Inheritance Tax on lifetime transfers and transfers on death - Valuation principles and transfer of value

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Overview

Inheritance Tax (IHT) plays a key role in estate planning and wealth transfer, affecting transfers made during life and at death. For those taking the SQE1 FLK2 exam, a thorough understanding of IHT valuation rules, value transfers, and the interplay of exemptions and reliefs is essential. This article explores these areas, highlighting recent legal updates and practical to prepare students for the exam.

Valuation Principles in Inheritance Tax

Accurate asset valuation is essential for determining IHT liability. The principles involved are complex and require consideration of multiple factors.

Open Market Value and the "Arm's Length" Principle

At the core of IHT valuation is the open market value principle, as outlined in Section 160 of the Inheritance Tax Act 1984 (IHTA 1984). This means assets must be valued at the price they would achieve in an open market sale, with a knowledgeable seller and buyer acting prudently and without pressure.

Key considerations include:

  • Market conditions and their effect on asset values
  • Asset-specific details impacting marketability
  • Potential for development or change of use

Joint Ownership and Related Property Rules

Valuing jointly held assets involves added complexity:

  • Joint Tenancy: Each party owns an equal share, regardless of contributions
  • Tenancy in Common: Shares are based on the parties' respective interests

A discount, usually 10% to 15%, is applied for the complexity involved in selling partial interests.

The related property rules, found in Sections 161-167 IHTA 1984, add another layer, requiring the consideration of other property interests held by a transferor or their spouse/civil partner to prevent depreciating values through fragmenting ownership.

Valuing Shares: Quoted and Unquoted

Valuing shares and securities presents unique challenges:

  1. Quoted Shares: Valued with the "quarter-up" method per Section 272 of the Taxation of Chargeable Gains Act 1992, averaging the highest and lowest prices and adding a quarter of the difference.

  2. Unquoted Shares: Requires a tailored approach, considering factors like:

    • Company's financial health
    • Dividend history
    • Asset backing
    • Voting rights
    • Transfer restrictions

Expert evaluation and detailed valuation methods such as earnings multiples or discounted cash flow analysis may be necessary.

Legislative Effects on IHT

Changes in legislation since 2006 have significantly affected IHT, particularly regarding trust taxation and anti-avoidance measures.

Trust and Settlement Taxation

The Finance Act 2006 brought major changes to trust taxation:

  • Relevant Property Regime: Most trusts are now under this regime, facing periodic and exit charges.
  • Immediate Chargeable Transfers: Transfers into most trusts are now immediately subject to IHT, removing the previous potentially exempt transfer (PET) status.

These shifts require careful planning regarding timing and structure of trusts.

Anti-avoidance Measures

Recent laws have tightened anti-avoidance rules:

  • Pre-Owned Asset Tax (POAT): Aimed at schemes involving gifts with reserved benefits.
  • General Anti-Abuse Rule (GAAR): Gives HMRC authority to counter tax advantages from abusive arrangements.

The Finance Act 2020 added targeted rules to prevent reducing estate values through artificial means.

Understanding Value Transfer

The transfer of value is a core aspect of IHT. Section 3(1) IHTA 1984 defines it as a disposition that lessens one's estate value.

Lifetime Transfers

Two main categories exist:

  1. Potentially Exempt Transfers (PETs):

    • Generally outright gifts
    • No immediate IHT charge
    • Exempt if the donor survives seven years
    • If the donor dies within seven years, the transfer is chargeable, with taper relief available
  2. Chargeable Lifetime Transfers (CLTs):

    • Include transfers into most trusts
    • Subject to immediate IHT if exceeding the nil-rate band
    • Additional tax may apply if the donor dies within seven years

Transfers on Death

Assets transferred upon death face IHT based on value at death, accounting for any applicable exemptions and reliefs. Important points include:

  • Deemed Transfers: Events like ending a life interest are viewed as transfers on death.
  • Aggregation: The seven-year rule aggregates lifetime transfers with the death estate.
  • Grossing Up: When IHT is paid from the estate, the tax must be increased to calculate the correct charge.

Exemptions and Reliefs: Reducing IHT

Understanding IHT exemptions and reliefs is vital for effective estate planning:

Key Exemptions

  1. Spouse/Civil Partner Exemption: Transfers between UK-domiciled spouses or civil partners are entirely exempt from IHT.
  2. Annual Exemption: £3,000 annual per tax year, with the option to carry forward one year's unused exemption.
  3. Small Gifts Exemption: Gifts up to £250 per recipient per tax year.
  4. Normal Expenditure out of Income: Regular gifts that do not affect the donor's standard of living.

Major Reliefs

  1. Business Property Relief (BPR):

    • Up to 100% relief on qualifying assets
    • Conditions include a two-year ownership minimum, and the business must not mainly trade securities or investments.
  2. Agricultural Property Relief (APR):

    • Up to 100% relief on qualifying property
    • Includes complex rules on occupation and property use.
  3. Woodlands Relief: Defers IHT on timber value until sold, excluding the land.

Practical Examples: Applying IHT Principles

Example 1: Valuation of Unquoted Shares

Scenario: Jane owns 30% of XYZ Ltd, an unquoted company. Her shares need IHT valuation.

Analysis:

  1. Company valuation: Net assets at £2 million, annual profits at £500,000
  2. Earnings multiple: PE ratio of 8 gives a company value of £4 million (£500,000 x 8)
  3. Jane's share: 30% of £4 million = £1.2 million
  4. Discount for lack of control: 20% discount, reducing value to £960,000

Consider asset backing and earnings with discounts for control and marketability.

Example 2: Failed PET and Taper Relief

Scenario: Mark gifts £400,000 to his daughter on 1 May 2018. He dies on 1 June 2023.

Analysis:

  1. The gift fails as a PET since Mark did not survive seven years.
  2. Taper relief applies as Mark survived more than three years:
    • 3-4 years: 20% reduction
    • Death occurred in year 6, so a 60% reduction applies
  3. Assuming a nil-rate band of £325,000 and 40% IHT rate:
    • Taxable amount: £400,000 - £325,000 = £75,000

Conclusion

Understanding IHT valuation principles, legislative impacts, and available reliefs is critical for effective estate planning and compliance. FLK2 students should aim to integrate these concepts to efficiently manage complex tax scenarios, ensuring optimal strategies are applied in both theory and practice.