Many individuals have heard of a ‘seven-year rule’ for inheritance tax (IHT) purposes. Even the least ‘savvy’ of those individuals from an IHT perspective often have at least a vague notion that if they gift an asset to another individual and survive for at least seven years, there will be no IHT (or further IHT) implications in respect of that gift; this is commonly referred to as the ‘seven-year rule’.
That notion may be accurate in many cases (leaving aside the ‘gifts with reservation’ anti-avoidance provisions in FA 1986, ss 102-102C, Sch 20). However, in other cases the order of gifts could result in IHT implications for up to 14 years. How can this situation arise, and how might it be prevented?
IHT is charged on the value transferred by a ‘chargeable transfer’, being a transfer of value (e.g., a gift) made by an individual which is not exempt. A ‘transfer of value’ is broadly a disposition resulting in the transferor’s estate afterwards being less than it was before; this diminution is the value of the transfer (IHTA 1984, ss 1-3).
The ‘seven-year rule’ mentioned earlier is referring to potentially exempt transfers (PETs). A PET is broadly a lifetime transfer of value that satisfies the following conditions (IHTA 1984, s 3A(1), (1A)):
A PET made seven years or more before death becomes an exempt transfer. Conversely, a PET becomes a chargeable transfer if made within seven years of death (IHTA 1984, s 3A(4)).
IHT is charged on death, as if a transfer of value had been made immediately before death equal to the value of the individual’s estate at that time. Furthermore, chargeable lifetime transfers of value are cumulated; the rate of IHT will depend on the total value of any such transfers made within the seven-year period ending with the latest transfer. After seven years, these transfers generally drop out of the cumulative total.
On an individual’s death, chargeable transfers to be cumulated include both immediately chargeable transfers (e.g., lifetime gifts to a discretionary trust) and ‘failed’ PETs (i.e., PETs within seven years of their death which have become chargeable because of death). No IHT would have been charged on the PET, as it was assumed to be exempt when made.
Importantly, in calculating the IHT position on failed PETs, it may be necessary to look back at transfers made more than seven years before the date of death, up to a maximum of 14 years (this is sometimes referred to as the ‘14-year backward shadow’). For example, if a PET was made six years and 11 months before death, the period 13 years and 11 months prior to the death needs to be reviewed. However, the only transfers more than seven years before death which need to be considered are immediately chargeable ones.
Peter dies on 24 December 2022, having made gifts (after IHT reliefs and exemptions) as follows:
31 December 2009 £150,000 transfer to a discretionary trust
5 April 2015 £175,000 gift to sister;
1 January 2016 £150,000 gift to brother;
The IHT position on Peter’s death in respect of his lifetime transfers is as follows:
31 December 2009: Transfer to discretionary trust £150,000
This was an immediately chargeable transfer, but no IHT was payable as the gross value was within Peter’s available nil rate band (£325,000 for 2009/10). The gift was also made more than seven years before Peter’s death, and no tax is payable on that event.
5 April 2015: Gift to sister £175,000
The gift to Peter’s sister was a PET when made, which became exempt after more than seven years. The gift is not cumulated with later gifts.
1 January 2016: Gift to brother £150,000
The gift to Peter’s brother was a PET made within seven years of death, which therefore becomes chargeable. The gift to the discretionary trust is cumulated, even though made more than seven years before death.
HMRC guidance in its Inheritance Tax manual confirms (at IHTM14514): “In practice, you only need to look for transfers outside of seven years of the death which were immediately chargeable.”
If lifetime gifts are to be made, individuals should ensure that adequate records are maintained for at least seven years, and for up to 14 years where appropriate (i.e., for any immediately chargeable lifetime transfers made outside of the seven years and up to 14 years before death). Keeping lifetime gifts within the available IHT nil rate band during the cumulation period should ensure that no IHT liability arises thereon upon the individual’s death.
If the individual was a surviving spouse (or civil partner), transferable nil rate band from the first death cannot be claimed on a chargeable lifetime transfer. The first spouse’s nil rate band is not available in that event. However, if the surviving spouse dies within seven years, extra nil rate band may then be available. The extra nil rate band can reduce the additional IHT on a chargeable lifetime transfer, and also the IHT on a failed PET.
Leaving at least seven years between gifts should prevent cumulation issues on the donor’s death, if practical.
Mark McLaughlin CTA (Fellow) ATT (Fellow) TEP is General Editor and a co-author of Ray and McLaughlin’s Practical Inheritance Tax Planning (Bloomsbury Professional).
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