Inheritance Tax is charged on the value of your estate when you die, and any gifts you made within the seven years before your death are also included. The first £285,000 of your estate is charged at 0% (the “nil rate band”), and all the rest is charged at 40%.
The above is pretty much common knowledge, as is the fact that if you can afford to do so, it makes sense to give away as much of your property as you can before you die.
PETs
A PET is a “Potentially Exempt Transfer”, so called because if you live for seven years after making the PET, it becomes exempt from inheritance tax.
In order to be a PET, a gift must be made by an individual to an individual. A gift from an individual to a Trust, or to a company, cannot be a PET – instead, it is chargeable to inheritance tax at the time it is made. The same applies if the gift is not from an individual. A common example of this involves shares in family companies:
Kirk owns all the 100 shares in a property investment company, Douglas Ltd, which is worth £2million. He wants his son Michael to have half the company, and he knows that if he simply gives 50 shares to Michael, he will be deemed to have disposed of them at their market value and will have to pay capital gains tax. He therefore arranges for the company to issue 100 shares to Michael, who pays the face value (known as the “par” value) of £1 per share. Michael now has half the value of the company, and in Kirk’s view, because he has not disposed of any of his shares, he has not made a capital gain.
Unfortunately for Kirk, allowing the company to issue shares for less than their market value is a “transfer of value” for inheritance tax, and the amount of the transfer is calculated like this:
Value of Kirk’s 100 shares before share issue to Michael | 2,000,000 |
Value of Kirk’s 100 shares after 100 shares issued to Michael (see below) | ( 800,000) |
Transfer of value to Michael | 1,200,000 |
Deduct £285,000 Nil rate band | (285,000) |
Chargeable to inheritance tax | 915,000 |
You might think that Kirk’s 100 shares are worth £1million after the other 100 shares have been issued, because the whole company is worth £2million and he has half the shares, but the point is that as he now only owns 50% of the company, he no longer has full control of it. The normal discount for a 50% shareholding is between 20% and 30%, so at best Kirk’s shares are now only worth £800,000. The ironic thing, of course, is that Michael’s shares are also only worth £800,000, but inheritance tax is based on how much the person giving has lost, not how much the person receiving has gained.
Kirk was also wrong about capital gains tax – there is a provision that deals with “value-shifting”, where you deliberately reduce the value of your shares in favour of someone else’s, but the good news for Kirk is that because inheritance tax is due on the transaction, he can “hold over” the capital gain and not pay any CGT.
GWROBs
Even if you make sure that your gift is from an individual to an individual, it will not be a PET unless the gift is “enjoyed” by the recipient “to the entire exclusion, or virtually to the entire exclusion of the donor”. Where a gift fails this test, it is known in the trade as a GWROB, or a “Gift With Reservation Of Benefit”.
Examples of GWROBs would be:
- A widowed mother gives her house to her children, but continues to live there
- Parents give their holiday cottage to their children, but continue to take holidays there
- Bill gives his vintage Bugatti to Ben, but continues to drive it to the pub for Sunday lunch
- The MD of a company retires, and gives his shares to his children who take over the running of the business, but he continues to draw a salary and drive a company Mercedes.
In all such cases, for inheritance tax purposes, when the person making the GWROB dies, the value of the asset concerned will still be counted as part of their estate.
How to avoid GWROBs
Apart from not continuing to use the asset concerned, there are three basic ways to avoid a GWROB:
- The “full consideration” rule – so if in the first example above, Mother paid a full market rent to her children after she gave them the house, it would not be included in her estate, but beware, for this is an “all or nothing” exemption, so if the market rent is £1,000 per month, and Mother only pays £950, then the full value of the house would be included in her estate. One interesting variation on this is that if you give a half share in your house to (say) your daughter, and she then comes to live there with you, then provided you both pay your fair share of the upkeep and the outgoings of the property, HMRC will accept that no GWROB has occurred.
- The “continuation of reasonable commercial arrangements” rule – this is commonest in the case of shares in a company – if the MD in the fourth example above had put in place a contract for himself which provided him with the salary and the company car, then he could escape the GWROB – though this is not as simple as it sounds and is a job for a good tax adviser
- The “de minimis” defence – that is, that the continuing enjoyment by the donor is so small that the “virtually to the entire exclusion” rule is satisfied. Be very careful about this – HMRC take a tough line on how much continuing enjoyment is permissible:
For example, if you make a gift of a house to your son, any more than the following will be considered to be a GWROB:
- Staying at the house for not more than two weeks per year when your son is not there (as in the holiday cottage example)
- Staying with your son at the house for not more than one month per year
- Social visits where you do not stay overnight
- Occasional visits for domestic purposes – such as to baby-sit your grandchild
In the case of the Bugatti (or any other car!), HMRC take the view that if Bill is given more than three lifts in it per month, it was a GWROB – and note they are talking about a lift, not Bill driving the car himself.
One ray of sunshine – a gift from one spouse to the other cannot be a GWROB.
POAT
Over the years, schemes have been developed to get round the GWROB rules, and in the 2004 Finance Act, a new tax was introduced – the “Pre-Owned Asset Tax”, or POAT.
Essentially, this charges you to income tax on the “annual value” of any assets which you either used to own, or which you provided the money for, and which you now have the use of.
Because POAT was introduced to counter complicated schemes to avoid complicated rules, it is itself fiendishly complicated, and like all anti-avoidance law, it catches quite unexpected transactions.
The details of POAT will be the subject of an article in a later issue of the Tax Insider – for the time being, remember that even if you believe you have managed to avoid a GWROB, you may instead be caught for income tax under POAT.
