Although no tax is popular it almost goes without saying that Inheritance Tax (IHT) is by far the UK's least popular tax. That despite the fact that it impacted only about 4% of estates in 2020-21, says Gerry Brown, Trust and Estate Planning Specialist, QB Partners.
Most commentators and advisers would agree that IHT needs reform but there is little or no agreement as to the way in which the tax should be restructured. Of course there is a body of opinion which suggests that the tax be abolished.
I'm gradually coming round to the view that an incoming Labour government (and that seems a realistic assumption) will make some significant changes to IHT.
A straight 40% charge is too severe - my bet is on the introduction of a reduced rate - £100,000 @20%?. Funded by reductions in business and agricultural relief?
Meanwhile, the Institute for Fiscal Studies (IFS), the UK's leading independent economics research institute, has reviewed some of the options for reform in its Green Budget.
IHT currently raises approximately £7bn a year. The IFS forecasts that by 2032-33 the IHT yield will rise to just over £15bn. Can the current government, in a time of projected increases in public spending afford to abolish IHT? Certainly the Labour party has shown no indication that it would abolish the tax if in power following the next general election.
The projected increase in the yield will largely arise because of an increase in the wealth held by pensioners and early retirees. It is worth noting that the IFS estimate is higher than that suggested by the Office of Budget Responsibility (OBR) used by the Treasury.
The IFS also observed that inherited wealth is growing compared with earned incomes, and this trend is set to continue.
The current ‘nil rate band', extended by the ‘residence nil rate band', allows many couples to pass £1 million free of IHT. As previously mentioned the proportion of deaths resulting in an IHT charge was around 4% in 2020-21, but this proportion is set to increase to over 7% by 2032-33.
The IFS analysis suggests that by 2032-33, one person in eight (12%) will have an IHT liability either on their own death or the death of a spouse or civil partner.
The IFS identified several problems with the design of IHT. Reliefs for agricultural and business assets and the exemption of most pension pots from IHT, offer relatively avoidance strategies.
The residence nil-rate band (RNRB) will be available if a person's estate includes a home and this is left to children or other direct descendants. The quantum of RNRB available is limited to the value of the home that is left to the direct descendants. There are also provisions to ensure that an individual who might lose some entitlement to RNRB because of a move to a less valuable home, or into a nursing or care home, is still able to qualify for RNRB. The rules are complex. It is widely assumed that RNRB primarily benefits homeowners in London and South-East England.
Abolishing RNRB (currently set at £175,000) coupled with an increase in the nil rate band by an equivalent amount (to £500,000) would cut the IHT yield by about £700 million each year. The proportion of deaths resulting in IHT would remain at approximately 4%. It is argued that this change would make IHT "fairer".
Agricultural relief effectively exempts the value of farms subject to a minimum holding period. Land farmed by the owner becomes exempt after two years. Land let to other farmers becomes effectively exempt after seven years. The relief was introduced in the early part of the twentieth century with the objective of preventing the break up of farms on the death of the owner. IFS considers that this objective is not being met as there is no requirement that the estate benefiting does not have had to farmed the land.
Business relief exempts from IHT the value of interests in a business and of shares in an unlisted company. The relief is confined to trading activities; investments are excluded from the scope of the relief. Sole traders and members of partnerships qualify for the relief as well as shareholders in unlisted trading companies. The relief is available even where the deceased was an ‘arm's length' investor.
The IFS argues that if the purpose of the relief was to protect employment in small family firms on the death of the owner then it should not apply to "outside" investors who are not involved in the running of the business. Around 80% of all business relief (by value) arises in respect of shareholdings in unlisted traded businesses (most notably AIM shares). It is hard to see how those shareholders had any active involvement in the conduct of the business.
The case for bringing pension pots within the scope of IHT is much less compelling. Inherited pension funds are of course subject to income tax where the deceased was over age 75. Extending that treatment to funds where the deceased is under 75 would seem to be a simple step to nullify arguments for the extension of IHT to such funds.
The IFS has calculated that "Abolishing agricultural and business reliefs and bringing pension pots within the scope of inheritance tax could raise up to around £1½ billion a year." This could fund an increase in the nil-rate band to around £525,000 or a cut in the inheritance tax rate from 40% to around 25%.
It remains to be seen how much effort governments, of whatever political persuasion, are prepared to reform and simplify IHT. There have been many missed opportunities to do so.
