INSIGHT: Understanding the U.K. Inheritance Tax Regime

As part of the 2019 Conservative Party conference in early October 2019, the U.K. Chancellor Sajid Javid openly remarked that the U.K.’s inheritance tax (IHT) legislation was in need of long overdue reform. Acknowledging what he perceived to be the public’s general opposition to the IHT, the chancellor even went so far as to suggest the government could scrap the so-called death tax altogether.

IHT in the U.K.

IHT regimes vary by national jurisdiction. If we look to Germany, for example, small inheritance bequests are exempt from being taxed, while a sliding scale is employed which takes into account the family relation and the value of the assets being inherited, before a final bill is produced.

In countries like Australia, Israel and India, inheritance tax systems have been completely abolished, while in other places like the Cayman Islands and Guernsey, the tax has never been implemented.

In the U.K., the history of the tax is long and complex, stretching back to 1694, when a probate duty was introduced on personal property in wills. An estate tax was later added in 1796 to help the government fund the Napoleonic Wars. Something akin to IHT as we generally recognize it today was announced in 1894, when a duty on the capital value of land first began.

In 1986, IHT was introduced to replace a similar capital transfer levy by then-Chancellor Nigel Lawson, who considered the latter to be hampering small businesses by disincentivizing the liquidation and transfer of assets. Interestingly, and reflective of its complicated history, is the fact that the tax is technically an estate tax rather than a transfer tax: assets are taxed by the U.K. government prior to being transferred to the beneficiaries stated in the will.

A Controversial Tax

IHT has long been a controversial issue in the UK. Public opinion polls have consistently shown that it is one of the country’s least popular forms of taxation, with 59% of people in favor of abolishing it.

While few taxes command popularity among those who pay them, IHT has been particularly vilified since its inception. The question is—why are so many people opposed to IHT in the U.K?

I believe there are two reasons for this. Firstly, out of principle there appears to be a general objection to double taxation. In other words, it is seemingly unfair to pay tax on assets which have already been purchased through a taxed income. Secondly, IHT can cause undue stress on parents trying to ensure their children and grandchildren have the necessary financial security in life.

Further, navigating the regulations guiding IHT in the U.K. can also be a complex task. Here at Market Financial Solutions we commissioned an independent survey of 800 U.K. landlords this year, which revealed that 28% do not understand recent reforms to inheritance tax. Specifically, there was confusion over the tax-free allowance for properties that are passed down.

Taking all these factors into account, one might be able to see why there is a general opposition to IHT. Nonetheless, understanding the basic regulations governing the tax regime can ensure that individuals holding U.K. assets are able to put into place effective inheritance plans that comply with the IHT. This is particularly true for U.K. expatriates, immigrants and emigrants, where the IHT rules are not as clear cut as they are for residents.

Of course, there are some interesting arguments in favor of the tax that should not be forgotten.

The purpose of IHT, to break the cycle of accumulated wealth and redistribute it to those less well-off, appears noble. In the U.K., there are a number of worthy exemptions, including cases involving serving army personnel who pass away while on duty. Furthermore, it works on a sliding scale and is not a flat tax, meaning those inheriting a larger estate have to pay more.

How Does IHT Work?

In the U.K., the tax is calculated to be 40% of the deceased person’s estate, with all gifts given in the seven years prior to death also subject to being charged—albeit incrementally less the earlier they are given.

The first 325,000 pounds ($420,575) of each estate is exempt as part of the “nil rate band,” and this is transferable between partners if it goes unused—meaning together a married couple could be entitled to pass on 650,000 pounds without needing to pay tax. In addition to this, further exemptions were introduced in 2017 for the passing down of family homes, so that those who inherit a family property are less likely to be forced to sell the asset in order to pay the tax. For the 2019–2020 tax year, an additional allowance of 150,000 pounds has been added, meaning a potential total exemption of up to 800,000 pounds for married couples.

Managing IHT Effectively

As with all taxes, governments regularly tweak the bands, rates and exemptions of the duty. Of course, there are common practices employed as part of a tax-efficient investment strategy.

People planning to pass on their assets to a family member can often gift items to those they plan to pass their wealth on to. Doing so reduces the actual amount of capital that will be left in the will.

What about actual exemptions that apply to IHT? In short, individuals are able to give up to 3,000 pounds of their estate away each tax year before it is subject to IHT. In addition, up to 250 pounds can be given to any number of people in a year. Similarly, parents may gift 5,000 pounds to each of their children if they are getting married, whilst grandparents may give 2,500 pounds and anyone else can give 1,000 pounds. The U.K. government also incentivizes charitable giving, meaning that if you leave 10% of your estate to charity, you will only be charged 36% on the remainder—4% less than the standard rate.

There are also slightly more sophisticated options. By putting money in pensions, you can potentially reduce your IHT bill. If someone passes away before turning 75, benefits left in a money purchase pension can be paid as a lump sum to a beneficiary without any tax to pay. So long as the fund remains in drawdown, it will be free from IHT—allowing each generation to pass on the account tax free.

And Those Outside the U.K.?

The U.K. administrative process of collecting an estate, paying IHT and passing on assets to beneficiaries is known as “probate.” Cross-border probate abides by the same process; however, the rules are different for foreign nationals with U.K. assets, U.K. nationals with overseas assets, expatriates with U.K. assets and those who live in the U.K. whose official home for tax purposes is abroad (non-domiciled residents).

The cross-jurisdiction nature of international probate makes it a far more complicated process and it is always a good idea to seek out professional counsel before making significant decisions.

For foreign nationals with U.K. assets, including those in the U.S., it is important that HM Revenue & Customs understands your non-domiciled status, otherwise you may be liable for the 40% duty on your worldwide assets, not just those in the U.K.

Since April 2017, all U.K. property, whether held directly or indirectly, became exposed to IHT, meaning that property investors will be subject to IHT to the extent the value of their shares is attributable to U.K. property. In this way, offshore corporate and trust structures no longer provide protection from the tax.

Planning Points

It is difficult to say in what direction IHT may be taken by governments of the future. It is neither broadly popular among the public, nor draws in a significant amount of revenue for the government, so reductions (or even abolition) may be more likely than one might expect.

What is clear, however, is that for those who take the time to comb through the details and seek professional advice, it is possible to effectively conform to current rules and regulations without suddenly being faced with an unforeseen tax bill.

For those living internationally, including in the U.S., this is even more crucial as recent reforms have added further complexity.

Paresh Raja is the CEO of Market Financial Solutions.

The author may be contacted at: info@mfskuk.com

Market Financial Solutions is not a tax specialist. MFS advises that independent professional advice should be sought for all issues concerning inheritance tax.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.