Potentially Exempt Transfers & IHT Gift Rules

Potentially exempt transfers, also known as PETs, can be an effective way of maximising the amount of money that a person can leave to loved ones tax-free after they die, helping to minimise any liability to Inheritance Tax that will fall due on a deceased’s estate.

Below we look at what PETs are, how these work, the taper relief rules, who pays the tax on failed PETs, how to value a PET and whether PETs must be declared to HMRC.

 

What is a potentially exempt transfer (PET)?

 

A potentially exempt transfer (PET) is a way in which an individual can make gifts of unlimited value during their lifetime, which will become exempt from Inheritance Tax (IHT) if that person lives for a further seven years. This essentially means that if the donor survives the date of transfer by a full seven years, the gift will escape any liability to IHT.

PETs are also treated by HMRC as exempt at the time of transfer, meaning that no IHT will be payable at that point ie; during the donor’s own lifetime.

However, if the donor dies within seven years from the date of the gift, this will become a chargeable transfer on death, where the value of the transfer must be added to the value of the deceased’s estate for the purposes of IHT. This is commonly referred to as a failed PET. The value transferred may also become chargeable to IHT in its own right.

IHT is payable on a deceased’s estate, typically at a rate of 40%, on anything over and above a threshold of £325,000. This threshold is known as the basic nil rate band and will remain frozen at this level until at least 2026. Where the net value of an estate exceeds this threshold, including any failed PETs, there can be a significant liability to IHT.

For example, if a cash gift of £400,000 is made within weeks of death, that gift will use up all of the £325,000 available nil-rate band, where the remaining £75,000 will become chargeable to IHT in its own right (£75k x 40% = £30,000), in addition to any IHT on the estate itself. Importantly, gifts always use up the IHT threshold first before other assets or property, although any unused threshold can be applied to the deceased’s estate.

 

What are the potentially exempt transfer rules?

 

Under the potentially exempt transfer rules, governed by the provisions of section 3A of the Inheritance Tax Act 1984 (IHTA), any lifetime transfer that is ‘potentially exempt’ must meet various conditions. Subject to certain exceptions, a PET is defined as a lifetime transfer of value that satisfies the following three conditions:

• the transfer is by an individual
• it would be a chargeable transfer, but for the provisions of section 3A of the IHTA, where
• a chargeable transfer is a transfer of value made by an individual that is not an IHT-exempt transfer, and
• it is a gift to either another individual or a specified trust where, for example, the transfer cannot be made from or to a company or corporation.

In addition to being a gift made by an individual to either another individual or trust, the gift must also be an outright gift. This means that gifts where the donor still has an interest in it, no matter how long ago the gift was made, do not qualify as PETs. These are known as gifts with a reservation of benefit. For example, if a person continues to live rent-free in a house that they ‘gifted’ to a relative ten years prior to their death, the value of the property would still be considered part of the deceased’s estate and, as such, subject to IHT.

Gifts with reservation of benefit, where the donor still benefits from it and so will count towards the value of their estate, could also include where they give away a caravan but still use it for free holidays, or gift a valuable painting but still display it in their home.

 

What is the taper relief for potentially exempt transfers?

 

The general rule is that where a lifetime transfer is treated as ‘potentially exempt’ at the time that it is made, because it is a PET, that transfer will become fully exempt where the donor survives for seven years or more after making it. However, even where a donor has not survived their gift by seven years, taper relief may still be available, depending on when a PET is made prior to death. Under the taper relief rules, provided a minimum of three years have passed since the date of transfer, partial exemption may be available.

The taper relief rules can be expressed as follows:

• Less than 3 years between gift and death: 40%
• 3 to 4 years between gift and death: 32%
• 4 to 5 years between gift and death: 24%
• 5 to 6 years between gift and death: 16%
• 6 to 7 years between gift and death: 8%
• 7 or more years between get and death: 0%.

These figures show the reduction in IHT that would otherwise be payable on the transfer where the donor does not survive for at least seven years. However, taper relief is only available against tax on gifts that have both a total value that is more than the IHT nil rate band and are made between three to seven years before the date of death.

Where any failed PETs exceed the nil rate band, tax will still be charged at 40% on gifts given in the three year period prior to death. However, under the taper relief rules, gifts made between three to seven years of death will be taxed on a sliding scale. For example, if a donor survives a £400,000 gift by three to four years, the IHT charge on the balance of £75,000 (after deducting the £325,000 nil-rate band) would be reduced from 40% to 32%. This means that the IHT due on the PET would be reduced from £30,000 to £24,000.

Importantly, taper relief does not reduce the value of the gift transferred, but rather it only reduces the tax payable on the gift post-death. This means that if there is no IHT payable on death on a specific gift, taper relief cannot be claimed to reduce the value of that gift.

 

Who pays the tax on failed potentially exempt transfers?

 

Any IHT due on gifts is usually paid by the estate, unless the deceased gave away more than £325,000 in gifts in the seven years prior to their death. Once they have given away more than IHT nil rate band, anyone who received a gift within that seven year period will be personally liable to pay the tax that falls due on their gift, minus any taper relief.

For example, if a person gifts £50,000 to their brother nine years prior to death, a further £325,000 to a sister four years and two months before death, and £100,000 to a friend three years and three months before death, the liability to IHT can be calculated as follows:

• the gift of £50,000 to the brother: there will be no IHT to pay, as this was given more than seven years before the donor died;
• the gift of £325,000 to the sister: there will also be no IHT to pay, as this is within the IHT threshold
• the gift of £100,000 to the friend: the friend will be liable to pay IHT on the £100,000 gift at a rate of 32% (£32,000), as the combined total in gifts within seven years takes this above the tax-free threshold and was given between three to four years before death.

If the deceased’s remaining estate is valued at £400,000, the estate would also be liable to pay IHT of £160,000 (40% on £400,000).

When calculating liability to IHT on all gifts made within seven years prior to death, these should be listed in date order, starting with the oldest gift first. This is because the oldest gifts will initially receive the benefit of the IHT threshold. Once the running total of any gifts chargeable to IHT exceeds £325,000, tax will be payable by the recipient on the portion of any gift that took the total over the threshold, plus any gifts made thereafter.

 

Do you have to declare a potentially exempt transfer?

 

As a PET becomes an exempt transfer if the donor lives for a further seven years, any gifts made seven or more years prior to death will not become chargeable to IHT. This means that, with the exception of gifts made with reservation of benefit, the personal representative(s) will only be asked about transfers made within seven years before death when completing the necessary paperwork to submit to HMRC for the purposes of IHT. This is because, to work out the total value of the estate on which IHT is charged, HMRC may need to add the value of these gifts to the value of the estate at the date of death.

A gift chargeable to IHT can be anything that has value, such as money, property or possessions, where HMRC will ask for the value of the gift at the date on which the transfer was made. This is because gifts must be valued based on how much they were worth at the time the donor gave them. Cash gifts are easy to value, although when it comes to other property and possessions, the value of the gift will represent the extent to which a transfer has reduced the value of the deceased’s estate. This is known as the ‘transfer of value’.

Under the transfer of value rules, this means that a PET can include, for example, where the recipient owed money but the donor forgave the loan. This is still a transfer of value, since the value of the donor’s estate is diminished. Equally, where a person sells their house to a relative for less than the property is worth, the difference in value will count as a gift.

In many cases, the loss to the deceased’s estate will be the same as the value of the property gifted, but this is not always the case. For example, where a person gave away 20 shares, where they owned 60 shares in a company with an issued share capital of 100 shares, the loss to their estate will be the difference between a control-holding of 60 shares and a minority-holding of 40 shares, which is greater than the value of 20 shares in isolation. This is because any loss incurred as part of the gift must be included in the assessment.

The personal representatives do not have to include any taper relief calculations when completing the necessary paperwork to declare gifts made within seven years of death. HMRC will first assess whether tax falls due on any gifts and, where a gift is chargeable to IHT, it will provide separate calculations, including any taper relief due. However, other exemptions or reliefs should be deducted, such as the £3,000 annual gift exemption.

 

Do I need legal advice when making a potentially exempt transfer?

 

Making transfers during your lifetime is just one way of planning in advance to help reduce any liability to Inheritance Tax when you die, but the law in this area can be complex. For example, by structuring the law to tax the loss to the estate under the ‘transfer of value’ rules, HMRC is able to stop people transferring large parts of their estate during their lifetime and reducing the value out of all proportion to what they actually give away.

It is therefore always best to secure expert advice from a specialist in estate planning, especially where your wealth bracket exceeds the IHT threshold of £325,000. In this way, you can look at planning ahead, making PETs where appropriate, and exploring other ways of minimising any IHT liability and maximising what you leave to your loved ones tax-free.