Inheritance tax (IHT) in the UK is a levy on the estate of a deceased person, including their property, money, and possessions. While the standard rate is 40% on estates above the tax-free threshold, various exemptions and reliefs create significant loopholes that can be exploited to reduce the tax burden. We will explore this and more below.
What is the basic inheritance tax threshold?
As of 2024, the inheritance tax threshold, known as the nil-rate band, is £325,000. Any part of an estate above this amount is subject to a 40% tax. An additional residence nil-rate band allows an extra £175,000 per person when passing on the family home to direct descendants, bringing the total potential tax-free amount to £500,000 per person, or £1 million for a married couple
What are the main inheritance tax loopholes?
Business property relief (BPR)
BPR allows some business assets to be passed on free from inheritance tax. If you own or invest in a business, including shares in qualifying companies listed on the Alternative Investment Market (AIM), these can be exempt from IHT if held for at least two years before death. This relief is designed to keep businesses operational upon the owner’s death, but it is often used to minimize tax liability significantly.
Agricultural property relief (APR)
APR works similarly to BPR, offering up to 100% relief on agricultural property. This applies to land, buildings, and some livestock and machinery, provided they are part of a working farm. The relief aims to preserve family farms, yet it has been criticized for enabling wealthy individuals to purchase agricultural land primarily to avoid IHT.
Gifts and the seven-year rule
Gifts given more than seven years before death are exempt from IHT. This rule encourages individuals to start estate planning early, distributing their wealth over time. Gifts made within seven years are taxed on a sliding scale, with the full 40% rate applying to those given within three years of death. Annual exemptions also allow tax-free gifts of up to £3,000 per year.
Trusts
Trusts can be used to manage and protect assets, potentially reducing IHT liabilities. Assets placed in a trust are no longer considered part of the estate, provided specific conditions are met. Different types of trusts, like discretionary trusts and loan trusts, offer varying levels of tax efficiency.
Pension pots
Defined contribution pension pots can be passed on free from IHT, provided the deceased was under 75 years old at death. This loophole encourages wealthy individuals to use other resources for living expenses, preserving their pension funds to pass on tax-free.
Why are these loopholes controversial?
These reliefs and exemptions disproportionately benefit the wealthiest estates, leading to an effective tax rate that is significantly lower than the nominal 40%. For instance, estates valued over £10 million pay an average effective tax rate of just 10%. This disparity raises concerns about fairness and revenue loss, prompting calls for reform.
What reforms have been proposed?
Capping reliefs
One proposal is to cap the amount of business and agricultural reliefs. For example, limiting these reliefs to £500,000 per person could curb excessive tax avoidance while still supporting family businesses and farms. This cap would also be transferable between spouses, allowing a couple to pass on up to £1 million【6†source】.
Removing AIM shares relief
Another suggestion is to eliminate the IHT relief for AIM shares. Since these investments are often held similarly to regular shares, their preferential treatment lacks justification and skews investment behaviour.
Ending tax-free pensions
Reforming the rules around pension pots is also on the table. Ensuring that inherited pensions are taxed could correct the current imbalance, where pension wealth enjoys more favourable treatment than other forms of inheritance.
Conclusion
While the UK’s inheritance tax system is intended to tax the transfer of wealth upon death, numerous loopholes allow significant portions of wealth to be passed on untaxed. These loopholes, including business and agricultural property reliefs, the seven-year rule for gifts, and tax-free pension transfers, enable substantial tax avoidance. Proposed reforms aim to close these gaps, ensuring a fairer and more efficient tax system.
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