Inheritance tax in the UK is charged on certain transfers of value during an individual’s lifetime and on the assets in a person’s estate at death. The rate of inheritance tax payable where a transfer is charged to inheritance tax in lifetime is 20%, but the rate of inheritance tax on death is 40%. However inheritance tax is not due where a gift is made by an individual unless the donor dies within seven years of making the gift. The gift is therefore referred to as a potentially exempt transfer. Inheritance tax only becomes due on the gift where the individual dies within seven years of making the gift.
Some persons may attempt to avoid inheritance tax by making a gift of an asset during their lifetime, to reduce the value of the estate that would be taxed on death, but arranging to retain the use of the asset. The rules relating to gifts with reservation of benefit are designed to combat this method of avoiding inheritance tax. The rules aim to cancel out any advantage gained by reserving some benefit when making a gift or continuing to receive some benefit from the asset after it has been given away.
The type of situation where this might occur is where the individual gives away the home as a gift but continues to live in it without paying any rent to the new owner, or paying rent that is well below the market levels of rent. The reservation of benefit rules could also apply to a situation where an individual transfer funds into a discretionary trust but is also a beneficiary of the trust.
The gifts with reservation rules provide that where the person receiving the gift does not enjoy the benefit of the property, or the property is not enjoyed entirely to the exclusion of the donor, the gifted property is still considered to be part of the donor’s estate at the date of death. It is then subject, with the other assets of the estate, to the death rate of inheritance tax.
When a donor makes a gift with reservation of benefit, as with any other lifetime gift between individuals no inheritance tax is payable at the time when the gift is made. The subsequent tax treatment depends on whether the reservation of benefit is lifted and the donor ceases to have any interest in the donated property. If the reservation of benefit is lifted more than seven years before the date of the individual’s death, the rules provide that no inheritance tax is payable on the gift.
Under the normal inheritance tax rules the law operates to charge inheritance tax on a gift if it is made within seven years of death. Where the reservation of benefit rules apply, if the reservation of benefit is not lifted until a date within seven years of the death, inheritance tax becomes payable. The inheritance tax is computed as if the gift was actually made on the date when the reservation of benefit was lifted, based on the value of the asset at that date.
Strict provisions apply in relation to gifts of land (including buildings). A gift relating to an interest in land or a share of an interest in land is treated as a gift with reservation of benefit if there is a significant “right, interest or arrangement” that enables the donor to enjoy occupation of the land without having to pay full consideration for the right.
Exceptions to the reservation of benefit rules
There are two important exceptions to the inheritance tax rules in relation to gifts with reservation of benefit:
Where the person pays full consideration for the right to enjoy land or tangible movable property (chattels), for example paying the market rate of rent for a house; or In the case of land, where an unforeseen change of circumstances (for example ill health) means that the donor has to occupy the property, and any services by the donee to the donor are normal services of care for an elderly or infirm relative.
Also, the gifts with reservation rules would not apply where a negligible benefit is retained by the person making the gift but effectively the donor does not obtain any benefit from the property.
The gifts with reservation rules would also not apply to the extent that the gift of property was covered by an inheritance tax exemption such as the exemptions for gifts to charities, political parties, housing associations, employee trusts, maintenance funds for heritage property or gifts for national purposes. The rules also do not apply if the gift is covered by the exemption for transfers between spouses and civil partners, the small gifts exemption or the exemption for gifts in consideration of a marriage or a civil partnership ceremony.
Pre-owned assets rules
The “pre-owned assets” rules were introduced to combat certain inheritance tax avoidance schemes. Under the pre-owned assets rules, a taxpayer is subject to an income tax charge on the benefit of using property that was formerly owned by that taxpayer. Where this charge arises on the taxpayer for the first time, it is possible to elect that the asset to which the charge relates will be included in the taxpayer’s estate for inheritance tax purposes at the time of death. The effect of this election is that no income tax charge will arise in respect of the asset. Where the reservation of benefit is subsequently lifted, the inheritance tax provisions relating to gifts with reservation will apply.
Sources:
HM Revenue and Customs www.hmrc.gov.uk
“Taxation” by Alan Melville, fifteenth edition, FT Prentice Hall 2010
“Taxwise II 2009/10” by R. Bennyworth, S. Jones and M.Waterworth, Lexis Nexis 2009