Inheritance Tax Faces Radical Overhaul

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A cross-party group of MPs has recommended radical changes to inheritance tax, which could lead to lower bills for estates caught by IHT. But the proposed shake-up to the nation's most-hated tax would also see the loss of certain loopholes which many people currently use to pass on their wealth.

Currently, inheritance tax is charged at 40% on an estates once they cross the tax-free threshold of £325,000. The All-parliamentary Group on Inheritance and Intergenerational Fairness (APGG) is proposing slashing this to 10%. But the seven-year rule, a popular method for parents and grandparents to gift substantial sums tax-free to their relatives, could be scrapped.

Such gifting is at the heart of the changes proposed by MPs. Currently people can give away up to £3,000 a year tax-free, but MPs are proposing to cap this at an annual allowance of £30,000, with anything above this taxed at 10%.

The seven-year rule is known as a “potential exempt transfer” as it is only tax-free if the donor lives at least seven years after the gift is made. Many people use the rule to help children and grandchildren to buy their first home or to pay school or university fees.

Financial planning firm Tilney says the current gifting system incentivises planning ahead, while also “preventing people from avoiding an Inheritance Tax bill by simply giving all of their money away on their deathbed”.

Rachael Griffin, tax and financial planning expert at Quilter, welcomes the proposals but warns that the Government needs to be careful about removing incentives for people to pass on wealth. “The generations of today are the first to be worse off then their parents, so taxing the flow of the wealth being passed down to them might not win the Government many favours,” she says.

One of these incentives in MPs sights is what's known as the "main residence nil-rate band", which in the current tax year is worth £150,000 when a home is passed on to a direct descendant in a will. This is reduced for estates over £2m, however. Miles Dean, head of international tax at Andersen Tax UK says the overall changes to the IHT system are welcome but not changes to this housing exemption. He thinks the loss of the seven-year rule exemption is an acceptable trade-off if the overall IHT rate drops from 40% to 10%.

The System Needs to be Scrapped

MPs are also keen for the proposals to limit the opportunities for tax avoidance created by the current complexity of IHT rules – their evidence concluded that tax rates above 20% incentivise tax planning. “By cutting rates, the proposal would lead to less avoidance, while keeping the UK attractive for wealthier individuals,” MP say.

Emily Deane, technical counsel at the Society of Trust and Estate Practitioners (STEP), agrees: “STEP welcomes any measures to simplify the current inheritance tax regime, thereby decreasing opportunities for avoidance and abuse.”

Overall, Quilter’s Griffin thinks any attempt to simplify the current system is sensible. “As with most complicated things, it’s easier to just scrap the whole system and start again. This proposal has the magical ingredient needed by most successful proposals – simplicity,” she says. Quilter has been lobbying the Government to include inheritance tax changes as part of the upcoming Budget.

While only 5% of UK estates are liable for IHT, the rising price of houses, particularly in southern England, means that more families are becoming liable for the tax. There are many exemptions, however, which create confusion for those tasked with managing their relatives’ estates.

The proposed changes are part of a wider social debate about how wealth is passed between generations and whether the current tax system is fair. The rising costs of housing and the phashing out of many final salary pension schemes have created friction between the generations. In many cases, inheriting property wealth is often the only option for young people to get on the housing ladder, experts say.

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