A history of inheritance tax – is reform likely?

Latest HMRC figures show inheritance tax (IHT) receipts increased by 4% in the 2021/22 tax year, an extra £0.23bn compared to the previous tax year. The number of estates caught by the IHT net also rose to 27,800, a 3% increase of 800.

Taxes on death are bringing in more money for the exchequer as house and other asset prices have risen and tax-free allowances have remained frozen. Some good news perhaps for chancellor Rachel Reeves as she looks for ways to plug a £22bn so called ‘black hole’ in public finances. However, at just £6bn a year IHT is just a slither of the total tax revenue collected by HMRC. For 2021/22 it represented less than 1%, so any changes would probably only go a small way to closing the gap.

Yet rumours are circulating that Labour’s inheritance tax plans might go further and ramp up the burden. The government has repeated it will not raise National Insurance, income tax, VAT or corporation tax, four of the five big revenue raisers, the other being council tax. The Chancellor will therefore have to look around elsewhere to increase revenue.

IHT could make a tempting target. With the baby boomer generation hitting their sixties and seventies their accumulation of wealth is increasingly being passed through gifts and through the taxation of estates. The easiest way to tax wealth is when it moves, and it remains a distinct possibility we will see reform to the current regime during the current government’s tenure.

Let’s look at the history of IHT to help guide us whether this is likely.

Inheritance tax explained

IHT is usually paid at 40% on the value of your estate over the £325,000 allowance. There’s an additional allowance of up to £175,000 if you pass on your family home to children or grandchildren. If you’re married or in a civil partnership, you can combine your allowances and transfer assets between each other free of the tax.

How inheritance tax works

However, inheritance tax has changed a lot over the years, and it has some surprisingly deep roots.

History of inheritance tax

1694-1894

• The origin of modern inheritance tax can be traced back to Probate Duty introduced in 1694 by King William III to help fund a war against France. This was initially a fixed duty, but in 1780 it became graduated according to value of personal assets, though not property or land. A Legacy Duty was also introduced at that time, which had to be paid by the beneficiary of an inheritance.

• However, there were big gaps in the system. It wasn’t until reforms by William Pitt the Younger requiring executors to formally record assets that it became a more significant revenue raiser. Later, in 1881, measures were introduced by William Gladstone to cover the ‘life interest’ in a property.

1894-1975

• A complicated, piecemeal system was partially overhauled in 1894 with a more comprehensive Estate Duty replacing Probate Duty and other succession duties. The full capital value of property also came into scope. Over the years the system became more graduated to lower the tax burden for smaller estates.

• However, there was a significant increase at the top end culminating in 1969 with a marginal rate as high as 85%. At the same time the five-year plus exemption for gifts before death was extended to seven, a period reflected in today’s rules.

1975-1986

• The ways around Estate Duty through gifting and using trusts were addressed by Labour Chancellor Denis Healy in 1975. He abolished it in favour of Capital Transfer Tax, which brought together the taxation of lifetime gifts and transfers on death.

• These measures featured a sliding scale for transfers made during a person’s lifetime that weren’t otherwise exempt. Even after some modifications under the Thatcher Conservative government the regime was criticised for having an adverse impact on enterprise as it had the effect of deterring passing of business ownership between generations.

1986-present

• Capital Transfer Tax was reformed by Conservative Chancellor Nigel Lawson in 1986 and replaced by the Inheritance Tax (IHT) we are familiar with today. This removed tax on lifetime gifts and echoed Estate Duty with tapered charge on gifts made within seven years of death.

• Over the years, there have been amendments to exemptions, reliefs, and thresholds. The most notable was an additional ‘nil rate band’ on main residences introduced from 2015 and gradually increased to £175,000 per individual in the 2020/21 tax year – where it remains today. This was designed to reduce the burden for most families by making it easier to pass on the family home to direct descendants without tax.

What might inheritance tax changes look like?

The various incarnations of tax on death demonstrate there is nothing permanent about policy. Often there is incremental change year by year, and more occasionally there are radical shifts that change the direction and the rules entirely. Comparatively, there has been significant stability around the rules in recent times.

With that in mind there are various levers the government can pull and dials it can turn. It could increase the rate of inheritance tax for estates of certain sizes, cut the tax-free nil-rate band, or change or axe IHT exemptions and reliefs including those for business assets. These sorts of rule changes wouldn’t require much effort and would be relatively straightforward to implement.

Another option would be to impose what’s been dubbed a ‘double death tax’ by applying capital gains tax (CGT) on top of inheritance tax to estates. Currently, beneficiaries can inherit assets without paying CGT, and if it did apply it could result in a marginal tax rate of over 50%, which would likely inspire a considerable backlash. The application of two taxes to estates would also be more administratively complex.

Perhaps a more likely option would be changing the rules so that an asset received by a beneficiary carries a base cost relating to original purchase rather than the value at inheritance, as is the case presently. The current rules effectively mean wiping the CGT slate clean upon death. Several commentators have highlighted this as a bit of a loophole, noting that in many cases a change would increase the CGT payable when the asset is eventually sold. However, having received an asset, a beneficiary might not have reliable records to go on to establish its purchase value. Again, this could be an administratively fiddly measure to implement.

A further possibility is the value of pension funds being dragged into inheritance tax calculations. Presently, pension pots are free from IHT, and a beneficiary can draw on an inherited pot subject only to income tax at their marginal rate, or in the case of the pension holder dying before 75 no tax at all when accessed in the first two years.

As ever, nothing to do with tax is ever easy and there are always second and third order consequences of any changes made. We will highlight these in our 30^th October Budget coverage and subsequent articles and podcasts. In the meantime, if you haven’t already, now is a very good time to consider who you want to benefit from your assets and check whether you might be affected by IHT. It may be that some financial planning can help minimise the amount of tax your estate pays or eliminate it altogether.