Playing the long game with inheritance taxby
Despite affecting a comparative few, inheritance tax has become a topic of much debate as a general election approaches. Helen Thornley looks at its history and possible reform.
For a tax that only affects a small proportion of the public – and makes a modest contribution to UK tax receipts – inheritance tax (IHT) is perhaps an odd choice of political football. But earlier this year The Telegraph, backed by a reported 50 Conservative MPs, launched a campaign to abolish the tax, claiming it was inherently unfair.
More recently, media attention has focused on whether Labour, if elected, would rein in some of the more favourable reliefs for business and agriculture – again in the name of fairness.
Potted history of death duties
Despite being paid by only 4% of estates, IHT is a particularly emotive tax. It’s taken 300 years to get from a basic flat rate to our comprehensive – and complex – system, with opposition at every stage.
The first instance of a death duty was probate duty, first introduced in 1694. Set as a fixed fee of five shillings on estates of over £20, it was one of a number of “stamp taxes” on legal transactions introduced to fund the war against France.
In 1780, with funds needed for the American Revolutionary War, an element of graduation was introduced to probate duty, along with a new tax – legacy duty. This was charged on the receipts given for legacies, with the rate dependent on the value of the legacy. Since there was no law requiring receipts to be given or received for legacies, this was fairly easy to avoid – until William Pitt fixed the problem in 1795 by requiring executors to issue them.
The following year, Pitt changed legacy duty again, shifting rates so they depended on how closely the recipient was related to the deceased. At first, wives and children were exempt, but as rates increased, within 20 years only transfers to a widow remained untaxed and had reached 10% for those not closely related to the deceased.
Both taxes were limited – they only applied to moveable assets passing on death, and generally omitted to tax interests in land, settled property or gifts. To try to broaden the tax base William Gladstone introduced succession duty in 1853. This taxed freehold, leasehold and heritable property – although not at the full market value, and with lower rates if passed to close descendants. As a consequence, the new tax raised much less than expected.
Further revisions and rate increases followed over the next 40 years, but the first comprehensive regime of death duties was estate duty, introduced for deaths from 1 August 1894. This replaced probate and account duty, and reduced the rates and scope of legacy and succession duty. Introduced by Sir William Harcourt, there was sustained opposition to the measures, and substantial parliamentary time spent on the issue. estate duty was even dubbed the “second son’s revenge” as Sir William’s father’s estate was expected to pass to his elder brother.
There’s a lot we would recognise from estate duty. Property was valued at the market value at the time of death, and the estate included land and property outside the UK as well as gifts made within three years of death.
The rates for estate duty were modest to begin with, ranging from 1% for estates over £100 (around £10,700 now) to 8%. Inevitably, they increased over the following decades. The 40% rate we have now in IHT first appeared in 1919, for estates of over £2m, with the rates peaking at 85% in 1969 for amounts over £750,000.
Estate duty lasted until the 1970s, when it was replaced by capital transfer tax by Labour Chancellor Harold Wilson. This sought to tax transfers of value in life as comprehensively as those in death. The regime lasted for around a decade, before Conservative Nigel Lawson reframed it as inheritance tax in 1986. He reduced the taxes on lifetime gifting, believing this would encourage enterprise. Bringing back some of the rules from estate duty, gifts made more than seven years before death could now potentially escape a tax charge altogether.
Where are we now?
In 2022/23, receipts from inheritance tax amounted to around £7bn – just under 1% of total tax receipts for that year. IHT is dwarfed by the “big three” revenue generators – income tax (first introduced in 1798), national insurance (1911) and VAT (1973).
IHT is not generally considered to be terribly popular. A recent YouGov survey suggests that 54% of people consider it either unfair or very unfair. But it does appear that views on this issue can be affected by how the question is framed.
A study by Demos in July 2023 found that while half of those surveyed thought that inheritances in general should always be tax free, this view shifted when presented with more concrete examples of specific inheritances. Only 17% of those surveyed thought that the inheritance of a second home that had increased in value should always be tax free, with the majority thinking that some tax should apply in these circumstances.
Interaction with capital gains tax
If IHT were abolished, it would represent a massive break in 300 years of evolving death duties. It would also have knock-on consequences for capital gains tax (CGT). Despite the latter’s relatively late arrival in 1965 – and in theory quite different policy intent – it’s generally impossible to advise without considering both.
As a rule of thumb, gifts in life are subject to CGT, while gifts on death are subject to IHT, unless business or agricultural property is involved. CGT is eliminated on death because assets are given a tax-free uplift to the IHT value.
When the Office of Tax Simplification (OTS) considered IHT in a 2019 report on Simplifying the design of the tax, they identified the uplift on death as distorting decision-making. Contributors to the report said that it encouraged people to hold onto assets that benefit from IHT exemptions. On this basis, there’s an argument that abolishing IHT entirely without any compensatory changes to CGT could curtail enthusiasm for lifetime gifting even further. Why incur CGT in life, or rely on holdover, when you could pass it over after your death with a CGT-free uplift?
The OTS recommendation was to consider removing the capital gains uplift and provide for the individual to acquire assets at the historic cost to the donor. While I can see the logic in this suggestion, my personal view is that this would be incredibly difficult in practice. It’s bad enough finding out base costs when the donor is alive, let alone when they are deceased.
Pressure for change
It’s difficult to imagine that we will ever return to a pre-1694 era of tax-free wealth transfers on death, but it is likely that pressures for some form of change will build. The latest Institute for Fiscal Studies report on reforming inheritance tax suggests that in ten years’ time 1 in 8 estates will be in scope – three times the current number. Combined with an election deadline of December 2024, we can probably expect to hear a lot more about what the different parties consider fair over the coming months.
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Helen Thornley has a focus on personal and capital taxes. Initially training as an accountant before moving to tax, she worked in practice until her appointment as a technical officer in 2017. She also has an interest in the history of tax.