Inheritance tax - a pre-Budget explainer

This explainer is part of a series produced by CIOT ahead of the Budget on 30 October 2024.

How does IHT work?

Most commonly, it is a 40% tax upon death on the value of someone’s estate (i.e. assets in their ownership) which exceeds a ‘nil rate band’ of £325,000. Surviving spouses can potentially have up to £1million of nil-rate band on their eventual deaths (two nil-rate bands plus two residential nil-rate bands (see more below) of £175,000 each).

Various reliefs are available, the most common of which are gifts between spouses or to charities and for business and agricultural property (see below).

Is it possible to escape IHT by giving your assets away before you die?

Gifts of assets into trusts and some limited companies can result in immediate IHT charges, but gifts to individuals are exempt provided the donor survives a further seven years (known as a Potentially Exempt Transfer). If a donor dies within seven years of making the gift, that gift will have ‘failed’ potentially resulting in an IHT charge on that gift as well as affecting the available nil-rate band for the estate itself.

What rumours are there surrounding IHT changes?

The BBC reported on 18 October that it had heard that the government is considering 'multiple changes' to IHT. The BBC does not know what the changes will be, but the most persistent rumours are around restrictions on (or less likely scrapping completely) business and agricultural reliefs.

Back during the election campaign, The Guardian highlighted a series of ‘draft documents and expert analyses’ that it said were being circulated among shadow ministers. The article suggested that these contained proposals to ‘overhaul inheritance tax’ included capping the benefit from agricultural and business relief at £500,000 for each person. Sources quoted in that article said wider changes were also being considered on gifts and IHT.

The FT says that the chancellor is looking at extending the “seven-year rule” to ten years to make it harder for wealthy people to gift assets ahead of death to avoid IHT. Other changes speculated about include bringing pension pots within the scope of IHT and ending the IHT exemption for shares in companies listed on the alternative investment market (AIM).

It has also been suggested that the chancellor may be considering the removal of the capital gains uplift that currently applies when someone inherits assets. This would technically be a capital gains tax change and is examined in our pre-Budget explainer on that tax here.

We explore each of the other possible measures below.

AGRICULTURAL PROPERTY RELIEF

How does agricultural property relief for IHT work?

Agricultural property relief (APR) gives 100% relief from IHT on the agricultural value (not necessarily the total value) of land and ‘character appropriate’ buildings occupied for agricultural purposes, including residential farmhouses.

To get full APR the land must have been occupied by the person who has died for the two years running up to their death. Land which is occupied by someone else – for instance a tenant farmer – can still give 100% relief for the landowner provided it has been owned by the person who has died for seven years. Some land subject to older (pre-1995) tenancies may only offer 50% relief.

Further information on what qualifies for APR can be read here.

There is no limit to the amount of the relief.

How much does it cost the government?

According to HMRC, APR cost HM Treasury £365 million in 2023-24.  This figure represents the amount of APR given but should be treated with some caution if assessing the effect on government finances if APR were removed or amended.  For instance, it does not consider (if APR were removed) what other reliefs might then have applied or what behavioural changes might be made by the owners of agricultural land and property. Indirect consequences such as the potential effects on agricultural land prices are also unlikely to be factored in.

What might the government do?

There are a few possibilities. These include abolishing APR altogether, capping it or restricting its applicability.

Restrictions that could be introduced include restricting APR to those actively farming (i.e. excluding those letting to tenant farmers) or reducing it where farm business tenancies are short (less than eight years has been suggested), as well as potentially excluding residential farmhouses from eligibility.  Reducing the rate of APR (for instance to 50% rather than 100%) might also be a relatively straightforward possibility.

What are the arguments for scrapping APR?

Critics of APR (and BPR) generally make the case that IHT should be levied on someone’s entire estate with as few exemptions as possible, and that all exemptions create an opportunity for abuse.

“Many super rich families – with no real connection to farming – are increasingly buying farmland in order to exploit this loophole,” say Tax Justice UK. Critics point to people like Sir James Dyson, of vacuum-cleaner fame, who is reputed to own 36,000 acres of UK farmland, and Anders Holch Povlson, a fast-fashion entrepreneur, who is said to own more than 220,000 acres. Whilst this is presumably all productive farmland, it is undoubtedly also a useful way to shelter fortunes from IHT.

Critics argue that most recipients of APR are not small family farmers. A recent report from the Centre for Analysis of Taxation (CenTax) found that between 2018 and 2020 around 1300 estates a year benefitted from APR but almost two thirds of that benefit went to the top 200 estates, which each claimed more than £1 million in relief, with an average estate value of £6 million. Analysing IHT and income tax records the report’s authors conclude that only a minority of those benefiting from APR in this period had identifiable trading income from farming in the five years before their death and that even among these active farmers trading income from agriculture was in most cases a minority of their income. The authors suggest that many small farms may fall within standard IHT allowances giving their owners no need to make use of APR.

It has also been suggested that the existence of APR drives up land values, forces out smaller farmers and prevents young farmers from entering the industry, by encouraging wealthy investors to buy farmland in order to avoid IHT.

Were APR to be abolished farms being run as trading businesses (rather than let to tenant farmers) would still be eligible to claim BPR (provided it were maintained) in place of APR. Of course the flipside of this is it would mean such a change would not save the Treasury as much money.

What are the arguments for maintaining APR?

Supporters of APR argue that the rationale for the relief is as strong now as it was in 1984 when the current relief was introduced, i.e. to keep the country producing food. Without this, many farms would have to be sold to pay the IHT, which may cause them to cease activity, resulting in drastic effects for the UK economy and food production.

The President of the National Farmers Union has said that “APR is what makes it possible for small family farms to pass from one generation to another”. The NFU says that the return on capital for farming can be very low and having to pay IHT would remove any ability to invest in the business.

Whoever owns and occupies these farms, they are nonetheless working farms producing food for a growing population. Removing or reducing the generosity of APR in respect of farmland rented out (whether for all lettings or just shorter leases) is likely to cause landowners to bring land in-hand and simply not let it out – meaning that tenant farmers (who are often younger farmers entering the industry for the first time) are going to struggle to find available land; this could have a drastic knock-on effect to the future of farming.

Even with relief available over the farmland, denying APR to farmhouses could still mean that farm assets may have to be sold to pay the resulting tax; alternatively, it may be considered that the farm as a whole is not viable with such latent liabilities upon death/gifting.

What are the arguments for capping APR?

Any relief which offers limitless 100% relief or exemption attracts arguments for capping. Farms worth tens of millions of pounds can currently receive full relief which might otherwise yield the Treasury large amounts of revenue. Capping the relief could potentially enable small family farms to continue to benefit fully from it while limiting the extent to which it could benefit the super-wealthy.

Limits on capital taxes exist in other places. Business Asset Disposal Relief for capital gains tax is capped at £1 million in one’s lifetime (£10 million prior to 2020). There is also a precedent for capping APR - under the old Capital Transfer Tax (the precursor to the existing IHT), agricultural relief was restricted to £250,000 or to an area not exceeding 1,000 acres (per Schedule 8 Para 5(1) FA 1975).

The IFS has recommended a cap of £500,000 per person covering both APR and BPR, with the unused portion of the allowance being transferable to a surviving spouse or civil partner (so a couple could pass on a farm or business worth £1 million). Because most of these reliefs are claimed by large estates they reckon this would raise £1.4 billion across the two taxes in the current tax year. Of course an issue with caps is that, not generally being inflation proofed, they tend to see their value eroded over time.

An argument sometimes heard against a cap is that it would support smaller, unprofitable farms and penalise larger, more profitable ones.

What are the arguments for restricting APR?

A criticism sometimes made of APR is that it is not well targeted. The government may be tempted to change the qualifying criteria in an attempt to target it more narrowly, for example by restricting APR to those who farm or manage the land themselves and excluding investors who use the purchase of farmland as a tax-free investment. Investments do not generally qualify for IHT reliefs and if this is to be the case as a matter of policy, it should arguably be uniform and apply to all assets.

For owner-occupied (or ‘in-hand’) farms, farmhouses can currently benefit from significant exemptions because of their basic agricultural value – but they are also a private residence. The value of a desirable residence is often greater than a basic farmhouse from which the land is worked. With no cap of the amount of benefit, there is an argument that APR should be restricted to land and non-residential farm buildings, as residential properties (outside the residential nil-rate band) do not qualify for IHT reliefs.  It is sometimes pointed out that farmhouses are the only sort of residential property that qualifies for IHT relief.

BUSINESS PROPERTY RELIEF

How does BPR for IHT work?

BPR gives 100% relief from IHT for businesses which are predominantly trading – sole traders and partnership shares come under this heading, as does ownership of unquoted trading company shares and controlling securities. AIM stock also benefits from this relief (see below).

A rate of 50% is available for assets personally owned by a shareholder or partner which are used by their company or partnership and in rare cases for controlling shareholdings in quoted companies.

How much does BPR cost the government?

According to HMRC, BPR cost HM Treasury £1.3 billion in 2023-4.  As with APR this costing ignores other reliefs and behaviour effects if the relief were abolished.

What might the government do?

As with APR the options include scrapping, capping and restricting.

What are the arguments for scrapping BPR?

As with APR the starting point tends to be the principle of minimising exemptions, noting that once you start drawing distinctions between treatment of different assets you create incentives, distortions and opportunities for abuse.

Adam Corlett of the Resolution Foundation has pointed out that the link between beneficiaries and the businesses they inherit is often not strong and there is nothing to prevent any property that is inherited tax-free as a family business from being immediately sold on. Corlett also draws attention to the OECD’s view that “the macroeconomic benefit of relief for family-business assets is unclear”.

What are the arguments for maintaining BPR?

According to the government, the aim of BPR is to “ensure businesses do not have to be sold or broken up following the death of the owner”.

Campaign group Family Business UK say that removing or capping BPR “would be catastrophic to family businesses, lead to the loss of good jobs, weaken the economy and leave Britain a poorer place.”

Like those surrounding farms and APR, these arguments are based principally around liquidity problems - the concern that an estate may not have the liquid assets to pay IHT and so would have to sell off all or part of the business. There is a second argument used for BPR and this is that it incentivises investment, both by the owners of businesses and by outside investors (see particularly the notes on AIM shares below).

What are the arguments for capping BPR?

As with APR the argument for capping is that it can protect small businesses while still bringing in a substantial amount of money.

CenTax, in their recent report, conclude that BPR “is a major contributor to the regressivity of IHT at the very top”. Between 2018 and 2020, they say, an average of £2.2 billion per year in BPR benefited around 3,400 estates per year. 72% of that went to around 400 estates per year (worth £7.6 million on average) that each claimed more than £1 million in relief. They calculate that, amongst estates worth £30 million or more, BPR lowers the effective average IHT rate from an average of 23% to 12%.

As noted above the IFS has recommended a cap of £500,000 per person covering both APR and BPR, which they estimate would raise £1.4 billion across the two taxes in the current tax year.

As with APR, the argument against capping is that a cap benefits smaller (and potentially less profitable) businesses but penalises larger businesses.  Why would you want to penalise more successful businesses and give incentives for them to restrict their growth? Also, unless the cap rises in line with inflation (or property prices), it is effectively being reduced each year.

What are the arguments for restricting BPR?

The main restriction discussed is removing BPR from arms-length investments, in particular AIM shares. This is explored below.

Perhaps a more likely restriction, although for some reason less discussed, is simply restricting the rate of BPR.  Prior to 1992 the rates of BPR were 50% and 30% (rather than the 100% and 50% referred to earlier).  While this would not address the regressivity argument, it would mean that there was no discrimination between larger and smaller businesses.  It would then be a compromise between recognising that some IHT should be paid, but giving some relief against the risk of businesses having to be split up to pay that IHT. 

It is also worth noting that where IHT is payable on shares, there is the option to pay the tax in instalments over 10 years.  At present (with 100% BPR) this instalment option is less used, but would in this case be an important safeguard giving family businesses more time to fund IHT caused by the death of the owner.

AIM SHARES

What are AIM shares and why do they have special treatment?

The Alternative Investment Market (AIM) is a sub-market of the London Stock Exchange which is designed to help smaller companies raise capital.

As companies listed on AIM are often fledgling businesses they are generally much riskier investments than established companies, so generous tax reliefs are provided to incentivise investment for these businesses (According to the LSE, in 2023 over 770,000 jobs were supported, directly and indirectly by AIM companies, which accounted for £68 billion gross value added to the country’s GDP).  Income tax and capital gains tax benefits are potentially available for investors in such companies which are treated as unquoted for purposes of capital gains tax reliefs; a further IHT incentive for would-be investors is offered by allowing the AIM stock of trading (rather than investment) companies the benefit of BPR.

The head of AIM has estimated that £6.5 billion of investment in AIM companies is held through funds specifically marketed towards customers seeking to limit their IHT bill.

What are the arguments for taking away this tax relief?

It can be argued that IHT reliefs, in so far as they should exist at all, should be reserved for situations where there is a substantial risk that the business might have to be split up on the death of the owner (so typically for active/owner-managed holdings in trading entities).  This rationale will rarely apply to AIM companies. Whilst the risks may be greater, investment in AIM stock represents a 100% limitless exemption from IHT which, its critics argue, should at least be subject to some limitation.

Some economists (eg. IFS) dislike the distortion that giving IHT relief for AIM shares creates.

What are the arguments for keeping it?

Small companies, such as those listed on AIM, often cannot attract capital injection by any other means and, it is argued, their survival will often depend on finding would-be investors; without such an injection they may not survive. Given the inherent risk of investing in such companies, potential investors need greater incentives and cost-offsets in the event of losing their money; BPR is a valuable relief and affording this to AIM stock provides a valuable incentive to include such stock in a varied portfolio.

To turn around the IFS’s argument above, supporters of the exemption point out that distorting investment choices is a deliberate intention of the relief. Governments incentivise investment in start-ups in various ways and this is one of them.

IHT AND PENSIONS

What are the current tax rules on inheriting a pension pot?

If the owner of an uncrystallised pension pot dies under 75, any payments made from the pension within the next two years are tax-free for the beneficiaries; lump sums exceeding the ‘lump sum & death benefit allowance’ (currently £1,073,000) will cause excesses above that amount to be taxed at the beneficiary’s marginal income tax rate.

If the owner was 75 or over upon death, irrespective of whether the fund is otherwise crystallised or not, beneficiaries are subject to income tax at their marginal rate on anything they receive.

For the deceased, the pension pot is generally outside of their estate for IHT purposes and is not assessed upon death.

What changes do we think the government are considering?

Changes have been rumoured surrounding pensions and income tax (reducing tax relief on contributions) and national insurance (potentially charging it on employers’ contributions), but for IHT the main possible change is that someone’s pension pot could be brought into their estate for IHT purposes.

What are the arguments for change here?

That pensions are essentially investments, like any other held in cash or shares, and all those other investments (except AIM) are subject to IHT.

As far as IHT is concerned, there is no limit on the size of the pension being outside one’s estate and thus exempt from IHT; therefore, there are potentially large amounts of value which could be tapped into to secure more revenue.

By giving preferential treatment to pensions the current set-up incentivises those who can afford to do so to use up other assets while they are alive and leave the pension untouched. According to a former senior Treasury adviser this is a particular concern to Treasury officials since the abolition of the lifetime allowance. 

What are the arguments against?

There are concerns it might discourage pension saving. It has been policy over many different governments to encourage saving for retirement.

There is also a fairness argument. Having been encouraged to make payments into their pension on the understanding it was exempt from IHT, it could be seen as unfair to change the rules retroactively and subject people’s pension savings to tax. In the words of the former adviser quoted above, it “would rightly lead to howls of anguish from millions of diligent savers.” 

The cumulative effect of potentially paying both IHT and income tax on pension pots is a further pragmatic reason for the current system.  Previously there were situations when the combination of both taxes (and certain other clawbacks) could lead to effective rates of up to 83%.  While income tax and IHT are different taxes and serve different purposes, this is not always widely understood.  It was largely in an attempt to relieve the perceived unfairness of these combined rates that the current system arose.

OTHER POSSIBLE CHANGES

Could the government change the point at which you start paying IHT?

The nil-rate band has been frozen at £325,000 since 2009 and is currently scheduled to remain so until 2028. It may be that the rate is frozen for longer still, or even reduced, accelerating the fiscal drag effect and bringing more people into the scope of IHT.  Had the nil-rate band increased with inflation from 2009, it would now be standing at just under £505,000.

In addition to the basic nil-rate band, an additional “residential nil-rate band” may also apply.  This exempts the first £175,000 of residential property passed to a direct descendant from IHT. Both bands are potentially inheritable by the surviving spouse or civil partner. Taken together this enables a family home worth £1 million to be passed by a couple to their children free of IHT.

The residential nil-rate band has been criticised for its complicated conditions and workings.  A “downsizing” relief is also available so that the band can still apply even if an elderly owner downsizes to a smaller property in their later years.  The band is also progressively clawed-back for those with net estates valued over £2 million. Last year the IFS suggested the residential nil-rate band be removed and the nil-rate band increased to £500,000.

Are there other reliefs that might be targeted?

The biggest IHT relief is the one that allows assets to be inherited by a spouse or civil partner tax free. While it seems unlikely the chancellor will target this, CenTax have observed that capping the spouse exemption at £10 million could enable the surviving spouse to maintain their standard of living whilst limiting the opportunity for very high value estates to use the exemption for tax planning. This reform would affect fewer than 0.1% of estates (100 deaths a year) and could raise up to £350 million in revenue.  Thought would need to be given, however, to the double-tax effect where one spouse leaves assets to another, but the survivor then dies in relatively short order.

Recipient spouses who are non-UK domiciled are currently subject to an exempt transfer limit of £325,000 (unless they elect to be treated as domiciled, which brings their worldwide estate into scope for IHT).

The other sizeable IHT relief is for gifts to charities, which cost £690 million in 2023-24. Changes have already been made to restrict this – from April 2024, only gifts to UK-based charities benefit from tax reliefs generally; however, this is currently limitless, so a cap could potentially be placed on this, although politically that might be difficult to do and might well reduce donations to charities.

Also, lifetime and death gifts to political parties (provided they had at least two MPs elected at the last general election, or one MP and at least 150,000 votes for the party’s candidates) are exempt and limitless. The amount this costs is, according to HMRC, ‘negligible’, but if other reliefs are reduced in generosity the government may feel they need to reform this exemption too.

What about lifetime gifts?

Lifetime gifting may be subject to change. As noted above, it has been reported that the chancellor is looking at extending the seven-year period, after which gifts fall outside of someone’s estate, perhaps to up to ten years – thus meaning more gifts could potentially ‘fail’ and remain liable to IHT. However this would move in the opposite direction to the recommendations of the Office of Tax Simplification which, in July 2019, noted that the status quo requires a lot of record keeping and does not raise much tax, so recommended that the seven-year period be reduced to five – albeit as part of a wider package of reform, including the abolition of the taper allowance (which gradually reduces the latent tax following three years of the gift). Amending/removing the three years+ taper relief, by itself, would be a simple way of potentially raising further revenue on failed gifts. However, reducing the incentives to make lifetime gifts could result in behavioural changes which would result in a lower tax yield, particularly as capital gains tax may also arise on such gifts.

Currently the amounts that may be given are limitless if the person survives seven years. There might be a change to limit that and/or have the donor pay some tax immediately (as is currently the case with chargeable lifetime transfers – usually gifts into trusts). Changes to lifetime gift allowances (the £3,000 annual allowance, £250 small gifts allowance, gifts in consideration of marriage along with normal expenditure out of income) could be removed altogether and replaced with a larger annual allowance as a means of simplification if not revenue raising. The OTS, in their 2019 report (see above), recommended removing all these lifetime allowances and replacing them with an overall personal gift allowance.

Are there any other changes that could be made to inheritance tax to raise money?

Changes have already been put forward with respect to non-UK domiciled individuals and offshore trusts (see our explainer here).

Changes could potentially also be made to UK trusts; every 10 years and upon capital distribution from most trusts, IHT charges arise. However, these are capped at rates of a maximum of 6% and are often less thanks to the presence of the nil-rate band and complex calculational rules. In the past there have been suggestions to fix the rate at 6% - but the government could go further this time and increase that rate. Exit charges do not arise at all for discretionary ‘will trusts’ when trust assets are distributed to beneficiaries within two years of the settlor’s death; this might be something the government could look to change.

Finally, one other suggestion which has been made is for the introduction of a banded IHT system to make the levy more progressive. Earlier this month Demos, a think tank, suggested that there should be a 30% rate on estates worth less than £1 million, a 40% rate on estates worth £1-2 million and a 45% rate for estates worth more than £2 million. This in itself would cost the government money but Demos suggested packaging it with some of the other changes set out above.