Draft Finance Bill 2012 – 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 the government wish 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 does not affect the charity exemption which applies to gifts to charity.

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%.

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Whether or not the 10% threshold has been met (the 10% test) will be determined first of all by identifying what is called in clause 5 of Schedule 1 of the Bill the ‘baseline amount’ for each of three components in an estate. This baseline amount is calculated as follows:

  • Step 1 – Determine the part of the value transferred by the chargeable transfer which is attributable to the property in that component
  • Step 2 – Deduct from the amount determined in Step 1 the ‘appropriate proportion’ of the available nil rate band (NRB) – this will be the proportion equal to the proportion that the amount determined in Step 1 bears to the value transferred by the chargeable transfer as a whole. The available NRB is of course that which is enhanced by a claim under s.8A and reduced by chargeable transfers made in the seven years prior to death
  • Step 3 – Add to the amount determined in Step 2 an amount equal to so much of the value transferred by the relevant transfer as (in total) is attributable to property that
    • Forms part of that component, and
    • Is property in relation to which s.23(1) applies

The three components of an estate are:

  1. The survivorship component – this includes all the property comprised in the estate that immediately before the deceased’s death was joint or common property liable to pass on their death;
  2. The settled property component – is made up of all the settled property comprised in the estate in which an interest in possession subsists to which the deceased was beneficially entitled immediately before death; and
  3. The general component –  which is all the property comprised in the estate other than the survivorship component, the settled property component and property the subject of a gift with reservation of benefit under s.102(3) FA 1986

If the 10% of the baseline amount is given to charity within a component then that component of the estate will automatically qualify for the reduced rate of IHT which is the 36% rate. Any remaining part of the taxable estate will be taxed at the usual 40%.

Paragraph 7 of the Schedule provides for an election to merge two or more components of an estate where the donated amount from one or more is at least 10% of the baseline amount for that component. If the combined components pass the 10% test they are to be treated as a single component which will qualify for the lower rate. To achieve merger of components an election has to be made by the appropriate persons.

The election has to be made within two  years of the death and must be made in writing by all those entitled to make the election. It may be withdrawn in writing not more than two years and one month after death. Both these dates can be extended at the discretion of an officer of HMRC.

It is inevitable that it will be necessary to have a formula gift in a Will or have a discretionary Will to achieve the tax saving 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, especially if agreement may not be reached between the three component parts to make an election to merge them for the purposes of the relief.

Application of the rule

The normal rules for establishing the taxable value of an estate apply:

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.

For the purpose of calculating the donated amount and not the baseline amount:

  • paragraph 6(1) provides that any calculations under s.38(3) or (5) IHTA 1984 (grossing up) will be made using the lower rate;
  • paragraph 6(2) provides that any reduction in the donated amount that would normally arise through the interaction of exemptions and relief under s.39A IHTA 1984 is to be ignored

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.

Difficult assets

Any type of asset qualifies for the new relief which 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 imposing the relief on an estate by making it apply automatically might actually cost the charity money and could increase the administrative burden for all concerned.

For this reason although the relief is to apply automatically paragraph 8 provides for an election to opt out of the lower rate for one or more components of the estate so that they are treated in effect as if the charitable donation failed the 10% test. The election has to be made by all the same appropriate persons.

There are provisions to disregard the relief where certain deferrals of tax apply such as with conditional exemption and woodland relief.

Practicalities

During the consultation process it was pointed out that that in many cases  Wills will have been prepared under old law and remain unchanged so there would be no provision to take advantage of the 10% rate reduction. 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 as to the value of a person’s likely estate on death 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 anticipated 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.

As a result paragraph 9 introduces amendments to s.142 IHTA 1984 to the effect that where property is redirected to a charity by means of an Instrument of Variation the variation is not to be treated as being made by the deceased unless the persons executing it show that the charity has been notified of the variation. This change is to apply whether or not the redirection is sufficient to qualify for the reduced rate.

Practice points:

  1. In each estate where, after consideration of reliefs and exemptions, there is a net chargeable estate it will be necessary to explain to the relevant beneficiaries the effect of making an Instrument of Variation to utilise the relief.
  1. There will be some significant number-crunching required in a few estates to ascertain the benefits or otherwise of merging different components
  1. It will be necessary to quote separately for the fees involved in:
  • potentially negotiating a merger of components; or
  • calculating whether, and if so how much of an estate needs changing in order to reduce the impact of IHT; or
  • helping a charity to decide whether or not to opt out of the relief.
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