In the run-up to the end of the tax year, I received a lot of questions on the use of the £3,000 inheritance tax (IHT) annual exemption. It was clear from some of the questions asked that there was confusion around how the exemption works and the importance of the order in which gifts are made. Like many aspects of life, issues tend to arise when putting into practice something you had previously only contemplated in theory.
The fact that lifetime gifts up to a total of £3,000 per donor per tax year are exempt from IHT is straightforward. There are, however, a number of points you have to consider in order to ensure you get the desired outcome. Where individuals have a potential IHT liability, and they can afford to make gifts, then making the maximum use of the annual exemption is important, for over a period of time it can lead to substantial tax savings.
If the annual exemption is not used, or only partly used, in one year, it can be carried forward to the next but will then be lost if not used in that following year. The current year’s exemption is always used first.
Example – Robert
Robert makes a gift of £5,000 to a discretionary trust on 6 April 2019. He makes no other gifts in the tax year and had made no gifts in the previous year. The 2019/20 annual exemption is offset against the gift in full and the remainder of the gift is covered by £2,000 of the 2018/19 annual exemption. On 6 April 2020, the £1,000 unused annual exemption from 2018/19 is lost.
It is important to note that current HMRC practice in relation to the annual exemption is to set gifts off in a strict chronological order. Generally it is advised that any chargeable lifetime transfers (CLTs), which covers lifetime gifts to discretionary and interest in possession trusts, are made before any potentially exempt transfers (PETs) to other individuals.
The reason for this is a CLT attracts an immediate IHT charge at the lifetime rate of 20% once the donor’s nil rate band has been exceeded and any other exemptions exhausted, whereas a PET is treated as exempt, incurring no immediate IHT charge when made. A PET will only become chargeable if an individual dies within seven years of the gift, and so the AE could be wasted on a PET if the donor survives seven years.
Example – Al and Diane
Al made a £331,000 gift to a discretionary trust in 2018/19 which used up his annual exemptions for 2018/19 and 2017/18 and his available nil rate band. He makes a further gift of £9,000 to the trust on 7 April 2019 and a gift of £7,000 to his daughter Diane, on 8 April 2019.
The gift on 7 April 2019 uses the AE for 2019/20, reducing the chargeable element to £6,000, which will be taxed at the IHT lifetime rate of 20%. The gift to Diane is a PET, so there is no IHT charge due unless Al dies within seven years of the date of the gift.
If, alternatively, the £9,000 gift had been made to the trust on 9 April 2019, then the full £9,000 would have suffered IHT at 20% as the AE would have been used against the gift to Diane on 8 April, even though this gift is a PET and does not attract an immediate IHT charge.
If gifts are made to different people on the same day then the AE is split in proportion. This raises the question, when are gifts actually made? Generally speaking, under English law, a gift is effective when the donor has done everything necessary to transfer the ownership of the property being gifted – for example, with an investment bond, it will be on completion of the assignment form.
An important point to make, however, is that care needs to be taken when it comes to using cheques. The effective date of the gift is when the cheque has cleared, thus being beyond the control of the donor. This may become very relevant in situations where a donor made a chargeable transfer using their nil rate band and the AE in the previous year, then in the following year made gifts by cheque for £3,000 to each of their two grandchildren.
With no control over when the cheques are banked, if one grandchild was slower than the other to bank the cheque and their grandparent died a short time after, then the grandchild who banked their cheque first would get the full benefit of the AE. The other grandchild would unfortunately not benefit from any of the AE and be liable to IHT at the full rate of 40%, giving a tax liability of £1,200 on the gift – an unintended consequence I am sure!
Although, in theory, the use of the annual exemption appears straightforward, there are a number of aspects that need to be carefully considered to ensure the exemption is fully used and that, in certain scenarios, one beneficiary does not benefit to the detriment of any others.
Neil MacGillivray is head of technical support at James Hay