10% reduction in IHT rate for leaving 10% of an estate to charity

 In Tax

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The Government announced in Budget 2011 that it wanted to support philanthropy, encourage charitable giving and reduce the administrative burden on charities. As part of that initiative a consultation is under way which concerns the decision to reduce the rate of Inheritance Tax (IHT) for those leaving 10% or more of their estate on death to charity – see http://bit.ly/kfjCV5

Introduction

The aim of the relief is to enable Government to share the cost of donating to charity. The new relief will come into effect on 6 April 2012 and there is no debate about the level of either the reduced rate of IHT or the minimum proportion of the net estate which must be left to charity.

It is not part of the scope of the consultation as to whether this policy will encourage charitable legacies.

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It does not affect the charity exemption which applies to gifts to charity. Since the consultation document states at paragraph 1.10 that after applying the IHT threshold and the various exemptions and reliefs most estates are not liable to IHT one wonders just who this relief is aimed at. In 2010-11 it is projected that only 3% of estates will actually pay IHT.

What is clear is that to introduce this relief will be to significantly increase the workload of all those involved and add to the complexity of IHT. Whether it will also increase charitable giving is debatable. It could in fact do the reverse as people may be deterred from making lifetime gifts thinking they would be better off leaving a legacy on death.

The ground rules

For deaths on or after 6 April 2012 estates that include charitable legacies of at least 10% of the net estate will benefit from a 36% rate of IHT compared to the usual 40%.

Whether or not the 10% threshold has been met (the 10% test) will be determined by comparing:

  • The total value of charitable legacies for IHT purposes; and
  • The value of the net estate for IHT purposes as reduced by:
    • Any available nil rate band (NRB);
    • The value of assets passing to a surviving spouse or civil partner; and
    •  Other IHT reliefs and exemptions e.g. Business Property Relief (BPR) or Agricultural Property Relief (APR) – apart from the charitable legacy itself.

If the 10% test is passed, the estate will qualify for the reduced rate of IHT.

The fact that a charitable legacy is made reduces the amount of the estate for the other beneficiaries and that will not change with this initiative – it will reduce the cost of making the legacy but to achieve it requires care because the incentive will only apply if the 10% point is reached on death.

It is inevitable that it will be necessary to have a formula gift in a Will to achieve this otherwise it will be a lottery whether on death, taking into account failed Potentially Exempt Transfers etc the amount given may not reach the critical level against the size of the estate on death to make the 10% threshold.

Application of the rule

Where the only assets which are subject to IHT are within the free estate:

  • Identify the amount of the estate that is charged to IHT (net after claiming all exemptions & reliefs and applying NRB)
  • Add back the value of the charitable legacies – apply 10% to this baseline
  • Compare the 10% of baseline figure with the value of the charitable gift – if the charitable gift is the same or more then the entire estate is charged to IHT at 36%. If it is less, then there is no relief at all.

Lifetime gifts eating into the NRB

The value of lifetime gifts which become chargeable because of death must use up the available NRB in priority to the estate.

The effect of a reduced NRB to set against the death estate is to increase the baseline figure for the 10% test – in other words any qualifying charitable legacy will have to be that much larger or there will be no relief.

Cases where the IHT estate includes more than just the free estate

This could arise because of :

  • Jointly owned assets passing by survivorship
  • GROBs
  • The deceased having a qualifying interest in possession under s.49(1) IHTA 1984

In other words, the aggregate of the free estate and these other values widens the assets on which IHT is charged; so the consultation asks whether or not the reduced IHT rate should apply only to assets within the free estate or should there be the possibility of widening its availability by election.

Problems

Valuation

Where someone leaves something to charity at present valuation of that asset does not give rise to any practical problems – irrespective of the nature of the assets the gift is IHT free. However, this will not be true with the new proposal because the value of the specific charitable bequest may affect the IHT due from the estate.

Having to agree valuations will incur the PRs in costs; take up HMRC resources and effectively potentially reduce the amount available for charity.

HMRC propose treating any changes to valuations made at the date of death as a result of claiming loss on sale value etc. in the normal way and they will affect the relief claim.

Difficult assets

If any type of asset qualifies for the new relief (and ideally this is what the Government would like to do) it could mean that charities are left with assets of little or no value (because their value is manipulated between date of death and date of distribution) or things which are hard to sell such as private company shares. In other words including certain assets within the relief might actually cost the charity money and could increase the administrative burden for all concerned.

Equally, assets which qualify for the type of reliefs which result in a deferral of IHT as long as certain conditions apply (Conditional Exemption and Woodlands Relief) would make the calculations ridiculously complex not least because IHT may become chargeable on the deferred assets a long time into the future when the relief might not apply. The proposal is to exclude these assets from the calculations altogether.

Overseas property is excluded from the scope of IHT for non-domiciled people and the proposal is to exclude it from these proposals and only apply the relief to assets that are chargeable to IHT.

Should the relief be automatic but with the right to disclaim or should the PRs have to make a claim for the relief?

Making the relief automatic saves PRs overlooking it in straightforward cases but could give rise to problems in less easy cases. If the costs of administering the relief outweigh the benefit to the charity (e.g. the cost of the valuations is greater than the reduction in IHT) it would be a good idea to be able to disclaim the relief.

Avoidance

HMRC are worried about avoidance where certain assets fluctuate in value between date of death and date of distribution. Natural market fluctuations do not worry them but the opportunity to manipulate the values does e.g. with family controlled investment companies where the family strip out cash between the date of death (when the share value needs to be high to claim the 10% relief) and the date of distribution when the impact of what is given may be made very small by taking value away from the shares gifted.

Grossing up

These rules apply where there is a partially exempt transfer and a beneficiary takes a gift free of tax. Although not many estates are currently affected by these rules more will be if it becomes common practice to leave a formula gift to charity to utilise this relief. The outcome of whether or not the relief can apply may turn on whether the grossing up is done at 36% or 40%.

Interaction

A similar problem arises where there is a legacy passing to charity and chargeable gifts of APR or BPR relievable assets. In this case HMRC propose applying the 10% test to the actual value of the legacy before the application of the reliefs.

Practicalities

If there is likely to be uncertainty as to whether a large estate has left enough to charity in order to benefit from the 36% rate then the Will may either include a formula or may even make no provision for charity. The question of whether in a particular case it would pay the residuary beneficiaries to undertake a Deed of Variation allowing for a sufficiently large charitable bequest will then arise after death and will depend on careful number crunching.

It is surely likely that the use of Instruments of Variation to introduce the new rate to an estate is the most likely method of it applying due to the uncertainty of people’s on death estate at the time their Will is drafted. It is after all the residuary beneficiaries who are effectively bearing the cost of the charitable gift.

HMRC foresee a potential problem in that unless there is a mechanism in place to prevent it this situation may be manipulated. Where there is a legacy in a Will charities are made aware of it following the issue of the Grant through the public nature of the content of Wills and the services which exist for notifying the charity. Instruments of Variation are not public documents and charities might not be aware of the Instrument and never know that they were due a gift but had not received it. HMRC are obviously worried that if they give the relief based on the Instrument of Variation what is there to stop the unscrupulous taking the advantage of the relief but never paying over the gift which generated the relief.

There will doubtless be much confusion over precisely how the new incentive will work which may be exacerbated by ‘over selling’ by the charities. For the vast majority of our Will making clients it will have no relevance at all because all they want to do is make a legacy to their favourite charity or their estate is in any event not liable to pay IHT. If people get too confused by the new rule they may be dissuaded from leaving anything to charity after all.

Most firms are going to need to issue some simple guidelines to clients which set out the typical cases where the relief will not affect the client’s charitable giving and the situations where a formula clause in the Will would be the best policy if the relief is likely to be relevant. Perhaps the Law Society could prepare a Practice Note or agree a protocol of some kind with the Institute of Legacy Managers or other appropriate body serving charities.

Practice points

  • All Will draftsmen and Probate practitioners need to read this consultation document and consider the worked examples included within it because what is not open for debate is that the relief is to apply from 6 April 2012.
  • Let’s be clear it will have no relevance to the estate which is below the tax threshold where the testator wants to make a gift to charity nor to the wealthy spinster making a gift of her NRB to chargeable beneficiaries and giving the whole of her considerable residuary estate to charity. It will therefore apply to few clients!
  • The implementation of these proposals will affect the design of the IHT forms; the familiar procedures and the legislation.
  • Complex estates will necessitate formula clauses for Wills and careful computations on death and may result in Instruments of Variation.
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