Inheritance Tax on lifetime transfers and transfers on death - Lifetime transfers: Potentially Exempt Transfers (PETs) and Lifetime Chargeable Transfers (LCTs)

Learning Outcomes

After reading this article, you will be able to distinguish between Potentially Exempt Transfers (PETs) and Lifetime Chargeable Transfers (LCTs) for inheritance tax purposes. You will understand how the seven-year rule, taper relief, and the nil-rate band apply to lifetime gifts, and be able to identify the main exemptions and reliefs available. You will also be able to apply these rules to typical SQE1-style scenarios.

SQE1 Syllabus

For SQE1, you are required to understand the practical application of inheritance tax to lifetime transfers and transfers on death. In your revision, focus on:

• the distinction between Potentially Exempt Transfers (PETs) and Lifetime Chargeable Transfers (LCTs)
• the operation of the seven-year rule and taper relief for failed PETs and LCTs
• the calculation and use of the nil-rate band for lifetime transfers
• the immediate and deferred IHT consequences of PETs and LCTs
• the main exemptions and reliefs available for lifetime transfers, including the annual exemption, normal expenditure out of income, business property relief, and agricultural property relief
• the interaction between PETs, LCTs, and the nil-rate band when multiple transfers are made

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the key difference between a Potentially Exempt Transfer (PET) and a Lifetime Chargeable Transfer (LCT)?
2. If a donor makes a PET and dies five years later, how is the inheritance tax calculated?
3. How does the annual exemption affect the IHT liability on lifetime gifts?
4. What is the effect of business property relief on a lifetime transfer of shares in a private trading company?

Introduction

Inheritance tax (IHT) applies to certain transfers of value made during a person’s lifetime and on death. For SQE1, you must be able to distinguish between the main types of lifetime transfers—Potentially Exempt Transfers (PETs) and Lifetime Chargeable Transfers (LCTs)—and understand how the IHT rules apply to each, including the impact of the nil-rate band, taper relief, and available exemptions and reliefs.

Types of Lifetime Transfers

There are two principal types of lifetime transfer for IHT purposes:

• Potentially Exempt Transfers (PETs)
• Lifetime Chargeable Transfers (LCTs)

Each is treated differently for IHT, both at the time of the transfer and if the donor dies within seven years.

Key Term: Potentially Exempt Transfer (PET)
A lifetime gift by an individual to another individual (or to certain disabled trusts) that is exempt from IHT if the donor survives seven years from the date of the gift. If the donor dies within seven years, the PET becomes chargeable to IHT.

Key Term: Lifetime Chargeable Transfer (LCT)
A lifetime transfer of value (usually to a trust or company) that is immediately chargeable to IHT at the time of the transfer if it exceeds the nil-rate band.

Potentially Exempt Transfers (PETs)

A PET is a gift made by an individual to another individual (or to a qualifying disabled trust). PETs are not taxed at the time of the gift. If the donor survives for seven years after making the PET, the transfer becomes fully exempt from IHT. If the donor dies within seven years, the PET becomes chargeable to IHT, and the tax is calculated using the value of the gift at the date it was made.

Key Term: seven-year rule
A rule that exempts a PET from IHT if the donor survives seven years from the date of the transfer. If the donor dies within seven years, the PET becomes chargeable.

Taper Relief

If the donor dies between three and seven years after making a PET (or LCT), taper relief reduces the IHT payable on the failed PET or LCT. Taper relief does not reduce the value of the transfer, only the tax due.

Key Term: taper relief
A reduction in IHT payable on a failed PET or LCT if the donor dies more than three but less than seven years after the transfer. The longer the donor survives, the greater the reduction.

Nil-Rate Band and Cumulative Transfers

When a PET becomes chargeable, it uses up the nil-rate band available at the date of death. If the donor made other chargeable transfers in the seven years before the PET, these are cumulated to determine how much nil-rate band remains.

Key Term: nil-rate band
The threshold up to which IHT is charged at 0%. The nil-rate band is applied to chargeable transfers in chronological order.

Worked Example 1.1

Scenario:
Amira gives £350,000 to her son in May 2017. She makes no other gifts. Amira dies in June 2021. The nil-rate band at her death is £325,000.

Answer:
The PET fails because Amira died within seven years. The first £325,000 is covered by the nil-rate band, so only £25,000 is chargeable. IHT is charged at 40% on £25,000 = £10,000. As Amira died between four and five years after the gift, taper relief applies (tax reduced by 40%). The IHT payable is £10,000 × 60% = £6,000.

Lifetime Chargeable Transfers (LCTs)

An LCT is a transfer of value that is immediately chargeable to IHT at the time it is made. LCTs are typically gifts to discretionary trusts, most other trusts (except disabled trusts), or to companies. If the value of the transfer exceeds the nil-rate band, IHT is payable at 20% on the excess. If the donor dies within seven years, additional tax may be due.

Immediate and Additional Tax

At the time of the LCT, IHT is charged at 20% on the value above the nil-rate band. If the donor dies within seven years, the tax is recalculated at the death rate (currently 40%), and credit is given for any lifetime tax already paid.

Worked Example 1.2

Scenario:
Ben transfers £500,000 into a discretionary trust in January 2020. He has made no previous chargeable transfers. The nil-rate band is £325,000.

Answer:
The chargeable amount is £500,000 – £325,000 = £175,000. IHT at 20% is £35,000, payable immediately. If Ben dies within seven years, the tax is recalculated at 40% on £175,000 = £70,000, less the £35,000 already paid. If Ben dies more than three but less than four years after the transfer, taper relief applies (tax reduced by 20%).

Exemptions and Reliefs for Lifetime Transfers

Several exemptions and reliefs can reduce or eliminate IHT on lifetime transfers.

Key Term: annual exemption
Each individual can make gifts of up to £3,000 per tax year free of IHT. Unused exemption can be carried forward one year.

Key Term: normal expenditure out of income
Gifts that are part of the donor’s normal expenditure, made out of income, and do not reduce the donor’s standard of living are exempt from IHT.

Key Term: business property relief (BPR)
Relief from IHT at 50% or 100% for transfers of qualifying business assets, such as shares in unquoted trading companies or interests in a business.

Key Term: agricultural property relief (APR)
Relief from IHT at 50% or 100% for transfers of qualifying agricultural property.

Worked Example 1.3

Scenario:
Chloe gives £10,000 to each of her two children in one tax year. She has not used her annual exemption for the previous year.

Answer:
Chloe can use her £3,000 annual exemption for the current year and £3,000 carried forward from the previous year, covering £6,000 of gifts. The remaining £14,000 (£20,000 – £6,000) is a PET.

Interaction of PETs, LCTs, and the Nil-Rate Band

When a donor makes multiple transfers, PETs and LCTs are cumulated in chronological order to determine how much nil-rate band is available for each. If a PET fails (because the donor dies within seven years), it is cumulated with any LCTs made in the seven years before the PET.

Worked Example 1.4

Scenario:
Dina makes a PET of £200,000 to her daughter in 2016 and an LCT of £200,000 to a discretionary trust in 2018. Dina dies in 2021.

Answer:
The failed PET is cumulated with the LCT. The LCT uses up £200,000 of the nil-rate band, so only £125,000 remains for the PET. £75,000 of the PET is chargeable. IHT at 40% on £75,000 = £30,000. Taper relief applies if death is more than three years after the PET.

Capital Gains Tax and Hold-Over Relief

Some lifetime gifts may also trigger capital gains tax (CGT). However, certain transfers—such as gifts of business assets to trusts—may qualify for hold-over relief, deferring the CGT liability until the recipient disposes of the asset.

Key Term: hold-over relief
A relief allowing the donor and donee to jointly elect to defer CGT on certain gifts, so that the donee acquires the asset at the donor’s base cost.

Worked Example 1.5

Scenario:
Ella transfers shares in her private trading company (acquired for £50,000, now worth £300,000) into a discretionary trust.

Answer:
This is an LCT. IHT is payable if the transfer exceeds the nil-rate band. For CGT, Ella and the trustees can claim hold-over relief, so the trustees acquire the shares at Ella’s base cost (£50,000). The gain is deferred until the trustees dispose of the shares.

Exam Warning

For SQE1, always check the type of recipient and the nature of the transfer. Gifts to individuals are PETs; gifts to most trusts or companies are LCTs. Exemptions and reliefs must be applied in the correct order. Taper relief reduces tax, not the value of the transfer.

Summary

Key Point Checklist

This article has covered the following key knowledge points:

• The distinction between Potentially Exempt Transfers (PETs) and Lifetime Chargeable Transfers (LCTs)
• The operation of the seven-year rule and taper relief for failed PETs and LCTs
• The use of the nil-rate band and the effect of cumulative transfers
• The immediate and deferred tax consequences of PETs and LCTs
• The main exemptions and reliefs available for lifetime transfers, including the annual exemption, normal expenditure out of income, business property relief, and agricultural property relief
• The interaction between IHT and CGT on lifetime transfers, and the availability of hold-over relief

Key Terms and Concepts

• Potentially Exempt Transfer (PET)
• Lifetime Chargeable Transfer (LCT)
• seven-year rule
• taper relief
• nil-rate band
• annual exemption
• normal expenditure out of income
• business property relief (BPR)
• agricultural property relief (APR)
• hold-over relief