It's time for radical reforms to inheritance tax
Where I propose substantial reforms to the IHT regime, making it simpler whilst shifting the burden onto the largest estates
As the new Labour chancellor, Rachel Reeves has some difficult decisions to make in her first budget on 30 October.
Her party went into the election pledging not to raise income tax, national insurance or VAT. That has led to speculation that changes are coming to taxes such as inheritance tax (IHT) and capital gains tax (CGT) - and with a warning from Ms Reeves within weeks of taking office that the financial picture is worse than they imagined, any such changes are likely to be radical.
As someone who has spent much of the past 14 years of my working life advising clients on IHT, calculating IHT liability and completing IHT returns, I have some radical proposals of my own:
Simplify the ‘nil rate bands’ (the tax-free thresholds) by:
Increasing the nil rate band to £500,000,
Continuing to increase the nil rate band by the rate of inflation every year, and
Scrapping the residence nil rate band.
Introduce a nil rate band taper threshold of £2 million, whereby the nil rate band is reduced by £1 for every £2 the value of the estate exceeds the threshold.
Increase the rate of IHT from 40% to 45%.
These proposals might sound drastic, but hear me out.
Background
Inheritance tax is unfair on a number of levels.
There is an argument (which once persuaded me) that IHT is taxing assets which have already been taxed by income tax, national insurance, stamp duty and the like. That is the principle unfairness which those whose estates are likely to pay IHT rail against; a complaint I hear on a regular basis in my professional life.
But that is a false narrative. For many people, the asset which takes them over the threshold at which IHT is charged is their home. It is an asset which will likely have increased in value far beyond the rate of inflation and that gain will have been tax-free, partly because an individual's home is exempt from CGT and partly because CGT is not (currently) levied on death.
For example, a house bought in the South East for £150,000 in 2000 would now be worth a little over £492,000. That £342,000 gain (for doing nothing beyond owning the home for 24 years and ensuring it does not fall down in the interim) is 'unearned' but also untaxed. Had it been a second home being sold by an owner who is very much still alive, the CGT payable would likely be in the region of £80,000.
To put it bluntly, IHT is a tax on assets which are no longer needed, because the owner of those assets has passed away. Sure, there are beneficiaries who stand to inherit those assets, but for those beneficiaries it is unearned income that they are only receiving because someone has been generous enough to nominate them in their will (or by being the right relation if there is no will). They might be in a difficult financial position themselves and that money might be of benefit to them, but by the time an estate reaches the value at which IHT comes into play, the beneficiary’s need is very much outweighed by the state’s need to take a slice to fund vital public services.
Take an estate of £1.5 million, for example. If the estate is being divided between three siblings, the difference to them between inheriting £433,333, after the estate has been taxed, or £500,000, if IHT did not exist, is an amount the most vulnerable in society could only dream of having to their name. That difference can, and should, be used to support vital public services for all, such as the NHS, police and support for the least well-off.
Inheritance perpetuates wealth inequality. The average net estate value in 2019/20 was £334,173, considerably less than the inheritance each child would have received in the above example. IHT does not exist to eradicate wealth inequality, but it is designed (in theory, at least) to ensure that the tax burden is only felt by the wealthiest - and there are very specific exemptions and reliefs which exist to support spouses, civil partners, business properties and agricultural holdings left behind.
But therein lies a genuine inequality within the IHT rules. While spouses and civil partners can leave an unlimited amount of money to each other tax-free, the 3.6 million unmarried cohabiting couples in the UK - and, for that matter, those who live and own their homes with their siblings - cannot.
Consider the fictional estates of Jeremy and Kwasi. Both died in the same week with estates worth £650,000. Logic would dictate that their estates would both pay the same amount of IHT. However, when you drill down into the facts of their estates, you soon discover that not all estates are created equal.
Jeremy is in a civil partnership with Nadhim. The jointly own their home, a two-bedroom terraced house in Kingston upon Thames worth £700,000. His estate benefits from the spouse exemption, so the total IHT liability on his estate is nil.
Kwasi is unmarried. He owns and lives in a two-bedroom terraced house in Kingston upon Thames with his brother, Rishi, worth £700,000. Everything above his nil rate band of £325,000 is taxed at 40%, so the total IHT liability on his estate is £130,000.
Fortunately for Rishi, Kwasi’s share of their home is worth £350,000 while the remaining £300,000 of his estate is in savings and investments. That means there are enough liquid assets to pay the IHT bill without having to sell his home, but while Nadhim inherits £300,000 in cash from Jeremy, Rishi’s cash inheritance from Kwasi is reduced to £170,000 after tax. Had Kwasi and Rishi been unmarried partners, they could have married or entered into a civil partnership for the tax benefits (yes, that is a legitimate line of advice estate planners can offer to unmarried partners), but as siblings that option is obviously not open to them (although The Lord Lexden did introduce a private members bill in 2017 which sought to introduce a ‘sibling couples’ category of civil partnership to address this very issue).
For The Few
For all the Telegraph and Express scaremonger about IHT at every opportunity, only about 4% of estates pay it. Last year it raised around £7.5 billion for the treasury - barely one-third of the £22 billion 'black hole' Ms Reeves 'uncovered' in July and representing just 3% of government spending on health.
For a government which (rightly) says that those with the broadest shoulders should bear the heaviest burden in clearing the mess left behind by the Tories, a tax which takes aim at the perpetuation of wealth inequality is a prime target for reform, albeit any reform is likely to have a negligible impact in the grand scheme of government expenditure.
The reforms I'm suggesting here would not solve every inequality; people like Kwasi would still face an IHT bill. However, they would reduce inequality, increase the level at which IHT becomes payable and ensure that the wealthiest bear the heaviest burden.
The nil rate band
Every estate has a tax-free allowance, known as the nil rate band. Put simply, the first £325,000 of the estate is not taxed. The surplus above the nil rate band is taxed at 40%, subject to any residence nil rate band, transferable nil rate bands, exemptions or reliefs available.
One of the reasons why IHT is an increasingly hot topic is because the nil rate band has been frozen at £325,000 since 2009 and the last government kept it frozen at that level until at least 2028. In that time, assets, in particular properties, have increased in value, dragging people into the IHT net who would not have been caught by it 15 years ago. If the nil rate band had risen by the rate of inflation every year since it was frozen, it would now be a little over £500,000.
Proposal: increase the nil rate band to £500,000 and increase annually thereafter by the rate of inflation.
Increasing the nil rate band would correct the tax-free allowance for inflation. Continuing to increase it every year would ensure it remains at a fair level, reducing the number of people dragged into the IHT net as the value of their assets increases.
Crucially, it would reduce the risk of siblings and unmarried cohabitees having to sell their home to pay a tax bill.
The residence nil rate band
Cast your mind back to 2007. The Conservatives were on the back foot after Gordon Brown ascended to the premiership, giving his Labour party a convincing poll bounce. In need of vote-winning policies, shadow chancellor George Osborne announced that IHT would not be paid on estates under £1 million.
Of course, by the time they made it to government, they were in coalition with the Liberal Democrats, who simply would not countenance the idea of such a tax break for the wealthy during austerity. Even the Conservatives balked at a straight increase in the nil rate band when they had the chance. Instead, they introduced the residence nil rate band, the effect of which is that some estates worth £1 million do not have to pay tax, while others do (remember: not all estates are created equal).
Keeping it simple, if someone leaves their home to their children or other descendants (I won't list the classes here; it is an extensive, if exhaustive, list), their estate is eligible for the residence nil rate band of £175,000. That puts their effective tax-free allowance at £500,000. If they are married or in a civil partnership and leave everything to their spouse, their residence nil rate band carries over to their spouse’s estate, leaving the surviving spouse or civil partner’s estate a tax-free allowance of up to £1 million.
In order to claim the residence nil rate band, a full IHT return needs to be completed and submitted to HMRC, even if there is no IHT to pay. This is in contrast to the nil rate band and transfer of a spouse’s nil rate band, which are applied without the need to contact HMRC. Many of the IHT returns I complete professionally are simply to claim the residence nil rate band; there is no IHT being calculated or paid. This takes time out of my day, which in turn costs my clients more and, from a public policy perspective, means taxpayers’ money is being used to pay for someone to sit and check through an IHT form for nil return to the treasury. And they are not short forms: the main return is on form IHT400, which is 16 pages long, while additional schedules can push the total return to upwards of 30 pages.
Proposal: scrap the residence nil rate band.
This would simplify the IHT process in removing a nil rate band which is discriminatory and not widely understood by the public (and I haven't even mentioned ‘downsizing allowance’), and ensure that the number of IHT returns being submitted to HMRC where tax is not being paid is significantly reduced.
By combining this with an increase to the nil rate band, scrapping the residence nil rate band would have no impact on those currently entitled to it, while those not entitled to it would have the same tax-free allowance, making the IHT regime fairer.
Tapering off
Remember when I said not all estates are created equal? Even in circumstances where a deceased’s home is being passed to their descendants the residence nil rate band is not universal.
Once the value of an estate reaches £2 million, the residence nil rate band begins to ‘taper off': for every £2 the value of the estate exceeds £2 million, the residence nil rate band is reduced by £1. On an estate worth more than £2.35 million, the residence nil rate band is not available.
(Whether there is a residence nil rate band which can be carried over from a spouse or civil partner depends on the value of their estate and when they died, a process involving yet another schedule and even more calculations).
The result of tapering off is that the very wealthiest estates pay more tax. Scrapping the residence nil rate band will have no effect on estates worth more than £2.35 million.
Proposal: introduce a nil rate band taper threshold of £2 million, whereby the nil rate band is reduced by £1 for every £2 the value of the estate exceeds the threshold.
A nil rate band taper would ensure those with the broadest shoulders bear the heaviest burden (or, at least, their estates do). An estate worth £3 million would have no nil rate band available to it. If the estate is entitled to the nil rate band of a predeceased spouse or civil partner, the nil rate band would completely disappear once its value reached £4 million.
In short, the wealthiest would be taxed more, further offsetting the hit the treasury would take by increasing the nil rate band.
The tax rate
When I sit in front of clients and tell them the IHT rate is 40%, I am always conscious of the look of horror which is inevitably returned. It is, indeed, one of the highest inheritance tax rates in the OECD.
And yet it is not the highest tax rate which is levied in the UK. Earned income falling within the higher rate income tax bracket is taxed at 45%. Assets which are no longer needed are taxed at 40%.
Proposal: increase the rate of IHT from 40% to 45%.
There is no great simplification or equalisation argument here. This proposal is purely, simply and shamelessly to increase revenue from those who can afford it the most, by aligning the IHT rate with the higher rate income tax rate.
The effect
To see the practical effects the above proposals would have, let us consider two estates.
Sajid had never married and had no children. His estate was worth £500,000, which he is leaving to his nieces and nephews. Under the current IHT regime, the tax bill would be £70,000. Under the above proposals, the whole estate would be exempt from IHT.
Philip was a widow with two children. His estate was worth £2.5 million, which he is leaving to his children. Under the current IHT regime, the tax bill would be £670,000. Under the above proposals, the IHT payable would be £787,500.
As you can see, the burden has shifted towards the largest estates, so while there might be more estates exempt from IHT, those which do pay it would often, if not always, end up paying more. In particular, the highest value estates would always end up paying more.
Summary
As much as I would like to take credit for these proposals, there is little new in them. Most have already been suggested by other, more influential bodies, either solely or in combination with others. Indeed, the Westminster rumour mill suggests at least some of this is under treasury consideration as we speak.
What is for certain is that IHT will feature in the budget on 30 October; it has to because the government has already tied its hands behind its back on income tax, national insurance, VAT and corporation tax.
This is an opportunity for the government to do something truly radical with IHT, making the regime fairer as well as increasing the amount it raises for the treasury. Whether Ms Reeves will be radical remains to be seen on 30 October.
I'll be watching with bated breath!
Note: the examples used in this article are entirely fictitious. Indeed, the more eagle-eyed will have spotted that the names used are those of the most recent former chancellors of the exchequer.