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Why the ultra-wealthy are the only winners of 'perverse' inheritance tax gifting rules

James Connington
Only gifts worth more than £325,000 benefit from the tax-relief taper, so smaller estates aren’t helped - Richard Allen for The Telegraph

Inheritance tax’s gifting system is a “perverse game of Russian roulette” that doesn't help people with smaller estates, experts have said, as the Office of Tax Simplification considers the rules as part of its review into inheritance tax (IHT).

The rules around gifting allow someone with hundreds of thousands of pounds to give away to benefit from a tax break that becomes more generous with the length of time that has passed between a gift being made and death. Those with smaller estates, however, must gamble on whether they will live more than seven years when they make a gift.

Everyone has an annual gift allowance of £3,000, which can be given away free of IHT regardless of when they die. There are also other small allowances. Larger gifts can be made that won’t count towards an estate if made more than seven years before death. 

For gifts made in the seven years before death, the amount of tax payable tapers depending on how much time has passed. Gifts made up to three years prior to death incur the full IHT rate of 40pc. The effective tax rate after taper relief is 32pc for three to four years, then 24pc, 16pc and 8pc for each following year. 

In practice, however, this taper helps only the hugely wealthy. This is because gifts made in the seven years before death are included in the value of the estate and are counted first, ahead of assets given away at death, such as property or investments.

inheritance tax

That means that benefiting from the taper requires someone to give away more than the “nil-rate” band of £325,000 in the seven years before death. Otherwise, their gifts simply use up the nil-rate band and don’t benefit from the taper.

So those who have huge sums to give away can do so in the knowledge that if they die three or more years later they won’t incur the full weight of IHT, whereas those who don’t are left to gamble on whether they’ll live for seven more years.

Gordon Andrews, a tax planner at Old Mutual Wealth, said: “Gifting during a lifetime has become a perverse game of Russian roulette. Do you think you’ll live longer than seven years, and how much money are you willing to put on that bet? These rules were introduced in 1984 and the £3,000 annual gifting allowance has been unchanged since then. The Government has previously acknowledged that the taper is valuable only for the wealthy.”

These gifting rules are now being considered in the Office of Tax Simplification’s IHT review.

“Among the questions being asked are whether thresholds and exemptions on gifting are distortive or too complex,” Mr Andrews said. He suggested that the gifting allowance could be adjusted for inflation, increasing it from £3,000 to nearly £11,000.

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Danby Bloch, the founder of Tax Briefs, said: “It is very silly indeed. It is much easier for someone with lots of money to be able to afford to make lifetime gifts without threatening their long-term security.”

He provided two examples to illustrate the problem. In the first, Mrs A gives away a fifth of her £1m estate, or £200,000. If she dies at any time in the seven years after making the gift, the £200,000 gifted amount just uses up £200,000 of her nil-rate band. Then £125,000 of the rest of her estate uses up the remaining nil-rate band. The other £675,000 incurs 40pc IHT. Her total IHT bill is therefore £270,000.

If she doesn’t give the £200,000 away, the result is the same: £325,000 of her estate uses up the nil-rate band, and the estate pays 40pc IHT on the remaining £675,000. 

However, if she lives for seven years after making the gift, that £200,000 doesn’t count towards the value of her estate. Of the £800,000 remaining, £325,000 uses up the nil-rate band and 40pc IHT is due on the remaining £475,000, for a tax bill of £190,000 – £80,000 less. 

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Mrs B, on the other hand, is much wealthier. She gifts £1m of her £5m estate. If she dies within seven years, the first £325,000 uses up her tax-free allowance. She faces the same problem as Mrs A here, and effectively pays 40pc IHT on this amount. 

On the remaining £675,000 of the gift, if she died within three years of the gift the full 40pc IHT rate would apply. But after that the taper takes effect. If she died after five years, for instance, the estate would pay 16pc tax on that £675,000, or £108,000, instead of the £270,000 payable at the full 40pc rate.

Mrs B has the security of knowing that if she survives longer than three years, the full IHT rate won’t be due.