Introduction
Inheritance tax is a tax levied on individual properties at the time of their demise. According to the universal tax laws, inheritance tax and estate tax are different. The estate tax is levied on the assets of the dead, whereas inheritance is levied on the inheritance received by the beneficiaries of the deceased’s assets. Nonetheless, the disparity between estate and inheritance tax is normally assumed by taxation laws. For example, in the UK (United Kingdom) inheritance tax is a tax levied on the assets of the dead and therefore estate tax and inheritance tax are more of the same.
Inheritance/ estate tax is a progressive tax which means that it is only applicable to the higher income earners. The changes in the UK tax law in 2007 set the exemption limit at £ 325000, which means that any property which values less than this amount is exempted from inheritance tax. In other words, inheritance tax cushions the poor and places a tax burden on the rich. The proponents of inheritance tax believe that it contributes in bridging the gap between the rich and the poor.
On the other hand, critics argue that it has done practically nothing to bridge the gap between the rich and the poor. In addition, inheritance tax discourages saving and investment. According to the economic experts, when the estate tax increases the number of taxable property decreases, meaning that individuals resort to high expenditure and less saving in response to the escalating tax rate. The paper explores UK inheritance tax and the laws governing it. In addition, the paper investigates the pros and cons of the inheritance tax law and attempts to find out whether it should be retained or abolished. The study embraces legal and academic view points to achieve this objective.
UK Inheritance Tax
Inheritance tax in the UK falls under the Capital Transfer Tax Act of 1984 (IHTA). Inheritance tax in the United Kingdom is levied cumulatively when an individual dies or on transfers during a lifetime. HHTA does not apply to transfers made by companies except for gifts to shareholders as articulated in section 98. Property or assets worth less than £ 325000 are exempted from inheritance tax and fall under the ‘nil band rate (IHTA s2). The UK government announced in 2010 that the minimum threshold for inheritance tax (£ 325000) will remain in place till 2015, after which it will increase depending on the consumer price index. Earlier the government had increased the threshold to £285000 for 2006/07, £300000 for 2007/08, and £500000 for 2009/10. The last increase was revoked by the labour government and frozen at the current rate.
Lifetime transfers are taxed at the rate of 20 percent and the cumulative value at the time of demise is charged at 40 percent. In a case where more than 10 percent of the deceased wealth is left for charity, the rate is reduced to 36 percent. Transfers made between three to seven years before the descendents demise also attracts reduced rates. On the other hand, transfers made seven or more years before the death of the descendent attracts the normal rate. A gift to business concerns or discretionary trusts that surpasses £ 325000 also attracts inheritance tax but at a reduced rate of 20 percent. The demise of the benefactor within seven years attracts additional taxation but the initial tax is deducted.
A number of assets or property, for instance, those related to farming and small-scale businesses are entitled to tax relief. Tax relief may reduce the value of an asset for tax purpose by half or more depending on property type. The UK government in 2007 permitted the use of unused threshold among spouses. This means that if one of the partners passes away, the surviving partner can bequeath double the inheritance tax threshold.
The cumulative value of assets on death includes all the assets of an individual irrespective of their location. They include real estate, personal belongings, and investments. Certain items are free from inheritance tax regardless of whether they were transferred during an individual’s lifetime or at the time of death. These items include gifts to spouses, gifts made to charitable organizations, gifts made to political parties, and dispositions for the interest of the nation (IHTA s25). However, it should be noted that spouses or civil partners with no domicile status have a lifetime limit in enjoying tax exemption. The limit is intended to tackle the risk of tax evasion in the future in case the beneficiary decides to get rid of the assets abroad. The limit has been fixed at £ 55000 since 1982. There are other gifts that do not attract inheritance tax. The most significant of these are gifts made as normal expenditure (FA 1986 s 102 (5), gifts made within a tax year and do not exceed £3000 (IHTA s20), and bride gifts that do not exceed £5000 (IHTA s22).
The inheritance tax liability of an individual in accordance with the UK laws is based on their domicile at the moment of property transfer. This well articulated in section 267 of the IHTA 1984. The residence status can be attained by origin, through parents or permanent residence. The concept of domicile according to the UK tax laws goes beyond physical presence in the country. This means that the property of the domiciled individual is subject to inheritance tax regardless of its location in the world. Individuals whose domicile lie outside the United Kingdom are only accountable to inheritance tax on property and assets that are located within the United Kingdom.
Domicile is a concept based on universal law and is not meant for tax purpose only. It described permanent residence or intention to settle permanently in a particular jurisdiction. Therefore, the UK laws ascribe domicile to any individual at birth and long-term residence. The latter must have domiciled within three years before the transfer of property or assets or have been a resident in the UK for 17 years out of 20 years. In addition, each and every individual is entitled to the nil-rate band irrespective of their domicile status.
Pros and Cons of the UK inheritance Tax
Further analysis of the law is important after exploring different chapters and sections. The analysis includes exploring the advantages and disadvantages of the law. There are a number of arguments for and against inheritance tax. Experts claim that inheritance tax can be more intricate. While the tax affects small number of the households, it perpetuates the progressiveness of the income tax by levying tax on wealthy estate owners and exempting the rest. This is well elaborated in section 2 of the law (IHTA 1984 s2). The Act delineates chargeable transfers and exempted transfers. Inheritance tax can be regarded as a premium profit tax since the inherited funds are not earned through work. It is usually valued at the date of the decedent’s death. If the property was to be sold on that particular day, it would tentatively pay nothing in capital gain-tax even if the deceased had accrued a considerable gain in the amount of assets. Therefore, inheritance tax eliminates a number of tax benefits associated with asset gains, thereby benefiting the government only while denying beneficiaries certain advantages.
In some jurisdictions, for instance UK, inheritance tax must be paid in cash within a specific period after the demise of the descendent. The amended IHTA s2 requires that Inheritance tax be paid in cash seven months after the descendent’s demise. In some instances, the only asset available is the business itself. Thus, inheritance tax may lead to the liquidation of an estate or business, instead of transferring it to the rightful heir. This may permanently affect the financial future of the beneficiaries. This may happen even if the business is in the right position to pay the tax.
The principal benefit of inheritance tax is the revenue it provides the government. Inheritance tax provides billion of pounds in revenue which has helped the government to fund major projects and pay civil servants. In addition, the revenue collected from inheritance tax has enabled the government to provide income tax breaks. The tax breaks enables the government to relieve the citizens of tax burden without resorting to other fiscal measures. However, the opponents argue that the inheritance tax fetches little revenue and in most cases constitute less than one percent of the overall revenue collected by the government. Furthermore, the government spends more money on salaries of the revenue officers keeping track of property and gifts transfers and the legal team handling defaulters.
Gorge Osborne argues that Inheritance tax is a secondary/double tax since most of the assets or properties inherited have already been taxed via income tax. Therefore, levying inheritance tax on a property or asset is unfair; particularly to those that earns little or no income. As a result, most of the taxpayers have resorted to unconventional practices to reduce or do away with the inheritance tax burden. For governments that heavily relies on the revenue generated from the system it may present a budget deficit. From the above arguments it is apparent that the cons outweigh the pros. For this reason, individuals in the UK have been exploring different ways of minimising the impact of the inheritance tax or avoiding it altogether. This leads us to the next chapter.
Avoiding Inheritance Tax
Most people spend most part of their life amassing a considerable amount of wealth to support them during the old age and their offspring. The government’s fiscal and monetary policies are aimed at encouraging savings and capital accumulation. However, with poor planning and lack of pre-emptive action individuals may face heavy tax burden. The inheritance tax, if left unchecked, may deprive individuals a considerable amount of the inheritance. The impact of inheritance tax can be avoided or minimised through careful planning.
In order to avoid paying high taxes, individuals must know the value of their estate that is taxable. The estate includes money, securities and other valuable assets. According to IHTA 1984 s49, inheritance tax on the gross estate can be minimised or avoided by transferring them to the surviving spouse or civil partner. However, IHTA 1984 s 102 (5A) prevents such exemptions provided that the benefactor does not enjoy or derives benefits from the same property/asset. Property transfers to a living spouse are the easiest, effective and legal way of avoiding inheritance tax. As long as the surviving spouse lives in the UK he/she is exempted from inheritance tax.
In the case of Thorner v Government, the defendant had gifted the property to another individual but still enjoyed rent free accommodation. Paragraph 143332 of the Amended UK Inheritance Tax Act 2007 prohibits gifts with reservation of benefits. Therefore, gifts that are still benefiting the original owner (benefactor) are taxable under the law. Such gifts are still considered to belong to the original owner. However, there are minor reservations to the law, for instance, temporary or occasional use of the property. The court found the defendant quality of tax evasion and was charged accordingly.
Transferring money or property to a trust is permissible under the UK’s Trustee Act 1925 s31/3.The trust can then loan the assets to the beneficiaries. The debt owed to the trust decrease the value of the asset and therefore little or no tax is charged on the asset. The use of special trust is most suitable especially when the spouse or heir is a non-citizen. However, the property will be taxed once the beneficiary dies.
The case of Macpherson v CIR is an example of tax avoidance through trust transfer. The defendant entered into an agreement with a trustee firm to hold some priceless painting for about a decade and half. The following day the company appointed a life interest in the property to the defendant’s child. The deal led to the decline in value of the painting. HM Revenue and Customs successfully challenged the case and showed that the defendant proposed to grant an unwarranted benefit to the child. For that reason, the trustees were denied benefits articulated under section 10 of the IHTA 1984.
A similar case involved Reynaud v CIR. The Reynaud brothers agreed to sell their company, Computer Limited. They each transferred their shares to a trust firm for the future benefit of their children. The next day the same company bought the same shares from the trustee firm. HM Revenue and Customs challenged the company’s tax relief in a special tribunal. The tribunal held that the transfer of shares to a trust firm was aimed at diminutions of the property value, thus violated section 268 (3) of the IHTA 1984.
Inheritance tax can also be avoided by transferring funds bit by bit to the heir while still alive as long as the amount do not exceed the nil-rate band. This technique is also effective and is permitted under gift reservation rule (FA 1986 section 20 par 7). Financial gifts in the form of school fees or medical expenses are free from any kind of tax, therefore not restricted to any amount transferred (FA 1986 section 20 par 9)37. Gift transfers to individuals who are more than one generation younger, for instance, grandchildren are subject to a reduced rate (FA 1986 section 20 par 8). Transferring property into a limited partnership also helps to minimise the effect of inheritance tax. Assets in limited partnership have limited tax value and therefore reduce inheritance/estate tax. The beneficiaries will be catered for through the issuance of shares39.
UK Inheritance Tax versus Four Maxims of Taxation
The four maxims of taxation help us to understand the suitability of inheritance tax law from a philosophical point of view. According to Adam Smith, the estate tax was in line with his first three maxims of taxation i.e. certainty, ease of payment and cost effectiveness in terms of collection. However, Smith felt that inheritance tax was against his fourth maxim of equality. According to him, a tax system should be fair to everybody in the society. The modern perspective of equity is based on two aspects-horizontal equity and vertical equity. Horizontal equity advocates for equal treatment of people within the same bracket both socially and economically. On the other hand, vertical equity calls for individuals in higher economic and social bracket to pay more taxes (except for benefit taxes where individuals pay in accordance with the benefit received.
Critics argue that inheritance tax violates the fourth maxim as it places a huge tax burden on the shoulders of the rich while exempting the poor through the nil band rates. However, supporters of the inheritance tax law are of the opinion that it is in line with the fourth maxim of equity. This is because people in the same socioeconomic bracket are treated equally and at the same time heavily tax properties above the threshold value. The rate charged is not constant and depends on a number of factors already been discussed.
Smith stresses that every citizen of a particular state should contribute towards the well being of the country in as much as possible and in accordance with their individual capability. For that reason, inheritance tax is unfair as it pushes the tax burden to the wealthy individuals while exempting the poor. The poor should also contribute even if it is at a lower rate.
Even though Adam Smith feels that estate tax is in line with the first three maxims. Many people will agree with him but only to a certain extent. According to the maxim of convenience, inheritance tax should be levied at the period or in a way that is okay with the contributor. According to the amended Inheritance Tax Act of 2007, Inheritance tax must be paid in cash seven months after the descendant’s demise. In many cases the benefactor does not leave liquid cash and therefore the beneficiaries are normally forced to sell the property in order to pay for the tax. Surviving spouses or civil partners are the only people permitted by the law to use business shares to set against tax on the inherited property or estate.
The maxim of predictability/certainty asserts that the amount of tax that an individual should pay must be predictable and not discretionary. This ensures that the taxpayers are well aware of what is expected of them by the government. The maxim of predictability also tries to eliminate any form of corruption from the revenue officers and tax evasion. Since 1984 changes in the UK inheritance tax laws has always been gazetted and the general public informed any changes. For instance, the government had increased the threshold level to £285000 for 2006/07, £300000 for 2007/08, and £500000 for 2009/10. However, the latter increase was revoked by the labour government and frozen until 2015. As a result, most of the UK citizens/residents know what is expected of them from the government.
As per the maxim of cost effectiveness, the tax collection cost must be lower than the amount of revenue generated from it. The taxation system should also be easy to administer. During the 18th century estate tax was very easy to administer and was cost effective. What made the tax administration easier was the fact that it only targeted real estate owners. However, nowadays the tax bracket has expanded and includes cash, shares and securities among other valuables. Monitoring the transfer of these assets has proved to be very difficult and complex. In addition, the taxpayers have invented novel ways of avoiding inheritance tax. The UK government incurs massive expenses in terms of salaries and logistics to track such transfers and dealing with the defaulters, whereas the amount of revenue generated is very small (less than 1% of the total revenue). The analysis of the inheritance tax system using the four maxims of taxation fronted by Adam Smith still leaves us in a major dilemma on whether to continue embracing the system or abolish it.
Should inheritance tax be abolished?
Inheritance tax is not only unfair but also fetches little revenue for the government. According to the Financial Statement and Budget Report 2011, inheritance tax only raised £ 2.7 billion. This is less than one percent of the total revenue collected in that financial year. However, whilst the inheritance tax is not significant in terms of government revenue, it is fairly important economically. The opponents of the inheritance / estate tax argue that it wastes resources, discourages hard work and savings, and does practically nothing to bridge the gap between the rich and the poor. In other words, they regard inheritance tax as a total failure and should be abolished. To some extend they are right.
Contrary to the fallacy that inheritance tax is principally paid by the rich, they do not pay tax. As a matter of fact, the rich have been using estate-planning techniques to avoid inheritance tax. Some of the techniques used include life-insurance trust, generation-skipping trusts, and charitable trusts among others. According to John Beckert, a professor of law at Princeton University, the rich have devised new methods of avoiding inheritance tax to an extent that paying tax has become voluntary for them. He asserts that the amount of tax revenue collected at the moment is ascribed to the unresponsiveness of the taxpayers to the above loopholes or lack of belligerence on the part of the planners in exploiting avoidance opportunities. Other experts reiterate that inheritance tax is not a tax but a fine imposed on those who have not planned ahead or have hired unprofessional planners.
Nonetheless, the ability of the estate owners to avoid inheritance tax is not the same. This is because the methods used to avoid paying or minimizing inheritance tax are not cheap and take long to execute. Hence, those in a better position to undertake such plans are the large estate owners. In addition, individuals that have accumulated wealth for long are more conversant with the tax loopholes. For that reason, people who are most affected are those who have just acquired their wealth.
Inheritance tax reduces revenue that could be raised from a given property. The impact of inheritance tax avoidance techniques also affects other sources of government revenues, for instance, income tax. For instance, assets that have been transferred to a charitable trust are exempted from tax. At the same time, the beneficiaries are entitled to the income from the estate until they pass away. Transferring an estate to a trust not only shields it from inheritance tax but also minimizes the income tax. Economic experts argue that the lost income tax revenue from a property may compensate for all the revenue the government collects from it.
Sceptics of inheritance tax believe inheritance tax also have considerable impact on the general economy since it discourages people from work, saving and investment. The effective marginal tax rate for people saving money for their offspring is the income tax and the inheritance tax. This tax rate can go as high as 70 percent with other government taxes pushing it even higher. Economic experts claim that the negative impact of the inheritance tax is not limited to the rich alone. In addition, inheritance tax encourages gifts transfers during the lifetime and may discourage the beneficiaries from working hard and saving.
Intergenerational property transfer represents a huge part of a country’s capital stock. In other words, inheritance tax is a direct tax on capital stock. Thus, inheritance tax has negative impact on the capital stock formation and savings rate. Additionally, since wealthy individuals already own huge portion of the existing capital and are well versed on inheritance tax avoidance techniques, they may actually become richer. Last but not least, inheritance tax inflicts an additional cost on the economy. For instance, the government is forced to employ more revenue officers to keep track of property and gifts transfers. Furthermore, government has to hire a multitude of tax lawyers to take up cases of tax defaulters.
However, liberals acknowledge the flaws in the current inheritance tax law. They assert that the solution to the inheritance tax flaws do not lie on its abolishment but on necessary reforms. They add that abolition of inheritance tax may eliminate the existing flaws, but may also result in other serious challenges. For instance, it may eliminate what is so far regarded as the most progressive tax instrument in the country. Abolition could also negatively impact nonprofit organizations and state revenues as well.
Liberals propose replacing inheritance tax on assets and gifts given with taxes on assets and gifts received. This is practiced in a number of American states. Placing the tax burden on the recipient may minimize emotions/ moral outrage normally generated when the descendent dies. They also propose raising the threshold which will reduce the number of people paying taxes while taxing the “justly rich”, thus deconcentrating wealth. Closing the gaps in the current tax regime by treating different properties in a nearly analogous manner will minimize tax evasion, and therefore make inheritance tax collection simple and unbiased.
The reduced rates will also minimize cases of tax avoidance and behavioural changes. Indexing the nil-rate band will automatically keep the tax burden stable over a long period of time. The UK Government should also pass new laws to seal the loopholes in the Inheritance Tax Act, especially those related to real property transfers, for instance, pre-owned assets charge (POAC). POAC targets real estate property donated but the donor still derives benefit from it. If such violations are detected, annual tax charge should be imposed on the benefactor.
The best alternative to the inheritance tax system is the accession tax which has recently been introduced in a number of American states. Accession tax is a progressive tax levied on the sum of gratuitous receipts of a person during a lifetime. The accession tax tackles the liquidity and tax evasion than the inheritance tax. Accession tax exempts non-liquid assets on receipts but only when the beneficiary converts it into a liquid asset or changes its eligible use. Bonuses and other distributions from the asset are taxed apart from the reinvested profit. According to this system, the spouses are only exempted from tax after meeting certain criteria. It ensures no generational skipping of tax and unwarranted advantages over bequest. In addition, its timing is excellent and rational.
Other fundamental alternatives include taxing gifts as income, wealth tax along with differentiation and an annual wealth and accession tax (AWAT)67. When gifts are taxed as income the rate will go down and will be well received by the citizens. Differentiated wealth tax means taxing wealth in accordance with the age and whether it is inherited or earned. The latter should be taxed at a higher rate. Lastly, AWAT merges wealth and accession tax and therefore lowers the rate of inheritance tax plus bridging the avoidance gaps.
Conclusion
Inheritance tax is a tax imposed on gifted/inherited assets. Generally, not tax system has ever been fair to the citizens but the current inheritance tax law has many flaws and is not fair to the citizens. The rates are very high and the rules are too stringent. These flaws are forcing the citizens to invent new ways of minimising the tax effect or avoiding it altogether. Critics call for the end of UK inheritance tax law. However, this could have a negative impact on the economy if an alternative is not found. For instance, the gap between the rich and the poor will continue widening and not extra revenue to the government. The current inheritance tax law can be amended to accommodate everyone and reduce the negative impact or the government can abolish it and introduce accession law which is more efficient than the current inheritance tax law.
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