Inheritance Tax on lifetime transfers and transfers on death - Anti-avoidance provisions

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Overview

Inheritance Tax (IHT) and its anti-avoidance rules are key in estate planning and tax law. For SQE1 FLK2 exam candidates, understanding these mechanisms is essential. This article delves into strategies related to lifetime transfers and transfers on death, exploring the legal framework that governs these areas. By examining IHT legislation, relevant case law, and practical examples, students will gain the knowledge needed to excel in this challenging exam section.

Inheritance Tax Overview

IHT is imposed on asset transfers at death, covering both lifetime and post-death transfers. The tax rate is 40% on assets above the nil-rate band of £325,000 per individual.

Legislative Framework

Core legislation under the Inheritance Tax Act 1984 includes:

  1. Section 1: Establishes IHT on chargeable transfers.
  2. Section 3: Defines chargeable transfers, including lifetime and post-death.
  3. Section 7: Details Potentially Exempt Transfers (PETs).

Rates and Thresholds

  • Nil-rate band: £325,000
  • Rate above nil-rate band: 40%
  • Residence nil-rate band: Additional allowance for main residences to direct descendants (since 2017)

Lifetime Transfers

Potentially Exempt Transfers (PETs)

PETs are initially exempt lifetime gifts. If the donor passes away within seven years of the gift, it becomes taxable, with liability based on the remaining time in the seven-year period.

Taper Relief

If death occurs within seven years, a taper relief reduces the tax:

  • 0% for years 0-3
  • 20% for years 3-4
  • 40% for years 4-5
  • 60% for years 5-6
  • 80% for years 6-7

Chargeable Lifetime Transfers (CLTs)

CLTs, common in discretionary trusts, are taxed if they exceed the nil-rate band.

Anti-Avoidance: Section 104 IHTA 1984 addresses "related settlements" to prevent repeated nil-rate band use.

Transfers on Death

These occur when an estate is distributed after death. IHT is calculated on values exceeding the nil-rate band.

Estate Valuation

Estate value includes all deceased's assets, minus liabilities, to find the net value.

Anti-Avoidance: Section 171 IHTA 1984 allows valuation adjustments if the sale within three years of death exceeds the agreed value.

Anti-Avoidance Measures

Gifts with Reservation of Benefit (GROB)

Section 102 IHTA 1984 ensures assets, where the donor retains benefits, remain part of their estate.

Case Law: In Ingram v IRC [2000], the House of Lords highlighted the transaction order in IHT planning.

Associated Operations

Section 268 IHTA 1984 allows HMRC to assess transactions collectively.

Example: John transfers his home to a trust but continues living rent-free, which could be seen as a series of operations aimed at avoiding GROB rules.

Pre-Owned Asset Tax (POAT)

Introduced by the Finance Act 2004, POAT applies income tax to assets given away but still used by the donor.

Application: Electing to treat the asset as part of the estate avoids this charge.

Settlor-Interested Trusts

Sections 49-52 IHTA 1984 include these trusts within the settlor's estate, preventing potential tax benefits.

Disclosure of Tax Avoidance Schemes (DOTAS)

DOTAS mandates disclosure of tax avoidance schemes to HMRC, with criteria for IHT schemes:

  1. Hallmarks: Identify reportable schemes, like avoiding GROB rules.
  2. Disclosure: Must be done within five days.
  3. Penalties: Up to £1 million for non-disclosure.

Practical Application: Case Study

Eleanor, a widow, plans to gift her £2 million estate to her children with minimal IHT:

  1. Transfers £1 million home to a discretionary trust (CLT).
  2. Lives rent-free (potential GROB issue).
  3. Gifts £500,000 to each child (PETs).
  4. Sells occupation rights for £200,000 (associated operation).

Analysis:

  1. The CLT triggers an IHT charge above the nil-rate band.
  2. GROB rules may apply due to continued occupation.
  3. PETs start the seven-year IHT countdown.
  4. Selling occupation rights could negate GROB avoidance.

This example underscores the importance of understanding IHT anti-avoidance measures.

Conclusion

Navigating Inheritance Tax rules is essential for the SQE1 FLK2 exam. Key points include:

  1. Differentiating lifetime and post-death transfers.
  2. Applying the seven-year rule for PETs and taper relief.
  3. Managing GROB rules in estate planning.
  4. Identifying associated operations that undermine tax savings.
  5. Addressing settlor-interested trusts and POAT impacts.
  6. Understanding DOTAS's role in mitigating aggressive avoidance.

By mastering these concepts and their applications, candidates will be equipped to handle complex IHT scenarios in exams and practice.