Time for a makeover: is inheritance tax dying for reform?

14th November 2023

Blake Morgan Partner Lisa Davies sets the scene on the call for inheritance tax reform and explains that the UK’s approach is still at odds with the majority of other countries.

This inheritance tax reform article was first published in the Solicitors Journal on 27th October 2023.

The Gov.UK website tells us that ‘Inheritance Tax is a tax on the estate (property, money and possessions) of someone who’s died’. It goes on to say that if the value of your estate is below the tax-free threshold, (or ‘nil rate band’ – currently £325,000), then there will normally be no tax to pay, as is the case if you leave anything above the threshold to your spouse or civil partner or to charity.

Figures from the Institute for Fiscal Studies (IFS) support the fact that only a small number of estates will pay inheritance tax (IHT). The IFS revealed in its Green Budget 2023 report on 27 September that IHT revenues are relatively low, at around £7 billion (or just 0.3 per cent of gross domestic product) a year. However, the nil rate band has been frozen since 2009 (and extended at this rate to 2028) and that, coupled with higher property prices, means more estates are likely to be liable for IHT in the future. This is a trend we can already observe when we note that HM Revenue and Customs (HMRC) collected a record sum of £5.4 billion from IHT in 2018/19.

Inheritance tax is not a new tax, or a popular one. Death duties, in some version, have been levied in the UK since they were first introduced in 1796 and, in its current form, IHT is often reported to be ‘Britain’s most hated tax’. A 2015 YouGov poll found that only 22 per cent of respondents believed inheritance tax was ‘fair’ (compared to 55 per cent who agreed with the fairness of income tax) and it was the least popular among the 11 major taxes featured in the survey.

It is widely accepted that inheritance tax is overly complex and in desperate need of reform.

Rishi Sunak has been reportedly considering a cut to inheritance tax rates, or possibly the total abolition of the tax. The government is clearly aware that there are serious issues around IHT and have been looking at its simplification and reform for some time. It set up the All-Party Parliamentary Group for Inheritance and Intergenerational Fairness (APPG), which reviewed the current IHT arrangements and made recommendations for reform to the Office of Tax Simplification (OTS). The OTS, in turn, published reports in November 2018 and July 2019, exploring the main complexities and technical issues that arise from the way the tax is structured and the existing administrative processes. The OTS made 11 recommendations for the simplification of IHT across three key areas: lifetime gifts, interaction with capital gains tax, and available reliefs.

The subject was revisited in January 2020, when the APPG produced a further report in which it once again suggested radical reform and simplification of the current IHT regime.

So, what reforms are now being suggested?

The current flat rate of IHT is high at 40 per cent. Having high rates, leads to there being lots of reliefs, problems with tax avoidance and an increase in lobbying for further exemptions.

One suggestion is to replace the current regime with a simpler, lower flat rate gift tax that would be payable both on lifetime and death transfers. The proposals would see an end to agricultural and business property relief; the charity exemption would remain, but there would be no reduced rate on the remaining estate where more than 10 per cent is given away, and the seven-year rule around potentially exempt transfers and chargeable transfer would go. This would have the effect of abolishing the anti-avoidance rules on gifts with reservation of benefit and pre-owned assets income tax, as all lifetime gifts would be taxed anyway. Finally, in a move that would delight the vast majority of tax practitioners, the residential nil rate band (an unfair and hugely complex relief applicable to qualifying residences left directly to certain categories of relatives) would be abandoned altogether.

Research among 500 members of the Society of Trust and Estate Practitioners (STEP), including solicitors, tax advisors, financial planners and accountants, showed that the majority (65 per cent) agreed with the recommendation of a new 10 per cent flat rate as the best way to simplify the system and discourage tax avoidance.

This low flat rate and the streamlining of gifting and inheritance tax would not only make the tax regime simpler and fairer, but could help bring the UK into line with tax regimes in other countries.

Twenty-four of the 36 Organisation for Economic Cooperation and Development (OECD) countries levy wealth transfer taxes. The UK is unusual in applying flat rates to inheritance taxes and is one of only seven countries that do. Of these, the UK has the joint highest flat rate of tax at 40 per cent, the same as the US, compared with flat rates in Hungary of 18 per cent and Portugal of just 10 per cent. In practice, the ability to claim allowances and reliefs means the average effective tax rate (the rate estates actually pay) is generally much lower, which suggests reducing the rate and simplifying the system would achieve similar results by a less tortuous route.

In contrast to the UK’s flat rate of tax, 15 OECD countries apply progressive rates, where the tax rate rises with the value of the inheritance. These range from 1 per cent in Chile to 80 per cent in Belgium. Nearly all countries with progressive tax rates apply different rates (and tax-free allowances) depending upon the proximity of the relationship between the donor and beneficiary, with only Korea applying one progressive rate to all heirs. Progressive rates for spouses and children are lower and vary less widely across countries than the higher rates that usually apply to other family and non-related persons.

The entire way we approach inheritance tax in the first place is still at odds with the majority of other countries. Twenty of the 24 countries with inheritance taxes as part of their statutes, levy the tax on the beneficiaries of wealth transfers; whereas only three other countries apart from the UK (Denmark, Korea and the US), impose estate taxes on deceased donors. Most countries that levy inheritance taxes also impose a gift tax on lifetime transfers, again typically on the beneficiary. Ireland is the only country of the 36 to have a combined inheritance and gift tax (‘capital acquisitions tax’, CAT), which considers all wealth transfers received by beneficiaries over their lifetime. Under Irish rules, you may receive gifts and inheritances up to a set value over your lifetime before having to pay CAT, but once due, it is then charged at the relatively high flat rate of 33 per cent.

Why not simply do away with IHT altogether?

A number of countries that previously taxed their citizens on inheritance and gifts have already taken this step. Ten OECD countries have abolished their estate or inheritance taxes, whereas two countries (Estonia and Latvia) have never taxed wealth transfers at all. Of those that have chosen to abandon this form of taxation, Austria, the Czech Republic, Norway, the Slovak Republic and Sweden have all abolished their inheritance taxes since 2000. Israel and New Zealand abolished them between 1980 and 2000, whereas Australia, Canada and Mexico took the step much earlier, seeing the back of inheritance tax prior to 1980.

One of the reasons for abolishing this form of tax in other countries is that they have found that the revenue inheritance tax generated was not significant. On average only 0.51 per cent of total tax revenues are sourced from these taxes in countries that still levy them, and revenue from inheritance, estate and gift taxes, generally, exceed 1 per cent of total taxation in just four OECD countries (Belgium, France, Japan and Korea).

It is not surprising then, that in response to the recent OECD Questionnaire on Inheritance, Estate and Gift Taxes, the most common rationale cited by countries for continuing to impose an inheritance tax was not revenue generation, but social justice: the redistribution of wealth and a wish to increase equality of opportunity and to tax unearned windfalls.

Paying taxes is a moral obligation to society; without taxes we would have no police, schools or hospitals. The suggested lower flat rate would address this by seeking to maintain the revenue stream, but in a way that is fairer than the current IHT regime. The aim of the reform proposed by the APPG would be to ensure that higher value estates, which currently take advantage of existing reliefs and exemptions, actually pay tax. The first OTS report in 2018 revealed that the average effective rate of IHT is 20 per cent for estates valued at £6 to 7 million, after which it falls to just 10 per cent for estates valued at £10 million or more. Furthermore, this does not take account of lifetime giving, which is likely to be more prevalent among the wealthier, whose estate value is less likely to be tied up in the family home. The proposed flat rate would be 10 per cent, or up to a maximum of 20 per cent, but not higher, as evidence gathered by the APPG suggests that rates above 20 per cent start to incentivise tax planning.

The current situation

The IFS forecast that by 2032-33, revenue from IHT will rise to the equivalent of £15 billion in today’s prices (representing 0.5 per cent of gross domestic product), largely due to increasing wealth in the hands of generations of retirees. In the UK, inherited wealth is increasing and this is set to continue. The IFS report that for those with the wealthiest one-fifth of parents, inherited wealth (as opposed to earned income) is set to rise from averaging 17 per cent of lifetime income for those born in the 1960s, to averaging 30 per cent of lifetime income for those born in the 1980s. They claim that if the annual flow of inheritance expected next year were to be shared equally across all those aged 25, this would equate to each person in that age group receiving a pay-out of around £120,000.

Changing the way inheritance tax is charged will not be sufficient to level-up as by the time inheritances are received, wealth inequality is already substantial. The IFS advise that in the age bracket 50-54, the children of the wealthiest one-fifth of UK parents will have an average of £830,000 in wealth, with the parents bequeathing around £380,000 per child, whereas children of the least wealthy one-fifth will have average wealth of around £180,000 and the parents will bequeath less than £2,000 per child. Clearly more needs to be done at the governmental level to make an impact on intergenerational wealth mobility, but IHT reform may be a good place to start.

One final thought – if we are not going to abolish inheritance tax, then alongside reform of the tax itself, perhaps a public image makeover would be advantageous?

We need taxes to fund public spending and we have established that even though IHT does not produce the biggest revenues, it is increasing. Changing the rates is not alone likely to alter the negative perception people have of IHT. The evidence is that inheritance tax is not well understood (partly due to its complexity), and many people wrongly overestimate the likelihood of their estates being subject to IHT or how much the effective rate would be once spouse exemption and other reliefs are considered (it is generally below 20 per cent compared to the headline rate of 40 per cent).

An OTS survey of nearly 3,000 people in the UK revealed that 26 per cent of respondents thought 20 per cent or more of people paid IHT, compared to the reality of less than 5 per cent.

People’s attitudes and public perceptions of capital and inheritance taxation change when they are given information on inequality. A 2021 Swedish study by Bastani and Waldenström on the ‘Perceptions of Inherited Wealth and the Support for Inheritance Taxation’ involving 12,000 adults randomly surveyed, found that exposing people to facts about inherited wealth significantly increased support for inheritance taxation.

Another area where reform is greatly needed and much overdue is the funding of social care. If inheritance tax were to be rebranded and the revenue collected from it earmarked for the financing of old-age care, perhaps it would be better perceived? The ‘social care charge’ has undoubtedly more appeal than death duties ever could.

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