Inheritance Tax on lifetime transfers and transfers on death - Nil rate band and tax rates

Learning Outcomes

After reading this article, you will be able to explain how the nil rate band and tax rates apply to Inheritance Tax (IHT) on both lifetime transfers and transfers on death. You will be able to distinguish between potentially exempt transfers (PETs) and lifetime chargeable transfers (LCTs), apply the correct nil rate band and tax rates, and calculate IHT liabilities in common scenarios, including the effect of taper relief and the residence nil rate band. You will also be able to identify the order in which the nil rate band is used and its transferability between spouses.

SQE1 Syllabus

For SQE1, you are required to understand the operation of Inheritance Tax on lifetime gifts and on death, with a particular focus on nil rate bands, tax rates, and the sequence in which they are applied. In your revision, pay close attention to:

• the definition and application of the nil rate band (NRB) for IHT
• how the NRB is allocated between lifetime transfers and the death estate
• the distinction between potentially exempt transfers (PETs) and lifetime chargeable transfers (LCTs)
• the calculation of IHT at lifetime and death rates, including the effect of taper relief
• the rules for transferring unused NRB between spouses or civil partners
• the operation and tapering of the residence nil rate band (RNRB)
• the order in which transfers are taxed and the impact on IHT liability

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 current nil rate band for Inheritance Tax, and how is it applied when there are both lifetime gifts and a death estate?
2. How does taper relief affect the IHT payable on a PET made four years before death?
3. What is the difference between a potentially exempt transfer (PET) and a lifetime chargeable transfer (LCT) for IHT purposes?
4. How can the unused nil rate band of a deceased spouse be used by the surviving spouse's estate?

Introduction

Inheritance Tax (IHT) is charged on the value of a person’s estate on death and on certain gifts made during their lifetime. The nil rate band (NRB) and the applicable tax rates are central to calculating IHT liability. For SQE1, you must be able to apply the NRB and tax rates correctly to both lifetime transfers and transfers on death, and understand how these interact with exemptions, reliefs, and the order of taxation.

The Nil Rate Band (NRB)

The nil rate band is the threshold up to which no IHT is payable. For the 2023/24 tax year, the NRB is £325,000 and is fixed until at least April 2026.

Key Term: nil rate band (NRB) The maximum amount that can be transferred (either during lifetime or on death) without incurring IHT. The NRB is currently £325,000.

The NRB is used in chronological order against chargeable transfers made in the seven years before death (including PETs that become chargeable and LCTs), and any unused NRB is then applied to the death estate.

Order of Application

When calculating IHT, the NRB is allocated first to the earliest chargeable transfer within the seven years before death, then to subsequent transfers, and finally to the death estate. This order is critical for determining how much of the estate is subject to IHT.

Key Term: chargeable transfer A transfer of value that is not exempt from IHT and is therefore potentially subject to tax.

Transferability of the NRB

If a person dies without using all of their NRB (for example, because their estate passes to a spouse or civil partner, which is exempt), the unused percentage can be transferred to the surviving spouse or civil partner and applied to their estate on death.

Key Term: transferable nil rate band The proportion of the NRB unused on the first death can be claimed and added to the survivor’s NRB on their death.

Types of Lifetime Transfers

IHT distinguishes between two main types of lifetime transfers: potentially exempt transfers (PETs) and lifetime chargeable transfers (LCTs).

Key Term: potentially exempt transfer (PET) A gift made by an individual to another individual (not to a trust or company) that is exempt from IHT if the donor survives seven years.

Key Term: lifetime chargeable transfer (LCT) A gift made during lifetime that is immediately chargeable to IHT, typically gifts to most trusts or companies.

PETs

• No IHT is payable at the time of the gift.
• If the donor survives seven years, the gift is exempt.
• If the donor dies within seven years, the PET becomes chargeable and is taxed using the NRB and rates in force at death.

LCTs

• IHT is payable at the time of the gift if the value exceeds the available NRB.
• The lifetime rate is 20% if the donee pays the tax (or 25% if the donor pays).
• If the donor dies within seven years, additional IHT may be due to bring the total tax up to the death rate (40%).

Tax Rates

There are two main IHT rates:

• 20%: The lifetime rate, applied to LCTs above the NRB.
• 40%: The death rate, applied to the value of the estate (and chargeable transfers) above the NRB.

If 10% or more of the net estate is left to charity, a reduced death rate of 36% applies to the chargeable estate.

Key Term: taper relief A reduction in the IHT payable on gifts made between three and seven years before death. It does not reduce the value of the gift, only the tax due.

Taper Relief

Taper relief reduces the IHT payable on chargeable transfers (PETs or LCTs) made more than three years but less than seven years before death. The relief is applied as follows:

Taper relief applies only to the tax due, not to the value of the gift.

Worked Example 1.1

A donor makes a PET of £400,000 four years before death. The NRB is already used up. What is the IHT payable if the donor dies four years after the gift?

Answer: The IHT at 40% on £400,000 is £160,000. Taper relief at 60% reduces the tax by £96,000 (60% of £160,000), so the IHT payable is £64,000.

The Residence Nil Rate Band (RNRB)

An additional nil rate band applies when a residence is left to direct descendants (children, grandchildren, etc.). For 2023/24, the RNRB is up to £175,000. The RNRB is tapered away for estates over £2 million, reducing by £1 for every £2 above this threshold.

Key Term: residence nil rate band (RNRB) An additional threshold (currently up to £175,000) available when a home is left to direct descendants.

The RNRB can also be transferred between spouses or civil partners if unused on the first death.

Downsizing and the RNRB

If the deceased sold or downsized their home after 8 July 2015, the RNRB may still be available if assets of equivalent value are left to direct descendants.

Worked Example 1.2

An estate is worth £2.3 million, including a residence valued at £700,000. What is the available RNRB?

Answer: The estate exceeds the £2 million taper threshold by £300,000. The RNRB is reduced by £150,000 (£300,000 ÷ 2), leaving £25,000 (£175,000 – £150,000) available.

Sequence of Taxation

When a person dies, the calculation of IHT follows a strict order:

1. Identify all chargeable transfers (PETs and LCTs) made in the seven years before death.
2. Apply the NRB to the earliest transfer, then to subsequent transfers, and finally to the death estate.
3. Calculate IHT at the appropriate rate (lifetime or death rate).
4. Apply taper relief to chargeable transfers made more than three years before death.
5. Apply the RNRB if the residence passes to direct descendants.

Worked Example 1.3

A person makes a LCT of £300,000 to a trust in 2017, a PET of £200,000 to a child in 2019, and dies in 2023 leaving an estate of £500,000. What is the IHT position?

Answer: The LCT uses £300,000 of the NRB, leaving £25,000. The PET uses the remaining £25,000 of the NRB, so £175,000 of the PET is taxable. The estate receives no NRB. The LCT is taxed at 20% when made; if the donor dies within seven years, additional tax is due to bring the total up to 40%. The PET and the estate are taxed at 40%. Taper relief may apply to the LCT and PET depending on the time between the gift and death.

Exam Warning

For SQE1, always apply the NRB to the earliest transfer first, then to later transfers, and finally to the death estate. Do not apply the NRB to the estate before accounting for chargeable lifetime transfers.

Summary

Key Point Checklist

This article has covered the following key knowledge points:

• The nil rate band (NRB) is the threshold up to which no IHT is payable, currently £325,000.
• The NRB is applied in chronological order to chargeable transfers in the seven years before death, then to the death estate.
• PETs are exempt if the donor survives seven years; otherwise, they become chargeable.
• LCTs are immediately chargeable at 20% above the NRB; further tax may be due if the donor dies within seven years.
• Taper relief reduces the IHT payable on gifts made more than three years before death.
• The residence nil rate band (RNRB) provides an additional threshold when a home is left to direct descendants.
• Unused NRB and RNRB can be transferred between spouses or civil partners.

Key Terms and Concepts

• nil rate band (NRB)
• chargeable transfer
• transferable nil rate band
• potentially exempt transfer (PET)
• lifetime chargeable transfer (LCT)
• taper relief
• residence nil rate band (RNRB)