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Inheritance tax: Lessons from the super-rich

Neil Jones, Wealth Management and Tax Specialist at Canada Life:

The recent report by the Office of Tax Simplification revealed something peculiar. While the inheritance tax rate increases in line with the size of the estate, there is a noticeable dip in effective tax rate paid when the estate reaches £10 million.

The graph below looks somewhat like a roof, albeit one where the ‘squeezed middle’ wealthy are the ones mostly getting rained on (and the smallest and largest estates are paying a lower average effective tax rate). The tax rate rises steeply for estates worth up to £1 million, plateaus at around 20% between £1 million and £9 million, then abruptly declines for those with bigger estates.

Figure 1: Average effective tax rate paid by estates

Effectively, those estates worth between £1 million and £9 million are those where inheritance tax takes the largest bite. So why does the effective inheritance tax rate actually decline for the largest estates?

What are the super-rich doing differently?

In some cases, ultra-high net worth families use family investment companies. For example, the Duke of Westminster was reportedly able to pass on the bulk of an £8.3 billion fortune to his son simply by using a trust.

These types of trusts can be subject to a 6% charge in tax every ten years, but they are not part of the deceased’s estate so avoid the inheritance tax of 40% when the owner dies. For financial advisers, a relatively straightforward analysis of life expectancy and tax rates should reveal how effective this could be for clients, but trusts are clearly a tried and tested method of efficiently passing on wealth to future generations.

Figure 2: Type of assets held by estates

It’s also important to note the comparison of composition of assets between high and low value estates. In particular, it’s striking how little is held in UK residential property as a proportion of the estates as they are getting larger – a decline from around 40% (for estates between £1-2 million) down to about 10% (higher value estates of £10 million and higher).

Typically, lower value estates mostly consist of cash and residential property which don’t attract relief from inheritance tax. Conversely, the greater the value of the estate the larger the amount typically held in securities and ‘other assets’.

There is no reason to suggest why smaller estates can’t benefit from similar strategies. Reducing the amount held in UK residential property and increasing it in more tax efficient assets is an option available to all, as are trusts. The option of using business relief is open to anyone eligible to invest in the AIM markets.

The key to all of this is planning. Whether the estate in question is worth £1 million or several billion, you can’t tax efficiently pass on the estate without planning – or consulting a financial adviser.

Methods to reduce an IHT bill

* The most obvious choice is not to be overlooked: trusts. Bare trusts (often the simplest kind of trust), discretionary trusts, excluded property trusts, among others, are all options.

* Agricultural relief can be incredibly valuable, putting the estate in for 100% relief if the deceased owned and occupied property that was used for agricultural purposes for two years before their death.

* Investment and portfolios that qualify for Business Relief allow for certain shares to be exempt from IHT as long as you hold them for at least two years (and at death). They’re also eligible for inclusion in ISAs, so you can shelter them from income and capital gains tax. Business relief provides relief from IHT on the transfer of relevant business assets at a rate of 50% or 100%. The deceased must have owned the business or asset for at least 2 years before they died. A word of caution here regarding investment risk: These will not be suitable for everyone as AIM stocks are typically more volatile than other shares and so the risk appetite may not be suitable for a portfolio built up over a lifetime.

* You could also consider taking out a suitable life policy to provide the beneficiaries with the ability to pay the inheritance tax liability. The solution can be very cost-effective and ideal for those estates which are asset rich and cash poor.

Source: Analysis of HMRC data from Inheritance Tax forms for the 2015 to 2016 tax year which is published here for the first time
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