How to Reduce Inheritance Tax on PETs and CLTs with Taper Relief
Taper relief can be applied to the inheritance tax payable on either a potentially exempt transfer (PET) or a chargeable lifetime transfer (CLT) made three to seven years before death. Here, we discuss PETs and CLTs and provide examples of how tax can be reduced by taper relief – useful reading for those who are studying for any of the CII CF1, R01, R03, R06, AF1, or AF5 exams.
THIS ARTICLE IS RELEVANT TO EXAMINABLE TAX YEAR 2020/21.
First, let’s quickly remind ourselves of what a PET and a CLT is.
A potentially exempt transfer (PET) is a lifetime transfer that is not liable to IHT at the time the gift is made but is counted in the cumulation for the future. A PET is a gift, not covered by exemptions, by one person to another person, or to a bare trust, or to a trust for a vulnerable or disabled beneficiary. If the person making the gift dies within seven years, the transfer becomes chargeable with taper relief available on any tax payable where death occurs after year 3 (remember, there can only be tax payable if the gift is over the nil rate band). After 7 years, the PET falls outside of the person’s estate.
A chargeable lifetime transfer (CLT) is a gift that is not covered by exemptions and that is not a PET. We normally come across them on lifetime gifts to trusts (other than the two mentioned above). If such gifts are made within the nil rate band, then they are chargeable, although no IHT is payable at the time. They would however be taken into account on the donor’s death and would mean less of the nil rate band available to set against the death estate.
A tax charge of 20% will occur on a CLT if it takes the person’s seven-year cumulation over the nil rate band. If the person making the transfer survives seven years, there will be no further tax to pay. If the donor doesn’t survive seven years, then death rates will apply retrospectively, with relief given for the lifetime tax paid.
Again, if the person survives more than three years after the gift, tax can be reduced by taper relief.
Here are a couple of examples of how inheritance tax on PETs and CLTs can be reduced by taper relief - useful reading for those who are studying for any of the CII CF1, R01, R03, R06, AF1, or AF5 exams. Click To Tweet
Example 1 – PET
Lois makes her first PET of £400,000 in November 2020. Assuming she has already used her annual exemption for this year and the previous year, the IHT is calculated as follows if she dies within the 7-year period:
| Years survived until death | Inheritance tax |
||
|---|---|---|---|
| 0 - 3 years (100% of the tax is payable £400,000 - £325,000 = £75,000 x 40%) | £30,000 | ||
| 3 - 4 years (£30,000 x 80%) | £24,000 | ||
| 4 - 5 years (£30,000 x 60%) | £18,000 | ||
| 5 - 6 years (£30,000 x 40%) | £12,000 | ||
| 6 - 7 years (£30,000 x 20%) | £6,000 | ||
| Over 7 years | £0 | ||
Note that it is the tax that is tapering.
Example 2 – CLT
Gina transfers £400,000 into a discretionary trust. Assuming she has already used her annual exemption for this year and the previous year, the IHT paid at outset is £15,000 (£400,000 – £325,000 = £75,000 x 20% = £15,000). If Gina dies during the following seven years, the IHT is calculated as follows:
| Years survived until death | Lifetime tax paid on the CLT | Tax due on death | Balance to pay | ||||
|---|---|---|---|---|---|---|---|
| 0 - 3 years | £15,000 | £30,000 (£400,000 - £325,000 = £75,000 x 40% = £30,000) | £15,000 | ||||
| 3 - 4 years | £15,000 | £24,000 (£30,000 x 80%) | £9,000 | ||||
| 4 - 5 years | £15,000 | £18,000 (£30,000 x 60%) | £3,000 | ||||
| 5 - 6 years | £15,000 | £12,000 (£30,000 x 40%) | Nil | ||||
| 6 - 7 years | £15,000 | £6,000 (£30,000 x 20%) | Nil | ||||
You can see that the £15,000 paid at outset can be used as a credit against the IHT due on death. However, if Gina had died between years 5 and 7, the lifetime tax is more than the IHT due on her death, but in these circumstances, no refund is due.
You should note that in early 2018, the Office of Tax Simplification (OTS) reviewed various aspects of IHT. The first report was published in November 2018 where it highlighted that fewer than 25,000 estates are liable to IHT each year (less than 5% of all deaths) even though 10 times as many estates have to complete forms. In July 2019, the second report was published with various recommendations that the OTS considers would make IHT easier to understand and operate. Two of the main recommendations are:
- To reduce the 7 years so that gifts made more than 5 years before death are exempt
- To abolish taper relief (the report says it is poorly understood and difficult to explain)
The full report can be found here.
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