Learn how outright gifts are dealt with for inheritance tax purposes and the implications of death within seven years.
- Potentially Exempt Transfers (PETs) enable an individual to make gifts of unlimited value which will become exempt (i.e. escape tax) if the individual survives for a period of seven years
- PETs are only chargeable if the transferor dies within seven years of making the transfer
- PETs are assumed to be exempt at the time of transfer, and as a result no IHT is payable at that time
- One condition of a PET is that it is a gift to another individual or to a specified trust
- The value is based on the loss to the transferor’s estate
- On 19 January 2018, Philip Hammond wrote to the Office of Tax Simplification requesting a review of the IHT regime
What is a potentially exempt transfer?
In its manuals, HMRC states that "most lifetime transfers are potentially exempt transfers (PETs)".
PETs enable an individual to make gifts of unlimited value which will become exempt (i.e. escape tax) if the individual survives for a period of seven years.
When is a PET chargeable?
S3A IHTA 1984 deals solely with PETs. This section states that a PET is only chargeable if the transferor dies within seven years of making the transfer. A PET made seven years or more before death is an exempt transfer.
S3A (5) states that PETs are assumed to be exempt at the time of transfer, and as a result no IHT is payable at that time.
If the transferor makes a subsequent chargeable lifetime transfer (gift into discretionary trust) the earlier PET does not enter into the transferor’s cumulative total at that time. If however the person then dies within seven years of the PET, it will become a chargeable transfer at the date of the gift.
Three conditions that must be satisfied
A PET is a lifetime transfer of value that satisfies three conditions
- the transfer is by an individual on or after 18 March 1986
- it would be a chargeable transfer apart from IHTA84/S3A (or, if only partly chargeable, is a PET to the extent that it would be chargeable), and
- it is a gift to another individual or to a specified trust
As a starting point, it is therefore necessary to consider what is meant by a "transfer of value". This is a disposition made by a person as a result of which the value of their estate has decreased. In very broad terms, this will comprise all forms of disposals and transfers of cash and other property, but "disposition" has a wider remit than just that and is explored by HMRC in its Inheritance Tax Manual.
For the avoidance of doubt, an "individual" is a human being and "individual" would not therefore include a corporation or company.
Transfers into trust are considered in the next section.
When the gift is made to another individual, then either the value transferred must become comprised in the estate of the recipient, or the estate of the recipient must be increased. The most obvious example of property becoming comprised in the estate of the recipient is an outright gift of cash from one individual to another.
For example, Charles gives his friend Deborah a cheque for £100,000.
This gives rise to a PET (ignoring exemptions).
Where property does not becomes comprised in the estate of the recipient, a PET may still arise if the estate of the recipient is increased.
Example of property not becoming comprised in the estate of the recipient
Emma owes her father £100,000.
Her father forgives the debt.
This is a transfer of value since the value of her father’s estate is diminished.
Emma does not receive any property from her father, but her estate is increased.
The transfer is a PET
Transfers into trust
A transfer into an accumulation and maintenance trust prior to 22 March 2006 gave rise to a PET. This cannot apply to property settled on or after 22 March 2006 except in specific circumstances where rights under a life insurance policy were settled on accumulation and maintenance trusts prior to 22 March 2006, but premiums continue to be paid after that date. In those circumstances, the payment of premiums on or after 22 March 2006 will continue to be treated as PETs if they are made to an individual. Note that if the settlor simply pays the premiums directly to the insurance company then this would give rise to chargeable transfers – the reason being that there would be no identifiable property becoming subject to trust.
A transfer to a trust for a disabled person gives rise to a PET.
A transfer by an individual to a bereaved minor’s trust on the coming to an end of an immediate post death interest (IPDI) will give rise to a PET. This is a bit niche, but how might this arise in practice?
Example of transfer to a bereaved minor trust on the ending of an IPDI
Karen has recently died, and in her will created an interest in possession trust for her husband, Lawrence. Under the terms of her will she also left funds to her 8 year old daughter and this qualified as a ‘trust for a bereaved minor’.
With regard to the trust in favour of Lawrence, the inter spouse exemption can apply and assuming Lawrence has an IPDI, then the relevant property regime will not apply to this trust. To qualify as an IPDI it is necessary to adhere to strict conditions as to the nature of the ‘remainder’ interest arising at the end of the interest in possession; and the ‘flexibility’ in the trust i.e. the extent of the trustees' powers to terminate or vary the interest in possession.
If very simply, income is payable to Lawrence for life with remainder to his daughter absolutely, then that would qualify as an IPDI. Similarly, if the bereaved minor trust is the remainder interest, then the will trust will qualify as an IPDI. With that in mind, if Lawrence’s interest is terminated while he is alive, then that would give rise to a PET.
Death within seven years
If the transferor dies within seven years of making the PET
- The PET becomes a chargeable transfer
- The transfer must be cumulated with the death estate
- The transfer must be cumulated with any subsequent lifetime transfers, and
- The value transferred (after cumulation with earlier transfers) may become chargeable in its own right
Example of death within seven years
Michael makes the following transfers (after exemptions and reliefs):
- £170,000 to his son, Noah, in August 2015
- £170,000 to his daughter, Olga, in February 2016
Michael dies with a death estate of £225,000 in October 2018 when the NRB is £325,000.
The gift to Noah becomes a chargeable transfer and absorbs £170,000 of the NRB at date of death. No tax will be due on the failed PET
The gift to Olga will use up the remaining NRB of £155,000 meaning that the excess of £15,000 becomes chargeable in its own right and is cumulated with the death estate to calculate the IHT payable. IHT is charged on the cumulative total of £240,000.
Olga is primarily liable for the tax due on the failed PET (no taper relief will be due.)
What is the value transferred?
The general rule is that this is the:
- amount by which the value of the transferor’s estate is reduced. In other words, the loss to the transferor’s estate, but
- ignoring excluded property which ceases to form part of the transferor’s estate. In broad terms this refers to overseas property held by someone who is domiciled outwith the UK.
Often the loss to the estate is the same as the value of the property given, but this is not necessarily the case.
Example of value transferred
Widget Ltd has an issued share capital of 100 shares. Alison owns 60 shares in the company and therefore has control of the company.
Alison gives 20 shares to Belinda.
As the gift causes Alison to lose control of the company, the loss to her estate (the difference between a control holding of 60 shares and a minority holding of 40 shares) is much greater than the value of 20 shares in isolation.
Note that a transfer of value may be partly an exempt transfer and partly a PET. A transfer of value which is however wholly covered by an exemption cannot be a PET, it is an exempt transfer.
For example, Gwyneth gives Hubert £10,000. She has a current year annual exemption of £3,000 available. Her gift is
- an exempt transfer of £3,000, and
- a PET of £7,000
IHT legislation also provides that the lifetime cessation of a reservation in gift with reservation (GWR) property is treated as a PET
Example of deemed PET
Ivan gifted his main residence to his daughter Jane 10 years ago but continued to live in the property rent free. This was a gift with reservation of benefit. Ivan now decides to vacate the premises. He is treated as making a PET of the gifted property, on the date the reservation ceased.
This is a deemed PET and comes into charge on Ivan’s death in the same way as any other PET made within that period.
In view of the fact that this is a deemed PET (there being no actual transfer of value when the reservation ends) then the annual exemption is not available against it.
Deemed transfers that are PETs
There is one deemed transfer of value that is a PET (a deemed transfer of value is one that is imposed by statute).
This ensures that a release of a life interest can qualify as a PET.
This was alluded to in the earlier example of Lawrence.
PETs and chargeable lifetime transfers made in the same tax year
From a tax perspective, the chargeable lifetime transfer (CLT) should normally be made before the PET. The reason for this, is that if the PET becomes chargeable, it will not impact on the CLT and it will not therefore be necessary to recalculate the tax due on the CLT.
Applying the annual exemption
It should also be noted that where gifts are made on different days in the same tax year, the annual exemption is applied to the earliest transfer first. It does not matter whether the transfers are PETs or CLTs.
For example, on 1 August, Arnold gives £50,000 to Barnaby. On 2 August, Arnold gives £60,000 to Calvin. He has already made CLTs that exceed the IHT threshold in the previous year and so tax is payable on the transfers in the event of death within 7 years. All of the £3,000 annual exemption is applied against the gift to Barnaby made on 1 August.
If the transferor makes multiple transfers on the same day, the annual exemption will be apportioned where necessary.