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Misnomer
Although termed ‘inheritance’ tax, the name is perhaps a little misleading. The tax is in fact charged not only on an individual’s estate (broadly, the value of all assets owned at death) but also on lifetime gifts made by the individual.
Lifetime gifts: Death within seven years
Having said this, things are not quite as bad as they appear at first glance. The legislation which deals with IHT is primarily contained in an Act, namely, the Inheritance Tax Act of 1984 (this original Act has over time been significantly amended; the latest significant amendments are contained in the Autumn 2024 Budget of 30 October 2024 which are anticipated to take effect from 6 April 2025) and within this Act are various exemptions and reliefs which alleviate the full impact of the tax.
For example, with reference to individuals, a lifetime gift made by one individual to another individual is only actually subject to inheritance tax if the donor (i.e., the individual making the gift) dies within seven years of making the gift, otherwise, if the donor survives the seven years, no inheritance tax is charged thereon. Furthermore, any inheritance tax charged, should death occur within the seven-year period, is tapered (i.e., reduced) depending upon how long after making the gift the donor in fact survives within the seven years; this aspect is for ease ignored in the discussion below.
So, for example, if Mr Smith in his lifetime gives his car worth £20,000 to his son, James, although inheritance tax is in principle levied on the value of the gift, this is so only if Mr Smith dies within seven years of making the gift. Unfortunately, this therefore means that at the time Mr Smith gifted his car to James neither of them will know if any inheritance tax will actually be charged in due course as they will have to wait seven years to find out! This is not, of course, particularly satisfactory.
Having said this, it may not in fact be strictly necessary for Mr Smith and James to wait for seven years to see if he survives.
Nil-rate band
Whether they will need to wait seven years will depend upon a number of factors. One such factor is whether at the time Mr Smith made the gift, he had used up his ‘nil-rate band’, commonly referred to as the NRB. The NRB is worth £325,000.
If, when Mr Smith made the gift, he had not made any earlier lifetime gifts, then he will not have used up any of his NRB so the value of the car, £20,000, will fall within the £325,000 NRB and, whilst technically still subject to inheritance tax, the applicable rate is nil, i.e., 0%; hence, no actual inheritance tax is payable even if Mr Smith dies within the seven-year period.
It was assumed above that Mr Smith had not made any earlier lifetime gifts and hence had not used any part of his NRB when he made the gift to James. Assume, however, that two years earlier, Mr Smith had made a lifetime gift of a painting to his daughter, Susan, worth £15,000. Now, when working out how much of his NRB Mr Smith has left when he makes the gift to his son, he has to take into account that he has already used up £15,000 when he made the gift to Susan, and so he is left with an NRB of [£325,000 – £15,000], namely, £310,000.
The £20,000 gift to his son thus still falls within his NRB of now £310,000 and so, despite making the earlier gift to Susan, it is still charged to inheritance tax but only at the nil rate, i.e., 0% on his son’s gift if Mr Smith dies within seven years of making the gift to his son. If Mr Smith did not die within seven years of making either gift, then neither gift is subject to inheritance tax and as a consequence, no part of his NRB is used; he would therefore still have an NRB of £325,000.
To work out how much of an NRB is left when an individual makes a lifetime gift, it is actually necessary to check what other lifetime gifts have been made within the seven-year period immediately before they made the gift. If Mr Smith had made a number of gifts within the seven-year period prior to making his gift to James, totalling £325,000 or more, no part of the NRB is available to offset against the gift to James. In this case, Mr Smith and James will know that if he dies within seven years of making the gift to James (having used up his NRB making earlier gifts), then there will be a charge to inheritance tax on the son’s gift.
The rate of inheritance tax which applies on a lifetime gift between individuals if death occurs within the seven years is 40%. Hence, should Mr Smith die within seven years of making his son’s gift, an inheritance tax liability on the car of £8,000 (i.e., 40% of £20,000; assume he has made earlier gifts that have used up the NRB) will arise when Mr Smith dies. Perhaps surprisingly, it is James not Mr Smith who is then primarily liable to pay the £8,000 to HMRC. This is not often understood by those individuals who give or receive lifetime gifts.
The legislation refers to the lifetime gifts made between individuals as ‘potentially exempt transfers’, more commonly known as PETs. What this means is that when Mr Smith made his son’s gift, it may be that he will survive seven years after having made it and thus at that time the gift is only potentially exempt; on surviving the seven years, the gift will no longer just be potentially exempt but will be totally exempt.
