Potentially exempt transfers

I’ve heard of potentially exempt transfers (Pets) as a way of avoiding inheritance tax (IHT). But I don’t really understand how this works.

A “Pet” is the act of giving away cash and assets to another person, or into some types of trust, in the hope of removing the value of these gifts from your estate.

It’s a pressing problem, as IHT is paid at 40 per cent on everything in the estate on top of the nil-rate band (which is free of tax). The current threshold for this is £275,000 (rising to £285,000 for 2006/7 and £300,000 for 2007/8).

The term “Pet” is a shorthand description of gifts that may (“potentially”) be considered outside your estate once you die. They are only “potentially” exempt from IHT because the donor has to survive for seven years after making the gift. After that, the money is outside the estate, provided it meets certain criteria.

How can you predict when you are going to die?

You can’t. And even the tax office isn’t omniscient. So there are measures that can ease problems if a donor doesn’t live for seven years. Taper relief is a way of giving some tax breaks on the IHT bill when the donor dies between three and seven years after making the gift.

I like to give some cash to my family each year. Does this count as a Pet?

Possibly not. There are some good tax breaks offered to everyone. For making gifts to children and grandchildren, there’s a useful annual £3,000 exemption that allows gifts up to this value to be made without worrying about tax. If you forget one year, the allowance can be carried over to the next tax year (but only for one year). Husbands and wives each have a £3,000 allowance per year.

When a child gets married, there’s a one-off opportunity for each parent to give £5,000, while grandparents can give £2,500 each. Any other donor can give £1,000. These gifts need to be made before the marriage.

For smaller amounts, a useful exemption allows donors to give £250 per year to any number of recipients, as long as they haven’t had any more than this amount (so you can’t, for example, give £250 to someone if they have already had all or some of your £3,000 annual allowance). Keep a written record of cash gifts, signed and dated.

I want to pay my grandchildren’s school fees. Could their parents end up paying IHT on this money?

Not if you plan carefully. There’s another useful exemption for getting cash out of your estate, for gifts made out of “normal expenditure”. Accountants Grant Thornton clarify that to qualify, gifts must be “habitual in nature and made out of income and not capital”. You’ll also need to show that giving the cash still leaves you with enough to maintain “your normal standard of living”. This can be a fiddly exemption to claim, as you should be able to show full income and expenditure charts (including expenditure on hobbies, holidays and meals out).

But it’s well worth it if it allows you to remove thousands from your estate.

So can I give away my house to my children tax-free if I survive for seven years afterwards?

Many parents attempt to bypass inheritance tax rules by gifting the family home to their adult children. Gifting assets, rather than cash, makes it far harder to prove that the transfer was a Pet, rather than the less desirable “gift with reservation”.

This latter rule affects people who give away ownership, or part-ownership, of a property while continuing to live there.

HM Revenue & Customs has (not surprisingly) an ongoing programme to find the ways people try to avoid IHT, and will clamp down hard. There are things you can still do, but these need careful (meaning expensive) tax planning.

What’s the situation if a married couple want to transfer assets and cash between themselves?

Transfers between married couples, and same-sex couples in civil partnerships, are exempted from the IHT regime. The big “but” in this affects couples where one spouse is UK domiciled and the other has a foreign domicile. In these cases, the UK-domiciled partner can only transfer cash and assets worth up to £55,000 to the foreign domiciled spouse before the IHT regime kicks in. In short, if you have a foreign-born spouse, you’ll probably need specialist tax advice.

Is this month’s Budget going to make any changes to the Pet rules and IHT?

The Pet regime came into force in 1986, as part of the now highly-complex web of IHT-linked provisions. Tax experts would be delighted to see the IHT rules overhauled, but the subject has become highly political, as a tax originally aimed at the very wealthy now hits “middle England” because of rising house prices.

However, a big announcement seems unlikely. PricewaterhouseCoopers’ Budget preview states that IHT is worth £3.3bn (and rising) to HM Revenue & Customs each year. It’s money the Treasury doesn’t want to lose.

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