Possible moves to increase taxes on the transfer of wealth at death continue to feature in speculation as to where ‘painful’ Budget measures will land.
As pre-Budget leaks start to trickle out, it has been reported that the Chancellor is backing away from reform of tax reliefs on pension contributions because of the probable impact on the public sector. Other pension tax measures are still possible, but this could switch the focus back towards capital gains tax and inheritance tax as Rachel Reeves starts this week to submit headline measures to the Office for Budget Responsibility ahead of October 30.
Ian Dyall, head of estate planning at leading UK wealth manager Evelyn Partners, says: ‘The taxation of pension pots at death looks like it’s in the crosshairs at the Budget now.
‘Just a year ago the talk was all about whether the Conservatives would cut or even abolish inheritance tax. But the tables have turned on death duties in the last 12 months, and particularly since the General Election, as Downing Street has admitted the need for more tax rises.
‘Rachel Reeves is not short of encouragement from think-tanks, a couple of which are keen that IHT “loopholes” should be closed, or that wealthy families should be prevented from making the most of certain reliefs. The problem is, one person’s loophole is another’s legitimate relief – or in the case of some family businesses, another’s lifeline.’
The Institute for Fiscal Studies and Resolution Foundation have both weighed in with recommendations to restrict Business and Agricultural Property Reliefs, and to bring defined contribution pension pots into the calculation of estates for IHT purposes.
Dyall says, ‘These seem to be the two frontrunners among the various suggestions to tighten up IHT rules although charging capital gains on the valuation of assets at death could be a dark horse in any bid raise more money from the transfer of wealth.’
In 2023/24 the Treasury took £7.5billion in inheritance tax receipts, twice as much as 10 years ago, with the tax take increasing in recent years as the frozen nil-rate band exemptions are surpassed by more estates, and more of the wealth in each liable estate. Receipts are running about 9.4 per cent higher so far in this tax year than last.
Dyall adds: ‘While inheritance tax is very unpopular, it does affect only a small proportion of families, about 5 per cent of deaths in 2022/23. But this is expected to rise in the next decade or two as the asset-rich baby boomer generation hits average life expectancy, which means more estates will be paying IHT, and some will be paying a lot more.
‘The Chancellor might judge that it’s an area where revenue can be raised without provoking a widespread outcry. But as the tax raises a relatively modest amount in the overall context of the public finances, you would have to make some fairly aggressive changes to substantially increase the tax take.
‘So this could mean that while only a minority of estates would be affected – as long as the Nil Rate Bands were not cut that is, which would broaden the scope of the tax – the ones that are could be impacted quite severely.’
Here are some of the possible moves that could be afoot in the Budget.
Cuts to the Nil-Rate Bands
Dyall says, ‘The main and residential NRBs have been frozen at £325,000 and £175,000 respectively in recent years and of course inflation in the values of property and investments means that more estates are being drawn across these thresholds.
‘So if these are cut in any way, more families of relatively modest wealth will become liable to IHT, which might not be the headline that the new Government wants.
‘While the RNRB provides an extra relief of value to many families as house prices have risen, it has been criticised for discriminating against those who don’t have children or who simply choose to leave their main residence to someone who isn’t a direct descendant.
‘The Chancellor might just get rid of the RNRB altogether, with the possible sweetener of raising the main NRB by a token amount to something like £350k or £400k – although it’s not clear how much would be raised by this combination of steps.
‘It seems unlikely that the headline IHT rate of 40 per cent will be raised as this is a relatively high rate by most standards.’
Business and Agricultural Property Relief
Business Relief (formerly Business Property Relief, which was introduced in 1976) reduces the value of business assets by either 50 per cent or 100 per cent for the purposes of calculating IHT. Therefore, it allows business assets, or shares in qualifying companies, to be passed to the next generation – either during lifetime or in a will – without triggering a big inheritance tax bill.
Some believe that many family-owned firms would have to be sold, liquidated or broken up if inheritance tax was imposed in full. Others argue that these reliefs are exploited by wealthy families simply to avoid IHT.
One lobby group estimates that family businesses employ about 14 million people in the UK, and says that 80 per cent to 90 per cent of owners’ assets are tied up in their companies, meaning many owners would need to sell or divest the business to cover any tax bill.
Farming businesses benefit from Agricultural Property Relief, allowing landowners to pass down farms to their children with either 50 or 100 per cent relief. Countryside and farming business groups say this is vital for business continuity and families make decisions like sending children to agricultural college and investing in new equipment on the basis of it.
Dyall says: ‘It is probable that modest family-owned small and medium-sized enterprises could get caught up in measures intended to target the very wealthiest families, with unintended consequences for employment and local communities.’
The AIM shares ‘anomaly’
One of the most widespread objections to Business Relief surrounds the potential eligibility of shares in companies listed on the AIM exchange. While it’s arguable that this provides an important source of funding in the UK for growth companies, some counter that it is an anomaly that means Business Relief is exploited by some investors as a loophole.
Dyall says, ‘It should be possible to exclude AIM shares from Business Relief without dismantling the relief altogether, but even that step must be examined for the unintended consequences it could have for the AIM market and encouraging funding for smaller UK companies.’
Taxing defined contribution pension pots
Currently defined contribution, or money-purchase, pension pots are usually not counted as part of a deceased’s estate for inheritance tax purposes. This means that substantial sums can be passed on free of IHT, and not only that but beneficiaries can receive withdrawals from pension pots free of income tax if the death occurs before age 75.
Dyall says, ‘It’s quite possible – and even, reading the runes, quite probable – that the Budget will reform the favourable tax treatment of pension pots at death. This could take the form of the full fund being subject to IHT or just the excess over the current death benefit limit of £1,073,100.
‘Bringing defined contribution pension pots into someone’s taxable estate seems to be very much on the cards, as it can be portrayed as fixing an IHT “loophole” and will have little impact on economic incentives. And the income tax rule for income withdrawals if the death occurred pre age 75 could also be abolished to make future withdrawals taxable at the beneficiary’s marginal rate in all circumstances.
‘The question is, if this does occur, will there be any transitional arrangements for those who have made significant financial decisions on the basis of current rules? Also, while taxing pension pots at death might not interfere with economic efficiency, it will of course have behavioural implications, in that savers are bound to take other steps to mitigate IHT.’
Crackdown on gifting
Dyall says, ‘One relatively easy way for the Government to make it more difficult for families to avoid paying IHT would be to tighten up the gifting rules – and specifically the seven-year rule which means that most gifts of any size leave the donor’s estate after this time period.
‘The annual gifting limits – which allow smaller gifts that leave the estate immediately – are very modest, having been frozen for more than four decades, so there’s not much wriggle-room there.
‘The Chancellor could however look at restricting the rules around “potentially exempt transfers”, which provide an incentive to give away wealth during lifetime. That’s not just because the assets will leave the estate altogether if the giver is still alive after seven years, but also because after two years there is a chance the gift(s) could be entitled to taper relief, where the IHT rate falls to as low as 8 per cent.
‘The rule could be extended out to 10 or more years or even abolished, but this is unlikely to raise much for the Treasury in this Parliament unless it is applied retrospectively, which seems unlikely. Plus, it could jam up the transfer of wealth to younger adults who are more likely to spend it, restricting the flow of liquid funds back into the economy.’
Reforming the capital gains at death ‘uplift’ rule
Dyall says, ‘This is a relatively under-the-radar possibility that could well prove attractive to the Chancellor, as it could raise a decent amount even though the implications could take a while to sink in for many people.
‘Currently, when someone passes on assets at death the capital gain they were sitting on is effectively erased and the beneficiary’s “purchase price” for the purposes of any future capital gain calculation is “uplifted” to the valuation at the point of death. In other words, a potential capital gains bill is extinguished, and a potentially large one too as the pregnant gain on assets held at death could have built up over several decades.
‘This could be targeted by either charging CGT on the gains at point of death, or making the beneficiary liable for all of the capital gains on assets inherited, back to the base cost when they were purchased by the deceased. The former, more aggressive, step would probably mean the estate will have to pay the CGT bill, as well as any IHT bill, and that could mean having to dispose of some assets – but would raise funds more rapidly for the Treasury.
‘Families need to be careful where IHT and CGT considerations collide. For instance, there have been reports this summer of parents and grandparents handing over investment or second properties and other family assets to children and grandchildren, firstly to realise the capital gain at current rates – in case CGT goes up at the Budget – and secondly, to start the seven-year clock ticking for IHT relief.
‘This might backfire even if the rate of CGT does go up, as the family could lose out on the reset of capital gains at death. The property given away in lifetime will trigger a capital gain and a CGT bill, but an IHT bill could also arise if the donor dies within seven years.
‘Whereas bequeathing the property in a will would only have incurred IHT and no CGT because of the uplift rule on death.’
