Inheritance tax is the UK’s most hated tax and it’s also one of the most complicated systems. A new report is aiming to change at least the second of these two realities.

The Office of Tax Simplification (OTS) was tasked with digging into the current system and working out how to make it simpler and easier for people to understand. It comes after recent HMRC research found that just 45% of people gifting money knew how inheritance tax rules worked, highlighting the need for both simplified rules and more education.

The OTS has released the second of two reports on the topic, suggesting changes from the way gifting works to raising the issue of the complicated newest tax break, the residence nil rate band. Its first report looked more at the system of applying for and processing IHT.

So what could be changing in the future?

CHANGING HOW GIFTING WORKS

Currently there is a messy system for how much money you can gift each year before it’s counted as part of your estate for inheritance tax purposes. Everyone can give away up to £3,000 a year, whether in one gift or multiple gifts equalling this amount. There are extra breaks for gifting when someone gets married or enters a civil partnership and you can also gift money out of your ‘normal income’. These allowances have been the same for years and haven’t kept pace with inflation.

The OTS report suggests cutting all these different allowances and just giving everyone one higher allowance each year that they can gift. It also suggests removing the ability to gift money from disposable income. This part of the gifting rules is little understood and there have never been clear guidelines on exactly how much you can gift, but removing it entirely would take away a very lucrative tax break.

DITCHING THE TAPER

The seven-year taper is another complicated area of the inheritance tax system. It means that if you gift more money than is allowed by the above gifts, and when you die your estate is liable for inheritance tax, any gifts made in the past seven years could be subject to inheritance tax. The taper part of this rule is because the amount of tax due reduces each year, until none is due when you reach the seven-year point – see the table below.

The OTS said that the rule ‘requires a large amount of record keeping but raises little tax’ and that it’s ‘widely misunderstood’.

Instead it suggests cutting the seven year limit down to five years, but crucially, scrapping the taper altogether. This means that if someone gifted money and died within five years the full 40% inheritance tax would be due on the money. The move would create a cliff-edge, whereby if someone died four years and 364 days after giving a gift then tax would be due, but if they died a day later the entire gift would be tax free.

RESIDENCE NIL RATE BAND

The new residence nil rate band, introduced in 2017, ultimately means that each couple can leave a £1m property in their estate with no inheritance tax to pay. However, it’s so fiendishly tricky that the OTS said some professionals refuse to advise  on it.

The rules have been branded as unfair, as the tax break only applies if you leave your main property to your children, grandchildren or step-children and step-grandchildren. The OTS acknowledged that this is unfair for those with no children or those who live with siblings and want to pass their house onto them.

However, it didn’t suggest an easy solution. It said that scrapping the relief entirely would lead to a 68% increase in the number of estates paying IHT by 2023-24, while scrapping it and raising the normal nil rate band to £500,000 would cost the Government an extra £7.5bn during that time – neither feels like a workable option.

Instead it deferred a decision until the relief had been in place longer and the Government could assess how well it’s working.

CHANGES TO CAPITAL GAINS TAX

Currently if anyone leaves you money or assets when they die, generally there is no capital gains tax due. If you subsequently sell on that asset you just pay CGT on the increase in its value since you inherited it – so if you sell it on immediately none is due.

The OTS argues that this makes people less likely to gift assets during their lifetime, as they would have to pay the CGT due on it. So instead it recommends scrapping this tax benefit.

It would mean that if you inherited an asset and then sold it on you would pay capital gains tax on the difference between what it was worth now and what the person gifting it to you had originally paid for it.

HOW DO PENSIONS FIT IN?

The rules around whether pensions are subject to inheritance tax aren’t clear cut. Currently HMRC rules force most providers to exercise discretion over how pension death benefits are paid out. This is because where discretion is not used, or a pension is transferred or contributions increased while someone is in serious ill-health, the money left behind is subject to IHT.

However, the process of exercising discretion can mean significant delays and extra costs. The OTS report acknowledged this issue, but didn’t offer a solution. Instead it called for a wider review: ‘It may be appropriate, at some point in the future for the government to consider a wider review of the tax system and pensions, possibly carried out by the OTS.’

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