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 £300,000 to a discretionary trust on 1.6.01. This was a chargeable transfer and IHT was paid accordingly. Five years later he made a PET of £100,000 to his son. Bertie died on 1.8.08 with a fully chargeable estate of £500,000 (after the 2001 chargeable transfer had dropped out of cumulation).

IHT on the failed PET (at 2008/09 rates) is £40,000, since the 2001 transfer formed part of Bertie’s cumulative total in 2006.

IHT in the death estate will be £115,200 calculated (as expected) by including the failed PET in the cumulative total.

By contrast, had the PET never been made and had instead Bertie’s son had taken a share of residue under the Will, with the consequence that a further £100,000 would form part of the death estate, tax on the enlarged estate of £600,000 would again be £115,200. On these facts therefore extra IHT arising out of the PET is £40,000.

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 (IHTA 1984 s131). However, note that this 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. 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.

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) 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 2006 s102(3) and (4)). See 2.13.1.

(d) 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 2.13.2.

(e) Other taxes 
See 2.15 for the possible impact of Capital Gains Tax (CGT), Stamp Duty Land Tax (SDLT) and even Value Added Tax (VAT).