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Technical: Ordering of absolute gifts in IHT planning

23 May 2017

Continuing her series of IHT and estate planning articles for Professional Paraplanner, Kim Jarvis, technical manager, Technical Services Team, Canada Life looks at absolute gifts and in particular a potentially exempt transfer (PET) in relation to a chargeable lifetime transfer (CLT).

In my last article I considered two structures where a client can make a chargeable lifetime transfer (CLT) for inheritance tax (IHT) purposes but still continue to receive a benefit.

Now, I will consider the situation where an individual makes a potentially exempt transfer (PET) – outright gifts to individuals and gifts to bare trusts – and a CLT in the same seven year period.

When an individual makes an outright gift to an individual or into a bare trust, the transfer becomes totally exempt if the donor survives seven years from the date of the gift. However, if the donor dies within seven years of making the gift IHT may become payable as the PET fails and is treated as a chargeable transfer.

It makes no difference to the IHT paid by the estate, but this means that if a PET is made before a CLT and it subsequently fails, it will be brought into account for the purposes of the ten-year periodic charge on the CLT.

Let us consider an example of how a failed PET can impact a ten-yearly anniversary charge.

Example 1

• On 6 January 2013 Alex made an outright gift of £300,000 to his daughter, Kate. As this is a PET no tax is payable when the gift is made

• On 6 January 2017 Alex sets up a discretionary trust, for his grandchildren, with a gift of £200,000

• Alex regularly used his £3,000 annual gift exemption and so the whole amount is a CLT

• As the gift is below the available nil rate band (£325,000) no entry IHT is payable

• Alex, sadly, dies on 2 January 2019 with an estate of £150,000.

Gifts made within seven years before death are included in the estate and are looked at in chronological order. As Alex died within seven years of the PET, the PET failed and became chargeable.  As there was a 100% transferable nil rate band available for his personal representatives to claim there was no IHT to pay on the gifts or the estate.

In January 2027 the trustees of the discretionary trust must calculate whether a periodic charge is due. Let us assume that the trust value has grown to £300,000 and the nil rate band has increased to £350,000

The trustees might assume that as the trust value is lower than the nil rate band that no tax is payable, but it should be remembered that if any other chargeable transfers have been made seven years before the trust was created, the full nil rate band will not be available.

Alex died within seven years of the PET, causing the PET to fail and become chargeable. This means that the available nil rate band at the ten-yearly anniversary (2027) is £50,000 (£350,000 -£300,000).

Therefore a periodic charge will be payable in 2027 on the trust of 6% x (£300,000 – £50,000) = £15,000. This also means that exit charges would apply for the next ten years on any money paid out to the beneficiaries.

On each subsequent tenth anniversary the available nil rate band will be less (due to the failed PET) and therefore the chances of periodic and exit charges continuing to apply will be greater.

In view of the above, the suggested order of gifting (where a number of simultaneous solutions are being considered to solve a specific IHT solution) is to make CLTs before PETs. However, even though this is the suggested order if the deceased made a CLT, followed by a PET made within seven years of the first gift, the earlier CLT may also be caught by the IHT regime, inviting the possibility of IHT being paid on gifts made up to 14 years pre-death.

Let us now consider an example where a CLT has been made in the seven years before a failed PET.

Example 2

• On 6 April 2012 Simone sets up a discretionary trust, for her children, with a gift of £300,000. Simone regularly used her £3,000 annual gift exemption and so the whole amount is a CLT.

• As the gift is below the available nil rate band (£325,000) no entry IHT is payable

• On 6 April 2017 Simone made an outright gift of £100,000 to her brother, James. As this is a PET no tax is payable when the gift is made.

• Simone, sadly, dies on 15 April 2019 with an estate of £150,000.

• It is assumed that the nil rate band available to use against Simone’s estate is £325,000.

At first glance, you may think that the CLT, having occurred more than seven years before death, can be ignored, and yes, when calculating the tax payable on the estate it can be. But when calculating the tax payable on a failed PET, the legislation states that it is necessary to consider gifts that occurred in the seven years preceding the PET. So, even though the failed PET is under the nil rate band you cannot assume that no tax will arise on the failed PET.

To calculate the nil rate band available to offset against the failed PET, it is necessary to look back seven years from the date of the PET.

Even though there is no IHT liability on the CLT (as Simone survived seven years from making the gift), it nevertheless reduces the available nil rate band which can be used against the failed PET.

So, in the above example, when calculating the IHT position of the failed PET, the nil rate band is reduced by the 2012 CLT (£300,000), meaning that there is only £25,000 available of her nil rate band to offset against the failed PET. Giving an IHT liability of £30,000 (40% x (£100,000 – £25,000)). No taper relief is available as Simone died within two years of making the gift. James being the recipient of the gift would be liable to the IHT. But if he can’t or will not pay, the amount due then it will come out of Simone’s estate.

But there is no IHT liability on Simone’s free estate because this rule does not apply to the ‘cumulation’ against the rest of the estate.

Even though there is tax payable on the failed PET, at the ten-yearly anniversary of the discretionary trust (2025) the trustees will be able to utilise a full nil rate band against the value of the trust fund.

CLTs should be made before PETs so that failed PETs do not impact on the periodic charges however, the longer the period between the CLT and the subsequent PET the longer during which the donor’s death will give rise to this extra liability.

For example, if Simone’s PET had been made a week after her CLT there would be a window of only one week during which she might die and trigger this extra liability. However, if Simone’s PET had been made six years and 11 months after her CLT there would be a window of nearly 14 years during which her death would trigger this extra liability.

Summary

A CLT made within 14 years of death may not itself create an IHT liability on death, nevertheless, it could reduce the nil rate band available to offset against a subsequent PET where death occurs within seven years of that PET and 14 years of the initial CLT.

Remember that this 14 year shadow is only an issue if the total of the CLT and PET exceeds the available nil rate band, meaning that tax is payable on the failed PET. And that it does not affect the death IHT computation.

For those considering making a PET and a CLT at or around the same time, it is logical to make the CLT before the PET for the reasons mentioned above. However, when making a PET, the donor should also be wary of any CLTs made in the previous seven years, and this is where professional advice is paramount.

 

 

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