IHT Update: Beware of failed PETs and double tax traps

Gifting is perhaps one of the most tax efficient inheritance tax planning strategies and can be highly effective. Gifts made to other individuals during the donor’s lifetime are known as potentially exempt transfers (PETs). Once the donor has survived for seven years after making the outright gift, the value of the gift falls outside their estate entirely for IHT purposes.

A PET does not attract an upfront IHT charge. IHT only becomes payable either if the donor reserves a benefit in the gift or dies within seven years of making it. (Termed a ‘failed PET’).

In previous years, some people were caught out by the ‘seven year rule’ with expensive consequences. As reported in the FT, over 13,000 wealthy families faced surprise tax bills in 2020-21 on lifetime gifts made, with some tax liabilities being as high as £1.4m. This was because the donor died within seven years of making the gift. This tax year was significant as a result of the spike in unexpected liabilities following deaths during the Covid pandemic.

However, it illustrates how you can get caught by the rules surrounding PETs and why, when it comes to trying to make IHT savings, it makes sense to gift assets sooner rather than later. Clearly this approach must be considered alongside the practical aspects of making outright gifts.

On the death of an individual who has made gifts within seven years of death, the value of the gift will first be offset by the annual IHT exemptions available at the time of the gifts, the donor’s lifetime exemption (currently £325,000) and any transferrable lifetime exemption from a pre-deceased spouse or civil partner.

Where lifetime gifts exceed these allowances, they will attract inheritance tax (IHT) at 40%. Any liability arising is payable by the recipient of the gift, unless at the time of making the gift it was documented as being free of IHT.

IHT payable on a failed PET

Where failed PETs exceed the exemptions available, IHT is payable at the rate of 40%, with tapering relief being due within three and seven years of the gift, as follows:

• A death between three and four years after the gift date attracts 32% IHT;
• A death between four and five years after the gift date attracts 24% IHT;
• A death between five and six years after the gift date attracts 16% IHT;
• A death between six and seven years after the gift date attracts 8% IHT.

According to records from the FOI, the average value of a failed PET in 2020-21 was £156,000 after allowances and exemptions, triggering a £62,400 tax bill on failed PETs on average. This is the most recent year for which this data is available.

Beware the trap of IHT and CGT

Where gifts of assets other than cash are made, it is important to consider whether the gift attracts capital gains tax (CGT). For example, a gift of investment property or quoted shares to a relative will attract CGT based on the market value of the asset less its original cost, even though no consideration is received. The market value on which the donor pays CGT at the time of making the gift will be the base cost of the property for the donee, for future CGT purposes.

If the donor then dies within seven years, the value of the gift will fall back into their estate for IHT purposes, but the donee will not receive an uplift to probate value for CGT purposes. This can give rise to an effective double tax charge.

If planning for lifetime gifts of assets other than cash, the impact of CGT should always be considered carefully, and a professional valuation of the asset should always be obtained.

If you would like further guidance about inheritance tax, HMRC’s IHT manual could be useful: https://www.gov.uk/hmrc-internal-manuals/inheritance-tax-manual/ihtm04057

For independent advice on inheritance tax and estate planning, please contact us via partners@rjp.co.uk.