Rethinking inheritance tax: potential options for reform
Mainstream media outlets recently reported that Prime Minister Rishi Sunak was considering IHT cuts as he attempts to attract voters and set his election battle lines. While Downing Street sought to play down speculation, given the backdrop of an impending election and the tax’s divisive and political nature, Inheritance Tax will, no doubt, be a topic of discussion for policymakers, economists and voters over the coming months. Although headlines about “scrapping IHT” may catch the eye, the discussions about potential reforms to the existing IHT framework will be far more nuanced.
What is IHT and how does it work?
Crunching the numbers
Generally speaking, IHT is charged on the value of someone’s estate when they die, taking into account any debts and applying any available allowances, reliefs (business relief/agricultural relief) and/or exemptions (spouse/charity). No tax is charged on the first £325,000 of net assets (the ‘nil rate band’), but 40% is charged on the value of other assets above £325,000, unless the assets are transferred to a civil partner or spouse, in which case they're exempt from tax or attract some form of relief. An additional £175,000 (the ‘residence nil-rate band allowance’) may be available per person if a main residence passes to lineal descendants. As allowances are transferable between married parties and civil partners, this results in the possibility of parents passing up to £1m to their children IHT free.
Gifts and charities
UK charities are exempt from IHT and if the value of the gift in a Will equates to at least 10% of the net estate, then the rate of IHT for any non-exempt beneficiaries drops from 40% to 36%. Although 10% may seem like a lot, in practice, because this is after the application of any allowances, reliefs and exemptions, the resulting loss is actually only 4%.
Business Relief (BR) and Agricultural Relief (AR)
BR and AR are very valuable reliefs which, if applicable, result in a 0% rate of IHT on those assets. BR is available on shares in trading companies and on AIM listed shares and AR is available on agricultural property, such as farmhouses, land and pasture. To qualify for either, specific criteria must be met.
How many estates pay IHT and how much money does it generate?
Since 2001 the percentage of estates that have given rise to an IHT liability has fluctuated between 3-6%. In the tax year 2020/21, there were 27,000 IHT paying estates. This represents only 3.73% of UK deaths and they generated £5.76 billion in IHT.
The Office for Budget Responsibility forecast that in the 23/24 tax year inheritance tax will raise £7.2 billion. This would represent 0.7% of all revenue tax receipts and roughly 0.3% of national income. This is predicted to grow significantly by 2032/33 to around £15 billion in today’s prices due to increasing levels of wealth held by subsequent generations of retirees.
What are the potential changes to IHT?
There are three ways that taxation on death could be changed, either through small changes to the existing IHT framework, larger changes to revolutionise the framework, or by changing the way other taxes operate on death.
Small changes to the existing IHT framework
There are certain easily identifiable parameters that could be changed without overhauling the entire IHT framework. For example:
- Changing the base rate of tax: The rate of IHT could be increased or decreased from 40%. This would represent a fairly seismic shift in current thinking, but isn't beyond the realms of possibility. A reduction in the base rate could be funded by other changes to how IHT or other taxes operate on death.
- Changing the bands: The nil rate band (£325,000) or residence nil rate band (£175,000) or its tapering could be increased or decreased from their current levels. These levels are currently fixed until April 2028 and although they're supposed to now increase in line with inflation, this may not necessarily be the case. Maintaining these bands at their current levels is one way to increase tax receipts, without overtly increasing the levels of taxation.
- Changing the rules on lifetime gifts: As discussed, lifetime gifts within seven years of death become chargeable for IHT purposes on death. This time limit could be increased or reduced as appropriate.
- Amending or removing Business Relief: BR could be amended or removed. One potential idea would be to restrict the level of assets that can be relieved to a certain amount for each estate. This would ensure that small businesses are not adversely harmed, while also increasing tax receipts. An alternative would be to provide specific exemptions for family owned businesses, as long as they remain family owned for a period of time.
- Amending or removing Agricultural Relief: AR could be amended or removed. Again, some sort of cap on the level of relief could be introduced. AR is also currently available for those who own a farm, but don't operate it. This could be amended so that only those who own and operate the farm could benefit from the tax relief.
Bigger changes to the existing taxation framework
There are, of course, more extreme measures that could be taken to reform taxation on death. For example:
- Progressive inheritance tax rates: Inheritance tax on death is currently charged at a flat rate of 40%. This could be changed to a progressive tax rate based on the value of the estate. This may help to alleviate pressures on squeezed middle class families that are asset rich but cash poor, while potentially increasing tax receipts.
- Tax variation based on asset type: Different assets could be charged at different taxation rates. For example, the family home could be charged at a lower taxation rate than investment properties so that fewer families have to sell their home to foot an IHT bill.
- Regional variations: Regional variations in IHT could be introduced to account for differences in the cost of living and local property values, although this may raise questions of regional inequality.
- Remodelling the taxation regime: The current framework doesn't take into consideration the financial position of the beneficiaries. We could remodel our taxation system so that the level of taxation is based on the individual receiving the legacy, rather than the net value of the deceased’s estate. This may encourage a wider distribution of wealth, although there may be challenges in ensuring compliance, and this would need to be comprehensively modelled.
- Abolishing IHT altogether: According to a recent YouGov poll, 55% of respondents supported the idea of abolishing IHT completely.
Changes to other taxes on death
Rather than changing the current IHT framework, it would be possible to change the way that other taxes currently operate on death. For example:
- Charge Capital Gains Tax (CGT) on death: Currently assets benefit from a CGT uplift on death meaning that no CGT is payable on the unrealised gains. According to the IFS charging CGT at the point of death would raise an additional £1.6 billion a year.
- Charge Income Tax (IT) on inherited pension pots: Pension pots are currently exempt from IHT. If income tax was charged on withdrawals from inherited pension pots regardless of the deceased’s age, then additional revenue would be collected.
Conclusion
Whilst it's unlikely that IHT will be abolished entirely, it's widely recognised that reform of the present system is long overdue. Such reform will require careful deliberation and consideration of the possible options; proposed changes are likely to be hotly debated. Designing a system which achieves something fair and equitable, while still encouraging individuals to generate wealth and keep that wealth in the UK, will not be easy.
How might IHT affect your estate?
If you’d like to know more about your estate’s potential IHT liability, please contact us. We offer solutions to help your family across generations to protect and pass on your wealth, always with a real understanding of you and the current tax, law and financial landscape.
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Justin Humphries
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Rebecca Minto
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