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In April and November of last year the National Audit Office (NAO) issued two reports heavily criticising the way that HMRC administer tax reliefs.
In those reports it stated that the value of Inheritance Tax (IHT) reliefs is seven times higher than the amount of IHT collected. It is not in the NAO’s remit to query policy, but could their observations, and the political reaction to them, lead to far-reaching changes to IHT and its reliefs?
IHT is unlike most other taxes in that the value of the reliefs far exceeds the amount of tax collected. The figures in the NAO’s reports are striking. In 2012/13 IHT raised £3.1bn for the Treasury and the value of reliefs was £22.4bn – seven times higher than the sum raised. In 2010/11 there were 560,000 deaths, but only 16,000 cases resulted in IHT being payable. This is about three per cent. In addition, 36,000 cases were valued above the IHT threshold, but 20,000 of those did not pay any tax because of the value of exemptions and reliefs they were able to claim.
HMRC was heavily criticised by the NAO for not checking that tax reliefs are working as intended and providing value for money. The concern is that the reliefs are being abused. Margaret Hodge, the Chair of the Public Accounts Committee, said it was “beyond belief” that HMRC were not monitoring reliefs more closely and has claimed that HMRC’s approach is “leaving the door open for tax avoidance.”
Many practitioners have become complacent, believing that while changes to IHT reliefs have been talked about for many years, nothing has happened. However, following the NAO reports, and with tax avoidance high up the political agenda, any review of the reliefs could mean that IHT is in for some long overdue changes.
Reforming APR and BPR
The NAO reports focus on Agricultural Property Relief (APR) and Business Property Relief (BPR) – a potential area for reform.
The NAO’s report published in April shows that the value of these two reliefs has grown faster than the amount of IHT collected. APR and BPR were two out of the four tax reliefs that had increased by more than 50 per cent in real terms since 2008/09.
||The value of claims
The NAO point out that whilst public spending has fallen sharply, the value of reliefs has continued to rise. It criticises HMRC for not automatically investigating any large increase in the value of claims to ensure it is not as a result of abuse. The NAO point out that the increase in claims for APR and BPR cannot be accounted for by any changes in policy. It fails to point out that much of the increase might be due to an increase in asset values. For example, according to Savills, the value of farmland has increased 270 per cent in the past ten years.
The NAO say the Government needs to know the “cost” of these policies to see if the cost is commensurate with the benefits. The NAO reports frequently refer to the “cost” of the reliefs, rather than the value of the claims. As HMRC points out these figures do not represent an amount of money which might be obtained by Government. For example, it does not take into account interactions between the reliefs. Therefore, it does not believe that these figures are helpful.
APR and BPR are, what the NAO refer to in its reports as, “tax expenditures”. They are designed to encourage certain types of behaviour to achieve economic and social objectives. They are an alternative to public expenditure, but can be more a more effective and efficient way to achieve the policy objective. BPR is designed to protect investment in risk-taking trading ventures. APR is designed to protect farmland and buildings, including let farmland. As well as encouraging entrepreneurial behaviour, they also encourage the rich to keep their wealth in this country. These reliefs are needed. However, are they needed in their present form?
The NAO made the point that providing tax advice is worth almost £2bn a year to the “big four” accountancy firms alone. APR and BPR are often used by tax planners as tools to reduce their clients’ exposure to IHT.
A common strategy to reduce IHT is to make substantial outright gifts. Here the client loses control of the assets and, as a general rule, they do not fall out of the tax net for seven years. APR and BPR, on the other hand, offer the opportunity to keep the assets until death and thereby keep control of those assets, get them out of the tax net after just two years, and pass them on free of IHT with a Capital Gains Tax (CGT) uplift.
So how could these reliefs be changed?
While the rules relating to both reliefs are very similar (same rates, succession provisions, clawback provisions, etc.), the policy objectives are different and, according to Toby Harris, do not make good bedfellows.
One dramatic answer might be to abolish APR and extend BPR. Having just one relief with a clear objective should make it simpler and easier to administer. Any changes must take in account the fact that we need a thriving agricultural industry. The horsemeat scandal reinforced that. How else are we going to ensure the availability of affordable quality food? Let’s consider how the abolition of APR might affect farmers. What assets are eligible for APR, but do not qualify for BPR? The two main items that could fall into the tax net would be farmhouses and let farmland.
HMRC closely examines any claim for APR in relation to a farmhouse and challenges any that it considers to be close to the boundaries. However, those boundaries and HMRC’s guidelines not as clear as they could be, which means that any claim for APR in relation to a farmhouse has to be fought for.
This might be because farmers are perceived to be getting an unfair advantage. Is there any difference between an author who works from home and a farmer? The farmer will get tax relief on the “agricultural value” of his home, which is likely to be a significant percentage of its open market value – at the risk at being shot at by surveyors, this is usually somewhere in the region of 70 per cent. However, an author may not get any tax relief at all, unless his Personal Representatives can argue that his office is used for wholly or mainly for business purposes. If so, they may be able to claim BPR on a relatively small percentage of the value of house.
In one case the claim was for ten per cent of the value of the author’s home. That may not seem fair, but farmers are in a unique position. The house, together with the land, is needed by the farmer who wants to pass that business onto his or her family. The farmer’s home needs to be near the land in order to farm it and they often work long hours. According to a Farmers Weekly survey published last year, farm-based workers work 52.1 hours a week, which is about 20 per cent higher than the national average. Few farmers are sufficiently wealthy to pay large amounts of tax without it severely affecting the viability of their business.
So, if APR were abolished, farming families may, just may, be able to claim BPR on a small share of the value of their home. It would be helpful to all involved if this could be clearly set out in statute or, at the very least, made clear in HMRC’s guidance. This change would remove the perceived advantage that farmers have. The percentage of the value of a home eligible for BPR is likely to be less than that currently available under APR, but many more claims in relation to a home are likely to be made.
The abolition of APR would mean that let farmland would not qualify for relief. This is likely to mean that farmland would be sold or used for other purposes. Wealth may leave the country and less land would be used for the production of food. It is possible that some let land could qualify for BPR under the principles in Re Farmer and Re Balfour, if it forms part of an overall trading business. The principles are clearly set out in case law, and appear to be accepted by HMRC, but it would be helpful to have these principles enshrined in statute.
Many farmers struggle financially and may need to diversify. A recent BBC news report claimed that it cost more to buy a bottle of water than a pint of milk. So many dairy farmers are struggling and are being encouraged to diversify. Would the abolition of APR encourage that? It might, but it could further jeopardise the production of food in this country.
APR is more generous than BPR in a few other scenarios. For example, in the case of farmland used by a partnership, where the landowner is a partner, and the partnership does not own the land. Landowners can get 100 per cent APR on the agricultural value, but BPR only gives them 50 per cent on the open market value. In theory, BPR could be extended to cover these scenarios, but such changes would not help reduce the value of claims.
An alternative to abolishing APR might be to reintroduce a relief that only applies to working farmers. Only farmers that get the majority of their income from farming would qualify. This should prevent wealthy ‘lifestyle’ farmers, or wealthy bankers that invest their bonuses in farms, from benefitting from the relief. This could be politically popular, even if it was at the risk of further complicating the tax system.
Turning to BPR, one possible reform might to be allow the relief only in instances where the business activity continues for a period after the death or gift, say two years. Again, this further complicates the tax system, but it does meet the objective of encouraging investment in risk-taking trading ventures.
Changes to the Nil-Rate Band?
While the total value of IHT reliefs quoted in the NAO report is striking, the Nil-Rate Band accounts for £18.4bn of the £22.4bn quoted above. It would seem to be politically difficult for any government to reduce the Nil-Rate Band or IHT threshold to increase revenue. However, this has been done in real terms because the threshold has not been increased since April 2009. The current policy, announced in the 2013 Budget, is to freeze the Nil-Rate Band until April 2018. If it had been linked to the Consumer Price Index, then the threshold would currently be somewhere in the region of £378,000.
This freeze means that more estates will be paying IHT. The Office for Budget Responsibility forecast that the revenue from IHT will increase to £5.8bn in 2018-19 with 9.9 per cent of deaths resulting in tax being paid. This growth is based on the predicted economic recovery and increase in house prices.
No major party has come out and said that they plan to reduce the Nil-Rate Band – just the opposite. The Conservative Party want to increase it significantly. Last year David Cameron hinted that he still wants to increase the threshold to £1m, once the economy and Chancellor allow. Given the current economic climate, it is more likely he is considering increasing the threshold to £500,000. This way the Conservatives could claim that, with the help of the transferrable Nil-Rate Band, married couples have a £1m threshold between them.
Simply increasing the Nil Rate Band to £1m would be very popular and, as we all know, an election is coming up. A recent poll by YouGov found that 65 per cent of people think raising the threshold to £1m would be a positive move, which is hardly surprising. For the time being relatively few deaths result in the tax being paid, but from the numbers of people who take advice on the issue, the evidence is that many people worry about it.
If the Nil-Rate band were to be increased to £1m, then only the very wealthy that do not heed the advice of their tax advisers, would be paying the tax. The Institute for Fiscal studies (IFS) calculated that if the Nil-Rate Band had been £1m in 2010-11 the receipts from this tax would have been reduced by 70 per cent from £2.6bn to £0.8bn. Those who do heed advice, would be making substantial gifts with a view to surviving seven years and those gifts falling out of the tax net. One way to increase the tax revenue might be to consider the policy proposed by the Liberal Democrats in 2007 in a paper entitled “Reducing the Burden” and increase that seven-year period to 15 years. The proposed increase was justified on the basis that we now live longer.
Time to consider more far-reaching changes?
It is well-known that politicians like policies that are popular, cheap and simple. Policies that are brave, expensive and complex cost them the election. With such principles to guide them, the risk is that a government might be tempted to tinker with the IHT system amending the reliefs. It may be tempted by supposedly simple, but dramatic reforms, such as increasing the Nil-Rate Band to £1m and/or abolishing APR. The IFS calculate that such an increase in the Nil-Rate band would have cost £1.8bn in 2010/11, but the abolition of APR would do little to make up the shortfall in revenue. APR claims were valued at £275m in 2010/11. If APR had not existed in that year, the country would not be £275m better off. Much of the assets subject to the claim would have benefited from BPR. The Government would have to consider the affect abolition would have on the agricultural industry.
The Government should be weary of simply increasing tax rates or removing reliefs. As we saw with the 50 per cent income tax rate, which according to George Osborne raised £1bn of revenue rather than the anticipated £2.5bn, these legislative changes change behaviour.
What the Government should be considering is exactly what we are trying to achieve with IHT. A root and branch reform is needed. As the Office of Tax Simplification said in one of its reports in 2011, “the reliefs for inheritance tax are integral to the policy and we consider that a more appropriate approach would be to review the tax as a whole.”
Not that any tax is popular, but IHT is deeply unpopular, with many seeing it as a form of double taxation. For the most part, the funds subject to IHT have already been subject to Income Tax and CGT. People just want to pass on their wealth to their loved ones intact.
The most likely justification for IHT is the argument that it promotes social mobility by limiting entrenched advantage and redistributing wealth. Why should children that happen to have wealthy parents have access to unearned wealth? With such a small amount of IHT being paid (0.6% of all tax revenue), it does not look as though the tax is achieving its objective. The low revenues, arguments that IHT is not achieving its policy objective, and the complexity of the current system, all support the case for abolishing the tax or, at the very least, substantially reforming it.
The IFS-led Mirrlees review suggested that one way of achieving this policy objective would be to tax individuals on the total amount of gifts they receive, either during the donor’s lifetime or on death. Ireland has had such a system in place since 1976. The difficulties with such a system are likely to be the need to keep records and the ease of avoidance – the very issue causing such consternation at the moment.
Others have suggested that IHT is replaced with an annual wealth tax or that CGT is payable on death, which should at least keep the family home out of the tax net. A report by Grant Thornton published in 2011 suggested that neither of these options would be popular.
A better option might be to keep a form of Inheritance Tax, but to introduce progressive rates of tax depending on the size of the inheritance and the beneficiary’s relationship to the deceased. Exemptions or reliefs for the main residence, as well as spouses and businesses, could be considered.
Whether the IHT system is abolished, amended or left intact, HMRC is going to be under increased pressure to ensure that the reliefs we do have are working effectively. This means practitioners are going to have to scrutinise their clients’ affairs particularly carefully to ensure that the legislation, and HMRC’s guidance, are followed to the letter, so that their clients can continue to benefit from these reliefs.
For more information please call Catherine Ball on 01604 463337 or click here to email Catherine.
For more information on our Inheritance Tax services please click here. This article was published in the latest issue of Trusts and Estates Law & Tax Journal (March 2015). Click here to log in and read the full article.