Inheritance Tax on lifetime transfers and transfers on death...

Learning Outcomes

This article explains inheritance tax on lifetime transfers for SQE1, including:

• the distinction between Potentially Exempt Transfers (PETs) and Lifetime Chargeable Transfers (LCTs), and how to identify the correct category for a given transfer based on the donor, recipient, and type of property involved
• the operation of the seven-year rule, taper relief, and the nil-rate band for PETs and LCTs, including the cumulative ordering rules and the practical “14-year” trap when earlier LCTs affect later failed PETs
• how to compute lifetime and death IHT on PETs and LCTs, including grossing up where the donor pays lifetime tax, recipient liability on failed PETs, and the interaction between PETs, LCTs, and the nil-rate band on death
• the main exemptions and reliefs for lifetime transfers—annual exemption, small gifts, normal expenditure out of income, spouse/civil partner and charity exemptions, business property relief, and agricultural property relief—and how they are applied and potentially clawed back
• the key CGT implications of lifetime gifts, focusing on when hold-over relief is available for gifts of business assets or chargeable transfers, and how CGT interacts with IHT in typical SQE1-style problem questions

SQE1 Syllabus

For SQE1, you are required to understand inheritance tax on lifetime transfers, with a focus on the following syllabus 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 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.

The IHT regime is cumulative and chronological. Each transfer is analysed in order, and earlier chargeable transfers reduce the nil-rate band available for later transfers within the relevant seven-year window. Valuation is by reference to the donor’s loss in value at the time of the transfer (the “loss to donor” principle), supplemented by specific valuation rules such as “related property” where holdings of connected persons increase value.

Key Term: loss to donor principle
The value of a lifetime transfer is the reduction in the donor’s estate caused by the transfer (not necessarily the market value of the item gifted in isolation).

Key Term: related property
Certain assets (often shares or matching chattels) owned by connected persons are valued together if this produces a higher value. The donor’s asset is then valued at the enhanced level and the retained part is valued consistently.

Note that the residence nil-rate band (RNRB) applies only to transfers on death where a qualifying residence is closely inherited. It does not apply to lifetime transfers.

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.

Transfers that are fully exempt (for example, to a UK-domiciled spouse/civil partner or to charity) are neither PETs nor LCTs because they are exempt when made.

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, reduced by any applicable exemptions and reliefs.

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.

In a failed PET, the recipient is primarily liable for the IHT attributable to that failed gift. The value is determined at the date of the gift (not the date of death), subject to the “loss to donor” principle and related property rules if they apply. Where appropriate, specific fall-in-value provisions can substitute a lower value at death for the original value at transfer.

Certain transfers are ignored altogether for IHT, such as reasonable maintenance of family members and costs of a child’s education or training; these are not transfers of value for IHT.

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. It applies only where there is tax to reduce (it is irrelevant if the transfer falls entirely within the nil-rate band).

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.

Common taper percentages:

• death within 0–3 years: no reduction
• 3–4 years: 20% reduction
• 4–5 years: 40% reduction
• 5–6 years: 60% reduction
• 6–7 years: 80% 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, and the PET is taxed at death rates (currently 40%) on the portion not covered by the nil-rate band. PETs are taken in chronological order, and earlier chargeable transfers (including earlier failed PETs and LCTs) reduce the nil-rate band available to later ones.

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.

Key Term: failed PET
A PET that becomes chargeable because the donor died within seven years of making the gift.

A planning trap arises because an LCT made before a PET can affect the nil-rate band available when the PET later fails. An LCT made up to seven years before the PET is included in the cumulative total for the PET when recalculated at death. This often creates the appearance of a “14-year” window: death can bring into account an LCT made more than seven years before death if it falls within seven years before the PET under assessment.

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.

Worked Example 1.2

Scenario:
In March 2010, Noor makes an LCT of £200,000 to a discretionary trust (after exemptions). In April 2016, Noor makes a PET of £300,000 to her daughter. Noor dies in May 2020.

Answer:
The PET fails. To assess IHT on the PET, cumulate earlier chargeable transfers made in the seven years before the PET (April 2009–April 2016). The 2010 LCT of £200,000 falls within that window, so the PET’s available nil-rate band is reduced by £200,000. At death (NRB £325,000), £125,000 of the PET is covered at 0% and £175,000 is taxed at 40% = £70,000. Noor died between four and five years after the PET, so taper relief reduces the tax by 40%: £70,000 × 60% = £42,000. The trust’s 2010 LCT is not re-taxed because it was made more than seven years before death; only the PET’s calc picks it up for cumulation.

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 the lifetime rate.

Key points on LCTs:

• lifetime tax is charged at 20% if the trustees pay it
• if the donor pays the lifetime tax, the transfer is “grossed up” (25% rate) because the tax itself is part of the donor’s transfer of value
• the small gifts exemption (£250 per donee) does not apply to transfers into trust
• the annual exemption (£3,000) can reduce the value of an LCT

Immediate and Additional Tax

At the time of the LCT, IHT is charged at 20% on the value above the donor’s available nil-rate band. If the donor pays the tax instead of the trustees, grossing up applies and the effective lifetime rate becomes 25% on the chargeable amount. 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. Taper relief then applies to the recalculated death tax on the LCT if death occurs more than three years after the transfer.

Key Term: grossing up
Where a donor pays lifetime IHT on an LCT, the tax paid is itself a transfer of value. The rate is 25% on the chargeable amount to reflect the grossed-up transfer.

Worked Example 1.3

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%).

Worked Example 1.4

Scenario:
Priya settles £400,000 into a discretionary trust. Her nil-rate band is fully available. She elects to pay the lifetime tax herself.

Answer:
The entire £400,000 is above the nil-rate band only to the extent it exceeds £325,000: £75,000 is chargeable. Because Priya pays the lifetime tax, grossing up applies at 25%. Lifetime IHT = £75,000 × 25% = £18,750. For IHT purposes, Priya’s transfer includes the tax she pays. If Priya dies within seven years, death tax is recalculated at 40% on £75,000 = £30,000, reduced by the lifetime tax paid (£18,750), and taper relief may reduce any balance depending on the interval before death.

Exemptions and Reliefs for Lifetime Transfers

Several exemptions and reliefs can reduce or eliminate IHT on lifetime transfers. These must be applied in the correct order.

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, and the current year’s exemption is applied before the brought-forward amount. It is allocated to transfers in chronological order.

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. There is no monetary cap; evidence of regularity and surplus income is critical.

Key Term: business property relief (BPR)
Relief from IHT at 50% or 100% for transfers of qualifying business assets, such as businesses, interests in businesses, or shares in unquoted trading companies. Ownership period and trading conditions must be satisfied.

Key Term: agricultural property relief (APR)
Relief from IHT at 50% or 100% for transfers of qualifying agricultural property, by reference to its agricultural value and occupation/ownership conditions.

Spouse/civil partner and charity exemptions (full exemption subject to UK domicile rules for spouses/civil partners) apply before any reliefs. BPR and APR reduce the value transferred if their conditions are met. Lifetime-only exemptions (annual exemption, small gifts, marriage gifts, and normal expenditure out of income) then apply to any non-exempt balance. For LCTs, remember the small gifts exemption does not apply to gifts into trust.

Further details:

• spouse/civil partner exemption may be restricted if the recipient spouse is not UK domiciled (a fixed exemption cap applies unless an election is made)
• normal expenditure out of income requires a pattern of giving, funded from surplus income, with no reduction in the donor’s standard of living
• BPR can be 100% (for unquoted trading company shares and interests in a business) or 50% (for certain quoted shares with voting control and personally owned assets used by a controlled company/partnership)
• APR is measured against agricultural value; any excess market value may potentially qualify for BPR if business conditions are satisfied
• for lifetime transfers, BPR/APR can be clawed back if the transferee does not retain qualifying property until the donor’s death within seven years (or if qualifying conditions cease to be met)

Worked Example 1.5

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.

Worked Example 1.6

Scenario:
Marcus, with substantial surplus income year-on-year, pays £1,500 per month into a savings account for his adult daughter for four consecutive years. He has maintained his normal standard of living throughout.

Answer:
On the facts, these payments are likely exempt as normal expenditure out of income. The regularity (monthly), the source (income), and absence of any reduction in Marcus’s standard of living support the exemption. There is no monetary limit. If established, no PET arises for these sums.

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 when calculating IHT on that PET. Later failed PETs also take into account earlier failed PETs and LCTs to determine the cumulative total.

The ordering rules are critical:

• at the time of a lifetime LCT, only earlier LCTs in the preceding seven years reduce the available nil-rate band (PETs are ignored while the donor is alive)
• on death, when recalculating tax on a failed PET or a recent LCT, include earlier chargeable transfers in the seven years before the transfer under assessment (this can pull in an LCT made more than seven years before death if it falls within seven years before the PET)

Worked Example 1.7

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.

Worked Example 1.8

Scenario:
Leila makes the following transfers:

• June 2015: LCT to a trust of £150,000 (after exemptions)
• July 2018: PET to son of £200,000
• January 2021: PET to daughter of £250,000
  Leila dies in March 2022. Nil-rate band at death is £325,000.

Answer:
Assess chronologically:

• 2018 PET (failed): consider chargeable transfers in the seven years before July 2018. The 2015 LCT of £150,000 reduces the nil-rate band to £175,000, leaving £25,000 of the PET chargeable at 40% (£10,000) subject to taper (death between 3–4 years, reduce by 20% → £8,000).
• 2021 PET (failed): consider chargeable transfers in the seven years before January 2021: the 2015 LCT (£150,000) and the now-chargeable 2018 PET (£200,000 minus NRB covered). For ordering, include the net chargeable amount of the 2018 PET in the cumulative total. Assume the 2018 PET used £175,000 of NRB and had £25,000 chargeable; cumulative chargeable total thus £175,000 used of NRB plus £25,000 chargeable, leaving only £150,000 of NRB for the 2021 PET. Therefore, £100,000 of the 2021 PET is taxed at 40% (£40,000). Taper does not apply to the 2021 PET (death within 0–3 years).

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. Relief may be available under s.165 TCGA for business assets, and under s.260 TCGA where the transfer is chargeable to IHT (including at 0%).

Key CGT-IHT interactions:

• gifts to individuals do not generally qualify for CGT hold-over unless the asset is a business asset under s.165
• gifts into most trusts are LCTs for IHT and may allow hold-over under s.260 even if the IHT rate is 0% (because the transfer is chargeable in principle)
• anti-avoidance restrictions apply: hold-over is not available where the settlor, spouse/civil partner, or minor unmarried children can benefit from the trust
• for residential property disposals, trustees and individuals may have different CGT rates, and reporting deadlines (notably 30-day reporting for UK residential property) can apply

Worked Example 1.9

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.

Worked Example 1.10

Scenario:
Jade gifts an investment portfolio (quoted shares, not business assets) worth £200,000 (base cost £120,000) to her adult son. She has made no prior transfers.

Answer:
The gift is a PET for IHT. For CGT, there is a disposal by Jade with a £80,000 gain. As the asset is not a business asset and the transfer is not to trustees, hold-over relief is not available. Jade may have CGT to pay (subject to her annual exemption and rates), while IHT will only arise if she dies within seven years.

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. For LCTs, identify who pays the lifetime tax: if the donor pays, grossing up applies (25%). Cumulative ordering is important: earlier chargeable transfers reduce the nil-rate band available to later PETs if they fail.

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, including the practical “14-year” trap
• The immediate and deferred tax consequences of PETs and LCTs, including recipient liability on failed PETs
• Grossing up where the donor pays lifetime IHT on an LCT (25% rate)
• 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
• BPR/APR key conditions and potential clawback on lifetime transfers if the donor dies within seven years and qualifying conditions cease
• The interaction between IHT and CGT on lifetime transfers, and the availability and limits 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
• loss to donor principle
• related property
• grossing up
• failed PET