Tax reform...at last!

Alistair Darling has got off to a good start as a tax-reformer. His first pre-Budget report has not only cut capital gains tax to 18%, but rescued millions of families from inheritance tax as well.

Of course it’s not quite as good as that. The capital gains tax reforms also abolished taper relief, so for some taxpayers 18% will actually be an increase from the 10% that could be achieved under the old system. But it’s a good start; the 18% will apply to everyone, without having to rearrange your deal so that you get within the most favourable category – and hopefully without the risk of being hit with an unfairly large tax bill if you got something wrong.

The inheritance tax reforms are similar. What Darling has proposed is that the inheritance tax threshold (the “nil rate band”) will be transferable between spouses, so that if the first to die doesn’t use it then the second can. Those who have taken advice (or read Finance Confidential) will know that it was usually possible to do this anyway, but he’s now handing it to everyone on a plate. Hopefully with no nasty traps and no need for expensive legal bills (although we haven’t seen the detail yet).

So how does it work? Let’s imagine Mr & Mrs Alpha, with £500,000 of assets between them (not excessive these days) and two children.

First the current situation:

If Mr Alpha dies first, and hasn’t thought about tax, he would probably leave everything to Mrs Alpha – no inheritance tax because of the spouse exemption. But when Mrs Alpha dies, she now has £500,000 to leave to the children. £300,000 is tax-free, but the other £200,000 is taxed at 40%; an £80,000 tax bill.

With advice, the Alphas would split their assets so that they had £250,000 each. The first to die would commonly leave their £250,000 to a discretionary trust, which would be under the threshold so no tax. Assuming Mr Alpha dies first, Mrs Alpha would be allowed to benefit from the trust’s investments while she was alive, but when she died those assets would belong to the trust, not her. The only assets in her estate would be her £250,000, which is under the threshold, so no tax on her death either.

That sort of works, but in many cases the trust would have been an unwanted complication and expense.

It should not be necessary to equalise assets or set up a trust any more.  Mr Alpha can leave all his assets to his wife, which will be covered by the spouse exemption, so there will be no inheritance tax to pay – and Mr Alpha hasn’t used any of his tax-free threshold.

Then Mrs Alpha dies, with the full £500,000. She can then use not only her own £300,000 nil rate band, but also Mr Alpha’s (because he didn’t use it).  That gives her a £600,000 threshold, more than enough to cover all of her assets, so no inheritance tax bill.

Remember that we haven’t had the draft law yet; stand by for some complications later (what about re-marriages, for example).

This is good news for any couple with assets between £300,000 and £600,000; you should now be able to escape inheritance tax without the complications of a trust.  Even couples with more assets than that could save tax – although with that level of assets you’ve probably got a trust structure set up already.

The people it will really help are those whose main asset is the house, where that is worth more than £300,000. This has always been difficult to fit into the trust structure, thanks to the Revenue’s anti-avoidance rules; the “gift with reservation of benefit” rule, the “pre-owned asset” charge, the Phizackerley case; all designed to stop those with moderate wealth – mostly bound up in their house - benefiting from the tax structures used by the wealthy.

So even if most people would have avoided this tax anyway, it is a major change of heart. The Treasury is giving us the tax break that they previously fought hard to stop us arranging for ourselves. It’s just a shame that they couldn’t have done this ten years ago when house prices started to rise; it would have saved a lot of distress and expense.

Regards,

Richard Teather

For The Daily Reckoning

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