PRE-BUDGET STATEMENT - INHERITANCE TAX (IHT)

Many tax payers may be confused by Alistair Darling's contradictory comment in the 2007 Pre-Budget Statement. 

Firstly, within a Pre-Budget Press Release, with respect to Income Shifting the following statement was made:

"The Government believes it is unfair for one person to arrange their affairs so that their income is diverted to a second person, subject to a lower tax rate, to obtain a tax advantage."

However, the attitude is quite different when considering capital assets, in his Pre-Budget Speech he stated:

"In capital gains tax there is currently transferability between spouses, recognising that capital assets are built up jointly over a lifetime.

In inheritance tax there is currently 100 per cent spouse relief, but no transferability of allowances.

I want to ensure that husbands and wives can benefit from each others unused inheritance tax exemptions."

From 9 October 2007, the new rules which will apply equally to married spouses and civil partners, will see  the combined tax-free allowance for spouses' estates increase to £600,000 rising to £700,000 by 2010.

The new allowance will also apply to people who have already lost their spouse.

By way of an example:

Peter dies on 14 April 2007 with an estate of £400,000, which he leaves entirely to his spouse, Beverley. Beverley dies on 17 June 2009 leaving an estate of £700,000 equally between her two children. When Beverley dies the nil-rate band is £325,000. As 100% of Peter's nil-rate band was unused, the nil-rate band on Beverley's death is doubled to £650,000. As Beverley's estate is £700,000 there is a liability to IHT on £50,000.

The new rules also provide for the transfer of a proportion of the unused tax-free allowance between spouses as the following example illustrates:

Jane dies on 27 May 2007, with an estate of £300,000. She leaves legacies of £40,000 to each of her three children with the remainder to her spouse Ken. The nil-rate band when Jane dies is £300,000. Ken dies on 15 September 2009 leaving his estate of £500,000 equally to his three children; the nil-rate band when K dies is £325,000. Jane used up 40% of her nil-rate band when she died, which means 60% is available to transfer to Ken on his death, So Ken's nil-rate band of £325,000 is increased by 60% to £520,000. As Ken's estate is £500,000 there is no IHT to pay on Ken's death. 

The reality of the change is not materially different to the position where basic planning has been carried out by a couple's solicitor. The affect of the change where no planning is undertaken is to provide an overall increased allowance of the difference between the nil-rate band at the date of death for both spouses.

Reconsidering the first example above, is the position different if Peter had given £300,000 to a Nil-Rate Band Discretionary Trust to benefit his two children on his death, with the remainder to Beverley. Upon Beverley's death her estate would now be valued at the reduced figure of £400,000 and she would be entitled to her nil-rate band of £325,000, so she will have a liability to IHT on £75,000.

The difficult question that now arises is with regard to drafting Wills. Should people be making use of Nil-Rate Band Discretionary Trusts upon the death of the first spouse or civil partner?