Valuation principles and transfer of value

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Sally, a horticulturist, owned farmland on the outskirts of a rapidly expanding town. For years, she considered applying for planning permission to build residential homes on part of the land, but she never completed the application process. Despite this, local estate agents had suggested the land’s open market value was significantly higher than typical agricultural land. In May 2022, Sally gifted a portion of the farmland to a family trust for her grandchildren’s benefit, but she passed away unexpectedly in January 2023. Her executors are now determining the farmland’s valuation for inheritance tax (IHT) and are uncertain how to account for its development potential.


Which of the following is the single best statement regarding the farmland’s valuation for IHT purposes?

Understanding Inheritance Tax: Technical Foundations

Inheritance Tax (IHT) applies to the value of a person's estate at the time of their death and to certain lifetime transfers. Governed by the Inheritance Tax Act 1984 (IHTA 1984), IHT calculations require precise asset valuations and a thorough understanding of the rules surrounding transfers of value. The accurate application of these principles is key to estate planning and legal compliance. This article examines the valuation methodologies, challenges of transferring value, and the legislative framework that shapes these processes.

Valuation Principles in Detail

Accurate asset valuation is essential for determining IHT liability. Several principles guide this process, ensuring that valuations reflect true market conditions and comply with legal standards.

Open Market Value and the Arm's Length Transaction

The basis of IHT asset valuation is the open market value, defined in Section 160 of the IHTA 1984. This standard mandates that assets are valued at the price they might reasonably fetch if sold on the open market at the time of the transfer. The "arm's length" concept ensures that transactions are considered independent and without any undue influence between parties. Factors affecting the open market value include:

  • Current market conditions
  • Unique features of the asset
  • Potential for future development or change of use

For example, a parcel of land with planning permission for development may have a higher open market value than similar land without such permission.

Valuation of Jointly Owned Assets

Joint ownership introduces extra considerations into asset valuation. Assets can be held as joint tenants or tenants in common:

  • Joint Tenancy: Owners have equal shares, and upon death, the interest passes automatically to the surviving owner(s).
  • Tenancy in Common: Owners hold distinct shares, which can be unequal and passed on according to their will.

The value of a jointly owned asset for IHT purposes may be discounted to reflect the difficulty in selling a fractional interest. Typically, a minority share might be valued at 10% to 15% less than the proportionate share of the whole asset's value.

Under Sections 161 to 179 of the IHTA 1984, the related property rules require that when valuing an asset, any related property owned by the transferor's spouse or civil partner must be considered. This prevents undervaluation through fragmented ownership.

Valuing Shares: Quoted and Unquoted Securities

Valuing shares depends on whether they are quoted on a recognized stock exchange or unquoted:

  1. Quoted Shares: Under Section 272 of the Taxation of Chargeable Gains Act 1992, the value is the price they might reasonably fetch in the open market on the date of the transfer. This is usually determined by the quoted price on the stock exchange.

  2. Unquoted Shares: Valuation is more complex and may involve methods such as earnings multiples or net asset valuations. Factors to consider include:

    • The company's net assets
    • Earnings and dividend-paying capacity
    • The nature of the company's business
    • Restrictions on share transfers

For instance, shares in a family-owned company with restrictions on share transfers may be less valuable than similar shares in a company without such restrictions.

Legislative Developments Impacting IHT

Recent legislative changes have modified the environment of IHT, particularly concerning trusts and anti-avoidance measures.

Changes to Trust Taxation

The Finance Act 2006 significantly reformed the taxation of trusts:

  • Relevant Property Trusts: Most lifetime transfers into trusts are now immediately chargeable transfers, subject to IHT at the lifetime rate if they exceed the nil-rate band.
  • Periodic and Exit Charges: Trusts may be subject to IHT charges every ten years (periodic charges) and when property leaves the trust (exit charges).

These changes necessitate careful consideration when creating trusts to ensure tax efficiency.

Anti-Avoidance Provisions

Anti-avoidance measures aim to prevent individuals from circumventing IHT:

  • Pre-Owned Assets Tax (POAT): Introduced by the Finance Act 2004, POAT charges income tax on individuals who continue to benefit from assets they have given away.
  • General Anti-Abuse Rule (GAAR): Established by the Finance Act 2013, GAAR allows HM Revenue & Customs (HMRC) to counteract tax advantages arising from abusive tax arrangements.

Staying informed about these provisions is important to avoid unintended tax consequences.

Understanding Transfers of Value

A transfer of value occurs when a disposition reduces the value of a person's estate. Under Section 3 of the IHTA 1984, this includes gifts and other transfers where the donor receives no consideration, or less than full consideration, in return.

Lifetime Transfers: PETs and CLTs

Two main types of lifetime transfers affect IHT:

  1. Potentially Exempt Transfers (PETs): Gifts to individuals that become exempt if the donor survives for seven years after making the gift. If the donor dies within seven years, the value of the gift is included in the estate for IHT purposes.

  2. Chargeable Lifetime Transfers (CLTs): Transfers into most trusts and certain companies are immediately chargeable if they exceed the nil-rate band (£325,000 as of the current tax year). The lifetime rate of IHT is 20%.

Transfers on Death

Assets transferred on death are generally subject to IHT at 40% on the value exceeding the nil-rate band. Certain reliefs and exemptions may apply, reducing the tax liability.

Aggregation and Grossing Up

When calculating IHT, previous lifetime transfers within seven years of death are aggregated with the death estate. Additionally, if the estate bears the burden of IHT on specific gifts, the tax calculation must be "grossed up" to reflect the true amount passing to the beneficiaries.

Exemptions and Reliefs: Strategies for Reducing IHT Liability

Understanding available exemptions and reliefs is important for effective estate planning.

Key Exemptions

  • Spouse or Civil Partner Exemption: Transfers between spouses or civil partners are exempt from IHT, provided both parties are domiciled in the UK.
  • Annual Exemption: Individuals can give away up to £3,000 each tax year free of IHT. Unused allowance can be carried forward one year.
  • Small Gifts Exemption: Gifts of up to £250 per person per tax year are exempt.
  • Normal Expenditure Out of Income: Gifts that are regular, made out of income (not capital), and do not affect the donor's standard of living are exempt.

Important Reliefs

  • Business Property Relief (BPR): Provides up to 100% relief on the transfer of qualifying business assets, such as shares in an unlisted trading company, subject to conditions in Sections 103 to 114 of the IHTA 1984.
  • Agricultural Property Relief (APR): Offers relief of up to 100% on the agricultural value of qualifying agricultural property.
  • Woodlands Relief: Defers IHT on the value of timber until it is sold, although the land remains chargeable.

Practical Examples Illustrating IHT Principles

Example 1: Valuing Unquoted Shares

Suppose Emily owns 25% of the shares in ABC Ltd, a private company. The company's net assets are valued at £2 million. To value Emily's shares for IHT purposes:

  • Her proportionate share of net assets is £500,000.
  • Due to the lack of marketability of minority holdings, a discount of 15% may apply.
  • This results in a value of £425,000 for her shareholding.

Example 2: Potentially Exempt Transfer and Taper Relief

Michael made a gift of £350,000 to his son on 1 June 2016. He died on 1 July 2021.

  • Since Michael died within seven years of the gift, it becomes chargeable.
  • The gift exceeds the nil-rate band.
  • Taper relief reduces the tax payable, as more than five years but less than six years have passed.
  • The IHT due is calculated on the value over the nil-rate band, with relief applied accordingly.

Conclusion

The valuation principles and transfer of value rules within the inheritance tax framework demand meticulous attention. Precise asset valuation, as mandated by Sections 160 and 161 of the IHTA 1984, ensures that IHT liability reflects true market conditions. The interaction between lifetime transfers, both PETs and CLTs, and the aggregation rules highlights the complexity of calculating IHT due upon death. Legislative changes, such as those introduced by the Finance Act 2006 regarding trusts, and anti-avoidance provisions like POAT and GAAR, further complicate estate planning strategies. Proficiency in exemptions and reliefs, including BPR and APR, is necessary for mitigating tax liabilities. Technical competence in these areas is essential for legal practitioners, enabling effective management of IHT obligations and the crafting of compliant estate plans.

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