Contents

Introduction and historical background
Tax rates and bands
How the tax is calculated
Farmland and Farm houses
The relationship between inheritance tax and capital gains tax
How a spouse can benefit from the unused allowance of a deceased spouse
Domicile
Cross border estates

Introduction and historical background

Inheritance Tax (IHT) is the modern name for one of the oldest taxes.  Previously, it has been called Capital Transfer Tax and death duty.  Death duty was introduced in 1694.  As a wealth tax, it was never popular but it did not begin to hit estates particularly hard until the 20th century. 

The tax provokes stronger feelings than any other tax, even among people who are unlikely to be affected by it in the near future.  It is not hard to see why.  Unlike other taxes, it does not make up a share of new money being generated.  It is quite simply a tax on wealth which many see as an unfair and arbitrary grab by the Government of what does not belong to them. 

There are a number of ways in which the impact of IHT can be minimised.  Nearly all of them require either some relinquishment of some of their assets from their control or the taking out of some sort of insurance.  The decision whether to take measures to save tax will depend very much upon what the individual wants as a priority.  IHT is usually reviewed by a person when they are considering making or changing their will or whether they taking personal financial advice relating to their affairs. 

Tax Rates and Bands

The Government has announced the IHT nil rate bands for the following tax years:

• 2009/10 - £325,000
• 2010/11 - £350,000

How the tax is calculated

Firstly, all of the assets in the estate are valued.  The assets include not only those which are in the estate just after death.  They will also include assets in the deceased's estate which passed automatically on death (usually joint property) and gifts (unless they are exempt) made during the deceased's lifetime within 7 years of his death.

The next stage is to look at how the deceased's is to be distributed and see which gifts and which assets qualify for special reliefs such as farmland, gifts to charity and gifts to spouses or civil partners.  The sum of the exempt items is then deducted from the estate and the total chargeable estate is determined.

The nil rate band  is then deducted from the total chargeable estate.  The result is the taxable estate.  The tax payable is 40% of the taxable estate. 

Note:  (1)  the nil rate band may now be higher on an estate where the deceased's spouse has any unused nil rate band up to a maximum of £600,000.
           (2)  in very large estates where there are significant life time gifts, tapering relief may apply to reduce the amount of tax if the death occurs between 3 and 7 years of the death.

Simple example

John dies in October 2007 unmarried leaving an estate of £720,000.  2 years before he died, he bought a house for his nephew Peter and his wife costing £150,000.  In his will, he leaves £100,000 to a cancer charity and the remainder to his said nephew Peter.  His Estate comprises his home, a 4 bedroomed house in the town worth £350,000.  He has 25 acres of farmland worth £100,000.  The remainder of his estate (£270,000) is made up of stocks and shares. 

Step 1.  Work out the estate for IHT purposes.  This has to include the lifetime gift because it was made less than 7 years before his death.  Total estate for tax purposes is £870,000

Step 2   Work out the taxable estate.  There is no spouse but the gift to charity is exempt.  So also will the farmland be subject to agricultural relief.  The taxable estate is therefore (870,000 minus 100,000 minus 100,000) £670,000

Step 3   Deduct the nil rate band and work out the tax.  The nil rate band in October 2007 is £300,000.  The tax is 40% of £370,000 (670,000 minus 300,000) which is £148,000

Farmland and Farm houses

If a property is farmland, it has 100% relief from inheritance tax.  Farmhouses are also exempt provided that they modest dwellings.  If a house on an estate is too large or not sufficiently functional as a farm house, it may not be eligible for relief.

The relationship between inheritance tax and capital gains tax

At first sight, these two taxes are mutually exclusive.  Inheritance tax is a tax on estates, whereas capital gains tax is a tax on lifetime gains.  There can, however be an overlap in the following way.  If a gift is made during the lifetime of the deceased, any tax already paid as a result of that gift being made will be offset against the element of it (if any) which is charged to Inheritance Tax.  That can only arise where the gift is made within 7 years of the deceased's death.

Once a death has occurred, there is no capital gains tax paid.  From the beneficiary's point of view, they acquire their asset out of the estate at the value that it was at the time of death.   If there is a gain during the course of the administration of the estate, capital gains tax can be payable on the difference between the sale value and the value at the time of death.

How a spouse can benefit from the unused allowance of a deceased spouse

If a person dies having inherited from their spouse in circumstances where the nil rate band was not used or not fully used, that unused nil rate band can be transferred to the deceased's estate.

The amount of unused nil rate band is worked out in percentages.  If for example, the deceased spouse died 20 years earlier when the nil rate band was about £140,000 the percentage not used is then set against £300,000 so there is no loss as a result of inflation.

Domicile

In modern law, domicile is concerned with legal jurisdictions.  Everybody acquires a domicile of origin when they are born.  At birth a legitimate child born during the lifetime of his father takes the domicile of his father.  If the child is born outside marriage, or the father is no longer living, then the child takes the domicile of his mother.  Once a child ceases to be dependent, his domicile is his domicile of choice.

A person can acquire a domicile of choice in another country by residing there with the intention of not returning to live in the country of his previous domicile e.g. his domicile of origin.  In other words when a person chooses a new domicile, his intention must be to spend the rest of his days in the jurisdiction of his new home. A person changing domicile must be able to prove that they made such a deliberate choice and that it is a permanent choice.

Deemed Domicile

A person’s domicile is his domicile for all legal issues arising from it, with one exception.  Under UK law, a person will also be deemed to be domiciled in the United Kingdom at a “relevant time” for UK tax purposes only if:

(a)    he was domiciled in the United Kingdom within the 3 years immediately preceding the relevant time; or

(b)   he was resident (for income tax purposes) in the United Kingdom in not less than 17 of the last 20 years of assessment ending with the year of assessment in which the relevant time falls. 

The importance of a person's Domicile

When a person dies, his (movable) estate will be taxed in the jurisdiction where he is domiciled.  Land is the exception.  The tax is paid in the jurisdiction where the land is.  If the deceased has land in a country which is subject to a double taxation treaty, his tax liability will be mitigated to the extent that he will not have to pay more than the maximum liability in either jurisdiction.

Another significant tax feature of domicile is that the spouse exemption for IHT purposes are limited (currently to £55,000) instead of absolutely if the spouse is domiciled outside the United Kingdom.

Under the Inheritance (Provision for Family and Dependants (NI) Order 1979 and the Inheritance (Provision for Family and Dependants) Act 1975, claims under those provisions can only be made if the deceased was domiciled in Northern Ireland or England and Wales respectively.

Cross border estates

If a deceased is domiciled in one jurisdiction with land in another, the estate will be subject to the double taxation treaty, if the other jurisdiction has a double taxation treaty with the UK.  Where the Double taxation agreement applies, as in the case of the Republic of Ireland, you do not end up paying Inheritance tax twice but you will in effect end up paying an amount which is equivalent to the higher rate between the two jurisdictions.

The following steps should be taken to ascertain what tax is payable and where.

Step 1. The tax liability is firstly worked out for the country in which the asset is located. 
Step 2. The effective rate ("p") is then worked out.  p is the percentage of tax paid after all reliefs and exemptions are taken into account in the first jurisdiction. 
Step 3. The effective rate ("q") is calculated for the second country by working out how much tax is due in the second country and then working out the effective rate in the same way as for p.
Step 4. The tax credit is then given at the lower of the two effective rates which we call r.  (IF p > q  THEN r = q ELSE r = p) 

The following is a relatively simple example in the case of a person with land in England and Ireland:

Peter was born in Ireland but spent the latter part of his working life in England.  About 10 years ago Peter came back to Ireland to live out his retirement.  He bought and moved to a small farm.   Peter died in 2007.  His Irish assets were worth €250,000 and he had an apartment in London worth Stg £500,000.  Under his will Peter bequeaths his entire estate to his son Michael. 

As Peter died Resident in Ireland, his son Michael will be taxed in Ireland on all of Peter’s assets including foreign assets.  As there is property located in England, the London apartment will be subject to inheritance tax (IHT) in the U.K.  The tax position will be as follows:

Step 1.            The tax liability is firstly worked out for the country in which the asset is located i.e. England. (Stg£1 = 1.40euro)

	Sterling	Euro
Value of London Apartment	500,000	720,000
Less nil rate band	300,000	420,000
Taxable amount	200,000	280,000

Tax is 40% of €280,000 = €112,000

Step 2.             The effective rate is then worked out.

U.K Effective Rate   p              €112,000 = 16%
                                                €700,000

Step 3.             The effective rate of tax is calculated for the Republic of Ireland (the second country) by working out how much tax is due there and then working out the actual percentage.

Value of worldwide inheritance taken by Michael                       €970,000
Tax Free Threshold                                                                   €496,824
Taxable Inheritance                                                                   €473,176

Tax @ 20%                                                                                €94,635


Irish Effective Rate  q         €94,635  = 9.756 %
                                          €970,000

Step 4.             The tax credit is then given at the lower of the two effective rates. 

€112,000 of IHT must first be paid in the U.K, as the asset is located there.  Will Michael be entitled to a full tax credit for the amount paid?  The rule is that the credit for the IHT paid in the U.K must not exceed the Irish CAT* chargeable on U.K assets.  The Irish CAT* chargeable on the London apartment is effectively 9.756% of €700,000 = €68,293.  Therefore Michael can only claim a tax credit of €68,293 against his Irish tax bill despite the fact that he has paid €140,00 of IHT in the U.K.  In effect he will get no tax credit for €43,707 (€112,000 – €68,293) of the tax paid in the U.K.

Michael’s total liability will be as follows:

 U.K Tax (IHT)                                                                                     €140,000

Irish Tax CAT                                      €94,635
Less U.K Tax Credit                            €68,293                                      €26,342

Total U.K IHT and Irish CAT*                                                                €166,342

* CAT stands for Capital Acquisitions Tax in the Republic of Ireland.

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