Chapter: 2 - Inheritance Tax Mitigation: The Basics

Potentially exempt transfers (PETs)

2.2.2

The scope of the PET regime was dramatically cut down by Budget 2006, as no longer can a PET be made into a trust (other than a trust for a disabled person).  However, in broad terms, a gift to an individual which he survives for seven years is IHT exempt, whatever the amount (IHTA 1984 s3A).  If he dies within the seven year period the gift is chargeable.  The nil-rate band is attributed to gifts made in the seven years before death according to the order in which they were made (after of course having knocked off any exemptions). 

Tapering relief is available if death follows at least three, but less than seven, years after the gift:

Years between transfer and death                                       Percentage of full tax rate    

Not more than 3                                                                                                100%   
More than 3 but not more than 4                                                                          80%   
More than 4 but not more than 5                                                                          60%   
More than 5 but not more than 6                                                                          40%   
More than 6 but not more than 7                                                                          20% 

There is no benefit from tapering relief if the whole gift falls within the nil-rate band, because no IHT is chargeable.  However, even if death does follow within three years, making a PET could bring valuation advantages, as the taxable value is that on the date of the gift, not at the date of death.

Certain points need to be borne in mind with PETs, as outlined below.

(a)   The danger of premature PETS
The effect of the legislation (IHTA 1984 s7(1)) can easily go unnoticed. In particular, it can render the IHT effects of making a PET worse than if the assets concerned had been left in the transferor’s estate on death.

Example 2.2
Bertie made a gift of £500,000 to a discretionary trust on 1 September 2004. This was a chargeable transfer and IHT was paid accordingly. Five years later he made a PET of £200,000 to his daughter. Bertie died on 1 October 2011 with a fully chargeable estate of £800,000 (after the 2004 chargeable transfer had ceased to be taken into account).

IHT on the failed PET is £80,000, since the 2004 transfer constituted Bertie’s cumulative total in 2009 – and exceeded the nil-rate band.

IHT in the death estate will be calculated by including the failed PET in the cumulative total, that is a chargeable total of £1m, producing a taxable amount of £675,000 after the nil-rate band of £325,000 and a tax liability of £270,000.

By contrast, had the PET never been made and had instead Bertie’s daughter taken a share of residue under the Will, with the consequence that a further £200,000 would form part of the death estate, tax on the enlarged estate of £1m would again be £270,000.

On these facts therefore extra IHT arising out of the PET is £80,000.

TAX TRAP:  This ‘7+7=14’ trap is easily overlooked.  Even where the transferor of a chargeable transfer is likely to survive that transfer by seven years, caution should await their elapse before making a PET, to avoid the possibility of an unnecessary IHT liability.

(b)   Falls in value since date of PET or chargeable lifetime transfer
What happens where the asset given away falls in value following the gift, so that its value at the date of the transferor’s death within seven years is lower than its value at the date of the gift? There is a measure of relief: subject to conditions, the person liable to pay the tax on the PET or chargeable lifetime transfer may claim that the lower value be taken, for purposes of calculating the IHT or additional IHT (IHTA 1984 s131). It is the transferee who has the primary liability for the tax.  There is no prescribed form and the claim is made simply by an informal letter (within four years after death).

However, note that this relief cannot apply where the asset given is a wasting asset, or to the extent that the fall in value occurs within the nil-rate band. The latter may seem unfair, since it has the effect of pushing up the IHT liability on the rest of the estate by denying it part of the nil-rate band, but the rule is apparently so drawn intentionally. Indeed, this restriction seems to be the legitimate corollary of the principle that appreciation in value of the subject-matter of a PET which becomes chargeable escapes IHT.  Where the transferee has sold the asset before the transferor’s death, the lower sale value may be taken into account instead of the market value at the date of death, provided that the sale has been made by the transferee or his spouse/civil partner in an arm’s length sale to an unconnected purchaser.

The eventuality can easily arise with development land where, for example, in the intervening period the development potential, secured typically by options, disappears.

TAX TRAP:  Do bear in mind the IHT downside of a fall in value of the subject-matter of a lifetime gift.  The loss of the nil-rate band on death to that extent could be an unwelcome twist.

(c)  When does the transfer of value take place, to establish a PET?  At what point does the seven year period start running?
While this was not the specific issue in the Court of Session case Linlithgow & Anor v RCC [2010] CSIH, the decision established a point which is also relevant to that broader question.  The point in the case was whether the gift had been made before 22 March 2006, following which gifts to accumulation and maintenance trusts were no longer PETs.  The transfers in land were made on 15 March 2006, but were not recorded in the Register of Sasines until 10 October and 16 November 2006 respectively.  HMRC argued as a result that the transfers of value were not PETs.  However, the Court held (unsurprisingly) that a transfer of value for IHT purposes occurred when the gratuitous disposition of heritable subjects in Scotland was delivered to the transferee rather than when it was recorded in the Register of Sasines. 

HMRC’s arguments seem very odd (although perhaps the amounts at stake might have been large), certainly in the context of clear findings by the Court in eg Re Rose [1949] Ch 78 with share transfers that it is the date of the transfer form not the date of registration in the company’s books which determines the date of transfer.  There is a clear distinction between the legal and (as relevant for tax purposes) the beneficial interest.  That said, there may be cases, typically involving private companies, where the transfer of value will follow the date of the transfer form, for example where there are pre-emption rights (when it will not be until all potential purchasers of the shares have been eliminated) or perhaps where certain transfers of shares require board approval: even so, in either case, this may be before the date of registration.

(d)   Ensure no reservation of benefit
If a benefit is reserved from the gift, the asset will not effectively leave the chargeable estate until such time (if ever) as the benefit ceases (FA 1986 s102(3) and (4)). See 3.2.2.

(e)   The pre-owned assets regime
The POA charge with effect from 2005/06 can catch successful attempts made since March 1986 to avoid the reservation of benefit rules.  If a person has disposed of land or chattels – or contributed to their acquisition – and he occupies the land or possesses the chattels, there is, subject to some exemptions, an annual Income Tax charge on the benefit.  A similar point applies in relation to ‘intangible’ property (life assurance policies and the like) owned by a trust from which the settlor can benefit.  See 3.2.3.

(f)   Other taxes 
See 2.14 for the possible impact of Capital Gains Tax (CGT), Stamp Duty Land Tax (SDLT) and even Value Added Tax (VAT).