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Inheritance tax review: the OTS’s second report

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Speed read
The second report of the Office of Tax Simplification (OTS) on its review of IHT looks in detail at the more complex issues raised in its 2018 call for evidence. Recommendations include: combining lifetime gift exemptions into a single allowance; reducing the PET period from seven to five years; abolishing taper relief for gifts made more than three years before death and the 14-year rule; reforming rules on allocation of the nil-rate band to lifetime gifts; removing the CGT uplift on death; and aligning rules on trading activity for CGT and BPR purposes. Some of the OTS proposals could be significant and some stray into policy, but they are not all as radical as they might have been, and in some instances the OTS has clearly tried to take a pragmatic approach. It remains to be seen whether the recommendations will be taken forward.

In January 2018, the chancellor, Philip Hammond, asked the Office of Tax Simplification (OTS) to conduct a review of inheritance tax (IHT). Its remit, as its name suggests, was to focus on simplifying IHT, and it has now published its second report which suggests several ‘packages’ of reforms. Christmas must have come earlier than ever this year.

The recommendations within the report cover: the lifetime gifts exemptions; the potentially exempt transfer (PET) survival period and taper relief; the interaction of IHT with CGT; APR and BPR reliefs for businesses and farms; life insurance proceeds; and anti-avoidance.

Although simplification was the aim, the report has inevitably strayed into matters of policy, and it proposes some potentially significant changes. Remember, however, that this is not a government consultation, and past OTS proposals have been slow to evolve, if at all.

The lifetime gifts exemptions package

I was pleased to see the report quote from my firm’s consultation response: ‘We think all of the exemptions should be increased to more meaningful amounts, and this is long overdue.’ As the report confirms, the reliefs have not kept pace with inflation: some gift allowances have remained unchanged since 1975.

The OTS therefore recommends that the government should:

  • reconsider the levels of the allowances, suggesting that there could be a de minimis allowance to replace that currently available for small gifts (£250) and noting that an increase to £1,000 would only reduce IHT receipts by £100k p.a.;
  • replace the annual gift exemption and that for gifts in consideration of marriage with an overall personal gifts allowance; and
  • reform the exemption for normal expenditure out of income or replace this with a higher personal gift allowance (one example suggests a figure of £25,000).

The first two are not very controversial, indeed to be welcomed, but the third is hard to justify and could prove problematic in practice. Dealing first with the concept of IHT, this replaced capital transfer tax (CTT) which, in turn, replaced estate duty (ED). They have all been taxes on capital, not income and the normal expenditure out of income exemption stretches right back to ED. It applies to current income, which will only just have borne income tax, so how could the government justify further (double?) taxation on a gift of that income? The OTS states that:

‘[S]ome people believe that inheritance tax should be a tax on capital or accumulated wealth and that this justifies the existence of the normal expenditure out of income exemption. However, such a distinction is not used for other inheritance tax purposes, which makes the exemption appear anomalous’.

With respect, that rather misses the point that IHT is a capital tax. The OTS also notes that IHT on death may catch employment income received a month beforehand, which is indeed true, but the same does not apply in all cases. Trustees, for example, have a five-year period in which to determine whether to accumulate (and so capitalise) income or not, which surely does demonstrate a distinction between current and past income.

And what of the many taxpayers who have existing arrangements that rely upon the normal expenditure exemption, arrangements that may not be at all easy to ‘unravel’? Common examples will be the payment of premiums on life insurance policies held in trust and payments to support grandchildren, maybe in the form of school fees. There are other recommendations in respect of insurance policies (touched on below) but this report seems blithely to ignore the impact of its suggestions on existing situations.

The replacement of this exemption with a fixed annual cap could also discriminate against taxpayers who run their own businesses and receive income by way of dividends. They tend to have fluctuating income streams depending upon the performance of their businesses and in some years will have income they can give away, but in others not. A fixed annual cap is therefore unlikely to be of much use to the self-employed.

The PET survival period and taper package

Here the ‘package’ that the OTS recommends comprises:

  • a reduction of the seven-year survival period for PETs to five, so that outright gifts made more than five years before death are exempt from IHT;
  • the abolition of taper relief; and
  • removing the need to take account of gifts made outside the seven-year period (e.g. where there is a combination of chargeable and potentially exempt transfers, when the ‘look-back’ period can extend to 14 years).

Taken together these reforms would provide welcome simplification for many and, although there will inevitably be losers as well as winners if taper relief is completely abolished, the report states that the seven-year period in fact raises little tax.

However, the next two, related, recommendations are rather trickier. These are that:

  • the nil-rate band (NRB) should be allocated proportionately across all lifetime gifts and then to the estate, rather than to the earliest lifetime gifts first; and
  • the executors’ liability for tax on lifetime gifts should be restricted: (a) to funds under their control which are due to the beneficiary concerned; and (b) so that it applies only when HMRC cannot collect the tax from the beneficiary itself.

As someone who frequently finds herself acting as an executor, these suggestions seemed attractive at first. But from the perspective of an adviser on wealth protection and devolution, there is a sting in the tail. If the NRB is pro-rated across all failed PETs, rather than applied to gifts in their chronological order, the potential tax on any PET will be impossible to calculate in advance (the liability will depend on what other gifts the donor makes in future and so how much of the NRB will ultimately be available). Planning would then become much trickier, especially when trying to take out suitable PET insurance. So, might this perhaps be swapping one set of problems for another?

Interaction with CGT

The OTS rejects the idea of replacing IHT with CGT on three grounds:

  • the two taxes serve different objectives;
  • it would double the number of taxable estates; and
  • it would cost the exchequer a significant amount, raising only about a quarter of the current IHT revenue.

However, the report takes issue with the CGT uplift in value of assets on death, which is felt to distort taxpayer behaviour by encouraging donors to hold on to assets until they die in order to avoid paying CGT on lifetime gifts. This may be a perennial bogeyman for HMRC, but it is very far from the experience of most practitioners, namely that people sell or pass on businesses for all sorts of reasons which have nothing at all to do with tax.

It is certainly true that the current rules can lead to either double or zero taxation: donors who pay CGT on a lifetime gift may also suffer IHT if they die within seven years; whereas if there is no IHT on death (for example, on gifts to a spouse or of business or agricultural assets), the beneficiary will both escape IHT and receive a tax-free uplift in the CGT base cost. The OTS’s conclusion is that the CGT uplift should be removed for assets passing on death which benefit from IHT reliefs, so that the surviving spouse or other beneficiaries of those assets receive them at the deceased’s historic base cost. Insofar as IHT and CGT have indeed been regarded as alternatives, that is one option. However, another way to remove some of the distortion would be to extend CGT hold-over relief to all lifetime gifts. Sadly, there is no mention of that idea at all in the report.

Moreover, if the spouse exemption on death is effectively limited to IHT, not CGT, this abolition will affect large numbers of taxpayers and may undermine a surviving spouse’s ability to fund themselves. And how would the principal private residence relief interact with these new rules? Or what would be the impact in cross border situations where taxpayers are also subject to non-UK taxes and are reliant upon an estate duty credit and a step up in base cost? None of these points (and doubtless many more) have been addressed in the report.

Standing back, one is left with an uncomfortable feeling that this particular proposal is effectively an additional 20% (or 28%, in the case of residential property) tax on death, albeit delayed until a subsequent sale or gift. If CGT rates are increased, is the reality that we are looking at something that could eventually end up being another (double?) death tax?

Finally, on this topic, let us briefly remind ourselves of the purpose of the OTS, namely to make suggestions to simplify the taxes which it reviews. It is hard to see how replacing CGT rebasing on death with a no-gain/no-loss arrangement can be described as a simplification: all of the deceased’s historical base cost records stretching back to acquisition or 1982, if later, would need to be accessed and retained following the death.

Businesses and farms APR/BPR package

The focus on business (and to a lesser extent agricultural) reliefs is perhaps surprising, as HMRC commissioned an independent review into the influence of these reliefs on estate planning and inheritances in 2017, which concluded that the use of the reliefs ‘appeared to be genuine and in keeping with policy objectives’. It is also worth remembering the purpose of both IHT and CGT reliefs for business and agricultural assets, namely to protect those businesses from tax charges on a death and thereby enable them to continue. That is particularly important for illiquid businesses, such as those in the agricultural sector and privately-owned companies which may find it difficult to raise money to pay tax.

Undaunted, however, the OTS suggests several proposed reforms to these important tax reliefs, which are dealt with as another ‘package’:

  • The first proposal, justified as a simplification and quite widely anticipated, is to align the trading threshold for businesses across IHT and CGT. The report invites the government to consider whether it remains appropriate for the IHT level (over 50% trading) to be lower than the CGT level (over 80% trading). This would be a big change and, if adopted, the owners of many businesses which include investment assets (including trustees in ‘Balfour’ partnerships) may well face IHT in the event of death or a charge under the relevant property regime. The OTS could have suggested an alignment of the percentages the other way around, giving CGT relief to businesses with a lower trading threshold but, again sadly, it did not do so.
  • The OTS does, though, recommend a review of indirect non-controlling holdings in trading companies to give relief to group structures and to ensure that LLPs are treated appropriately for business relief purposes. This is welcome. 

Other recommendations outside the above ‘package’ include granting IHT relief for furnished holiday lets that qualify for relief from income tax and CGT, and on farmhouses where farmers need to leave for medical treatment or to go into care.

The report also makes a welcome recommendation that HMRC should provide clearer guidance about when a valuation of a business or farm is required; and, if it is, whether this needs to be a formal valuation or an estimate.

In this section of the report, there is also a comment (rather than a recommendation) questioning whether companies listed on AIM should qualify for BPR. If HMRC was minded to change the status of those companies, it could do so very easily, and it would be most unfortunate if this comment dissuaded investors in such companies, which are smaller and riskier companies but undoubtedly need help to attract investment to expand and grow.

Life policies

Here the recommendation is that term policies should be exempt from IHT, whether or not they are written in trust. This seems sensible as many policies are taken out specifically to cover IHT and it is unnecessarily cumbersome to have to create a trust to ensure that the policies are not themselves subject to IHT (although a trust may be useful for other purposes). But, as mentioned above, no attention is given to the position of those who have existing policies in trust which they fund by using the normal expenditure out of income exemption.

Anti-avoidance rules

A suggestion towards the end of the report that would be well received by many is that the pre-owned assets income tax rules (introduced to bolster the gift with reservation provisions) should be reviewed to see whether they work as intended and are still needed.

Grossing up

Grossing up, the bane of many lives, lives on! A whole chapter is devoted to the subject but, in the end, reforming it seems to have proved just too difficult, so it will have to remain a necessary evil.

What did the OTS shy away from?

The report touches upon some other aspects of IHT but makes no formal recommendations on them for various reasons, including:

  • an extension of the spouse exemption to unmarried partners, which the OTS considers would be far reaching and is a matter for a wider government response to social change;
  • reform of the complicated and arbitrary residence nil rate band, which is felt premature as it has not been in force long enough to assess (although it would be much better to abolish it and replace with a higher universal nil-rate band);
  • reform of the reduced rate of IHT for gifts to charity, which is another measure thought to be too new to review; and
  • IHT on trusts, which is already under review by HMRC.

Final thoughts

So, what can we conclude and what practical steps might we all now take?

There is no doubt that the some of the OTS proposals could be significant, but they are not as radical as they might have been, and in some instances the OTS has clearly tried to take a pragmatic, balanced approach to the issues. As with all ideas for reform, if this report gains any traction, there will be winners and losers, but at this stage it is too early to tell where it might lead. Whether it will gain traction is of course a different matter and, in the current political climate, nothing can be guaranteed. Even if Boris Johnson (at the time of writing the front runner in the Tory leadership contest) brings forward an early autumn budget, it seems unlikely that there will be room in that for these proposals. But we have been shown some writing on the wall, as it were, which will be worth bearing in mind when drafting wills or formulating long term tax planning proposals for clients. 

For the OTS report, see

The OTS’s 11 recommendations


  1. As a package, replace the annual gift exemption and the exemption for gifts in consideration of marriage or civil partnership with an overall personal gifts allowance; consider the level of this allowance and reconsider the level of the small gifts exemption; and reform the exemption for normal expenditure out of income or replace it with a higher personal gift allowance.
  2. As a package, reduce the seven-year potentially exempt transfer period to five years, and abolish taper relief.
  3. Remove the need to take account of gifts made outside of the seven-year period when calculating the IHT due (under what is known as the ’14-year rule’).
  4. Explore options for simplifying and clarifying the rules on liability for the payment of tax on lifetime gifts to individuals and the allocation of the nil rate band.
  5. Where a relief or exemption from IHT applies, remove the capital gains uplift and instead provide that the recipient is treated as acquiring the assets at the historic base cost of the person who has died.
  6. As a package, consider whether it continues to be appropriate for the level of trading activity for business property relief (BPR) to be set at a lower level than that for gift holdover relief or entrepreneurs’ relief; review the treatment of indirect non-controlling holdings in trading companies; and consider whether to align the IHT treatment of furnished holiday lets with that of income tax and capital gains tax, where they are treated as trading providing that certain conditions are met.
  7. Review the treatment of limited liability partnerships to ensure they are treated appropriately for the purposes of the BPR trading requirement.
  8. HMRC should review its current approach around the eligibility of farmhouses for agricultural property relief in sensitive cases.
  9. HMRC should be clear in its guidance as to when a valuation of a business or farm is required and, if it is required, whether this needs to be a formal valuation or an estimate.
  10. Ensure that death benefit payments from term life insurance are IHT-free on the death of the life assured without the need for them to be written in trust.
  11. Review the pre-owned asset tax rules and their interaction with other IHT anti-avoidance legislation.