gift.
Trustees might want to use a life of another policy to cover a potential liability. Taper relief only applies to the tax: the full value of the gift is included within the estate, which in this situation will use up the NRB that becomes available to the rest of the estate after seven years.
Whole of life cover
Therefore, the estate itself will also be liable to additional Inheritance Tax on death within seven years, and depending on the circumstances, a separate level term policy written in an appropriate trust for the estate legatees might also be required.
Where an Inheritance Tax liability continues after any potentially exempt transfers or chargeable lifetime transfers have dropped out of account, whole of life cover written in an appropriate trust should also be considered.