A new broom

Last month, I called for major reform of inheritance tax (IHT) on individuals and trusts in a speech to the House of Lords. IHT affects estates worth more than £285,000 and is charged at 40%.

Originally intended as a tax for the very rich, the respected Institute of Fiscal Studies calculates that some 3.25 million individuals and estates in this country are now potentially liable to pay the tax. The threshold has increased year on year, but not in line with asset prices which is why so many of us now find ourselves under the shadow of possible IHT charges.

As a consequence, more lawyers and accountants are finding themselves having to advise on complex inheritance tax issues, because more and more of their clients are entering the band at which IHT becomes payable. In some cases, smaller firms are having to 'buy in' the expertise of tax specialists to ensure that their clients receive the best advice.

IHT weaknesses

Following my talks last year with the Paymaster General during the passage of the Finance Bill, I used my latest speech to identify the weaknesses of current IHT legislation and to suggest ways in which the system could be improved and made more fair — encouraging people to invest in the future wealth of the nation.

The greatest flaw in the inheritance tax system is that the very rich can afford to avoid the tax whereas married couples or civil partners in middle Britain with combined assets of more than £570,000 find themselves liable to pay it. In addition, the IHT regime imposes great pressure on even those with modest means to gift assets to their beneficiaries too early. This can leave them emotionally and economically vulnerable. The fear of the tax has lured people into making rash and foolish gifts and investments.

The current regime does little to encourage people to invest and save. Some middle-aged and older individuals take the view that if the taxman is going to take the money in any event, why not spend it? But surely one of the most compelling reasons for fundamentally changing the tax is that we should encourage the entirely natural and praiseworthy ambition of most of us to work hard and save to pass assets and cash on to our children and our grandchildren.

I believe that there are straightforward changes that could make IHT more simple and fair.

Marriage and civil partnership

One approach I suggested is to allow married couples and civil partners to transfer their unused nil rate band exemption on the first death. Such couples can leave assets to each other and, in most cases, not pay IHT on those assets. However, when the first partner dies and the second partner inherits his or her assets, any nil rate band exemption on those assets is lost.

People have side-stepped the problem by putting assets into what are known as mini discretionary trusts, which are largely incomprehensible to the public and carry a bureaucratic and administrative burden. By allowing couples to pass on their unused nil rate exemption (as illustrated by the Example below), I believe that the system will be more straightforward and simple. Individuals often have sound reasons for creating a mini discretionary trust and they should be free to continue to do so.

Divorce and re-marriage is especially difficult, particularly given the changes made in last year's Finance Act. The creation of lifetime trusts attracts an immediate charge to IHT. There are eminently sensible reasons for wishing to gift either a former or new spouse the right to the income from assets, for example for his or her lifetime, ensuring that the capital moves, in due course, to the children or grandchildren.

IHT reliefs

I also suggested that as a bargain for abandoning the potentially exempt transfer regime, the nil rate band tax threshold should be lifted to £500,000 and that the rate of tax be fixed at 10% or graduated to a maximum of 20%. There should, in addition, be more generous holdover relief for capital gains tax on lifetime gifts whether absolute or into trust.

I also called for unmarried siblings living together to be treated far more fairly (at the moment there are no reliefs for them — they must pay the 40% IHT charge on what is left to them by their sibling, on assets worth more than £285,000), and for there to be more equitable treatment for relatives and others who provide live-in care for the elderly and infirm.

This might at first glance appear to be a generous regime, but lower tax rates do not necessarily mean less money flowing into the Treasury. When the Conservatives under Baroness Thatcher reduced corporation tax from 52% to 33%, it vastly increased the amount of corporation tax raised because sensible tax rates encourage jobs, businesses, investments and savings.

A Labour government which set up capital transfer tax in the Finance (Number 2) Act 1975 rightly introduced the inter-spouse exemption on gifts whether by lifetime or by will.                                  

Lord Burnett is a consultant for Stephens & Scown and can be contacted on 01392 210700. Further information is available by logging on at www.stephens-scown.co.uk.

Example: transferable nil rate bands

Let us assume that the law has been amended to allow unused nil rate bands to be transferred between spouses.

Mr and Mrs A, both 75, own a property worth £400,000 and have investments of £100,000. Other income is from pensions which will cease on the death of the last to die.

Their 'mirror' wills leave their estates to each other on the first death and then to their children. If Mr A were to die in 2006-07 and Mrs A in 2009-10 (when the property is worth £500,000, but other capital remains at £100,000), their potential inheritance tax liabilities would be as follows:

Potential liabilities with 'mirror' wills:

Potential liabilities with 'mirror' wills, but with transferable nil rate bands:

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