STEP LONDON CENTRAL BRANCH STEP CHARITY SPECIAL INTEREST GROUP IHT RELIEF FOR 10 PER CENT CHARITY BEQUESTS 1. The relevant legislation is contained in Schedule 1A to the Inheritance Tax Act 1984, added by Schedule 33 to the Finance Act 2012. It has effect in relation to deaths occurring on or after 6 April 2012. We cannot therefore use it by way of a post-2012 variation of the will of a pre-2012 testator. * 2. In essence the relief is that, if an estate includes gifts to charity amounting to 10 per cent, then not only is that exempt from inheritance tax, as it would have been before, it also reduces the rate of tax on the rest of the estate by 10 per cent from 40 per cent to 36 per cent. This represents part of the Big Society. It is a way of encouraging private individuals to shoulder some of the burden of what would otherwise be public expenditure. The heritage of such an idea is at least as old as the Charitable Uses Act 1601. Some say myself included that it would have been better if the legislation had applied also to lifetime philanthropy, and I shall return to that point in a moment. But it is a start. 3. What I am going to do is to attempt answers to the following for questions : (a) How does the relief work? (b) How does this affect will drafting? (c) How will it affect deeds of variation? Mark Herbert 2012 1 29 November 2012
(d) How could the relief be extended to lifetime giving? How does the relief work? * 4. The first point is that the estate has to be divided between three components, survivorship, settled property and general. The relief applies separately to each component. On the other hand there is provision for an election to merge two or more components, which might be useful if a charitable bequest exceeds 10 per cent of the general component. The three components are roughly what you might expect, but there are points of importance to bear in mind. * 5. The survivorship component consists of property which is taxable as part of the deceased person s estate but which accrues to another person on death by survivorship. It therefore does not include a severed share of property held in common. On the other hand it does include property held by way of a joint tenancy, even if there is a later deed of variation by which the joint tenancy is treated as if it were severed. It also applies to overseas property which accrues in a similar way under the local law. An estate may include several assets in this category, possibly with more than one joint tenant. But all of them have to be taken together as a single component for the purposes of this relief. This component is not immediately relevant unless the joint owner is itself a charity, but it might become relevant for a merger. 6. The settled property component consists of settled property which is taxable as forming part of the deceased person s estate at his death. It does not include a discretionary trust which comes to an end on the death. So it includes only property in which the deceased person had a pre-2006 interest in possession, an immediate post-death interest or a deceased person s interest. Again the deceased person may have had interests in possession in more than one trust, but they must all be taken together as a single component. * Mark Herbert 2012 2 29 November 2012
7. The general component consists essentially of the free estate. It does not include potentially exempt transfers made during the last seven years of the deceased person s life, nor does it include gifts with reservation of benefit. Those are taxed at the full rate but as lifetime dispositions, so they use up the first tranches of the available nil-rate band. On the other hand the general component does include the deceased person s share of property held in common, including previously joint property where severance has actually occurred during lifetime. Also a gift with reservation of benefit can be brought into the reckoning by an election to merge it with the general component. 8. One way of explaining the relief is to go through a worked example : * Facts : Lord Snooty died in May 2009 leaving his residuary estate then worth 3 million to his widow the second Lady Snooty. She has now died in May 2012 and her estate consists of business property worth 2.4 million and investments worth 4.5 million. She has left a legacy of 535,000 to charity, and residue to her daughter by an earlier marriage. * Lady Snooty also had a life interest under her husband s will in Skyfall Manor, now worth 1.2 million. This passes to the second Lord Snooty. Some years ago she gave her second home worth 300,000 to her daughter, but on examining the facts you find that she reserved a benefit. **** 9. The nil-rate band was unused at Lord Snooty s death, so that ( 325,000) can be added to Lady Snooty s own (also 325,000). The settled property component contained no charitable element, so that will be taxed normally at 40 per cent. The value of Skyfall Manor ( 1.2 million) is exactly 20 per cent of the total taxable estate, so that 20 per cent of the available nil-rate band will be applied to the settled property, 5 per cent ( 300,000 as a proportion of 6 million) and only the remaining 75 per cent will be left for the general component. *12 Mark Herbert 2012 3 29 November 2012
Actual Value General component Value for tax k k Business property 2,400 Investments 4,500 4,500 Less charity bequest (535) (535) Less 75 pc of NRB (487.5) Chargeable transfer 6,365 3,477.5 Add back charity bequest 535 * Baseline amount 4,012.5 IHT @ 36 per cent (1,444.5) 1,444.5 The heiress 4,920.5 ** 535,000 is more than 10 per cent of 4,012,500, and the relief is therefore available. 10. The legislation provides for the executors to merge other components with the general component. The idea is that the reduced rate of tax can then apply to the other component provided that the charity bequest is at least 10 per cent of the aggregate baseline amounts of the two merged components. In the example, the executors might consider merging the settled property and general components. The total baseline amount would be 5,082,500. And 535,000 is more than 10 per cent of the aggregate of the two baseline amounts. There could therefore be an election to merge those two components. But that would benefit little Lord Snooty, not Lady Snooty s heiress daughter, and for all we know they may not be on good terms. If they were on good terms, however, Lord Snooty s tax bill could be reduced by 42,800. The gift with reservation could also be merged, and this would benefit the daughter herself, reducing the tax bill on the gift with Mark Herbert 2012 4 29 November 2012
reservation by a further 10,700. The incentive to merge all three components would seem reasonably clear. 11. The election for merger needs to be made within two years after the deceased person s death, by the personal representatives and all the affected third parties and trustees. The election can be withdrawn, this time within two years and one month after the deceased person s death. HMRC do have a discretion to extend the period. * 12. The legislation also provides for the personal representatives to opt out of the relief. The point here is that, for the first time, the value of the charitable bequest needs to be ascertained in order to operate the relief. Bequests may be of assets other than cash, in which case professional valuations may be needed. Depending on the facts, the executors may form the view that the additional cost of valuation is disproportionate to the relief available, or in an extreme case might actually exceed it. Executors need to apply the usual standards of care and single-minded loyalty to the interests of their beneficiaries when deciding to make such an election. * 13. In real life estates are never so simple. Three particular problems occur to me : (a) The first may arise if land is sold within three years (but more than two years) after the deceased person s estate, and the sale price of all such land is substituted for the value at death. This may require re-computation of the relief. (b) The second problem is what is sometimes jokingly called the Schleswig-Holstein question, which is sometimes a challenge for all of us. What I mean is Part II Chapter III of the Inheritance Tax Act 1984, sections 36 to 42, under which value is attributed to different parts or shares of an estate when some shares are exempt but others not. This is far too complicated to be dealt with in a talk of this kind. Mark Herbert 2012 5 29 November 2012
(c) What happens if (1) the relief would apply to the general component on its own, (2) an election is made to merge another component and (3) the values turn out to be such that the charity bequest is less than 10 per cent of the combined baseline amounts? Is the relief on the general component irretrievably lost? 14. On the positive side, however, the arithmeticians have worked out that the net cost of a 10 per cent charity bequest is exactly the same as the net cost of a 4 per cent bequest. So, if the will prescribes more than 4 per cent, the beneficiaries have a positive incentive to make it 10 per cent. Will drafting 15. Disappointingly perhaps, I shall not attempt to include a drafting lesson in this talk. What I do say, however, is that in general simpler drafting is better than more complex drafting. In that context I heartily recommend the draft suggested by STEP itself, or the similar draft offered by HMRC themselves at paragraph 45008 of the IHT manual. * Deeds of variation 16. As for strategy, it may be thought that the best course might be to leave the decision to beneficiaries, by way of a deed of variation. However, that would leave the testator in uncertainty. One already well-known stratagem is to include a charitable gift in the will but subject to a 4 per cent minimum value. Simple arithmetic would then reveal to the supposedly reluctant beneficiaries that the amount of tax (and the net after-tax value of the estate) would be completely unchanged if they were to increase the charity bequest to 10 per cent. In this way the whole of the increase would be borne by the State. Better still, if the minimum in the will is set above 5 per cent, and the beneficiaries increase it to 10 per cent or above, they will actually receive a repayment of tax. Mark Herbert 2012 6 29 November 2012
17. It is essential, as it was before, that the deed of variation must not include anything by way of external consideration. Also there is something new in section 142(3A), namely that you have to show that the charity actually knows about its increased bequest. 18. Even greater flexibility could be provided, over and above the 4 or 5 per cent minimum, by providing an overriding power of appointment with charity as one of the objects. This could be helpful if there were a question whether or not to elect for a merger of components. A section 142 approach might be jeopardised by the prohibition on external consideration moving from the trustees of the other settled property (or, as the case may be, the co-joint-tenant or donee of a gift with reservation), while it would not be improper for the will trustees to take account of negotiations with such third parties when deciding on an exercise of their power of appointment. Lifetime philanthropy 19. At present the relief applies only to testamentary dispositions, and it is not to be immediately extended to lifetime philanthropy. But the consultation paper issued in early 2011 mentioned a promise to have a further consultation on the possibility of extending the concept to lifetime gifts of museum-quality works of art etc to the nation. This consultation was said to be planned for the summer. It did not specify which summer. Many commentators have pointed out that the really important aim should be to encourage lifetime giving, and that the proposed relief in its present form misses the point. Mark Herbert 2012 7 29 November 2012
20. It would be possible to extend the relief to take account not only of bequests to charity, as the legislation already does, but to take account of the cumulative value of lifetime gifts. No doubt HMRC would regard this as tax avoidance, but to my mind the more practical objection is that professional valuations of charitable gifts might then become necessary. Subject to that, this would be an improvement, and it should not be limited to museumquality works of art. To my simple mind the economy needs spendable assets. Mark Herbert TEP QC 5 Stone Buildings 29 November 2012 Mark Herbert 2012 8 29 November 2012