Transferable nil-rate bands

Inheritance tax is a subject rarely absent from newspapers’ financial sections and there is constant speculation as to how the tax might be changed. Most of this just remains speculation, but there has been one really significant change in recent years and for all of the public interest in the subject, it’s a change that is often misunderstood.

We were recently asked to advise a client whose late wife had established a trust in her will. However, other than the lady’s jewellery (worth £10,000 and left bequeathed to her daughter), there was a very modest residual estate, also of £10,000. This was all taken into the trust and the husband received nothing.

The transferable nil-rate band legislation started in 2007, and is often (misleadingly) simplified to say that if you leave all of your assets to your spouse, they can inherit your nil-rate allowance. This led the executor in our case to inform the client that, since his late wife hadn’t left him anything, none of her nil-rate band allowance could be transferred over.

Our client has a significant estate, and so the loss of an extra allowance would eventually mean a lot of extra tax. The executor therefore proposed paying out the trust to the client (within the two-year window), so the trust was effectively ignored, and the client would inherit 50 per cent of the estate and therefore 50 per cent of the late wife’s nil-rate band.

If you are familiar with the principles behind the rules, you will have spotted that this isn’t how it works at all – and so of course the solution was also mistaken. The mistake was to focus on what was left to the husband (zero per cent of the estate), rather than what was not an exempt transfer (£20,000). Perhaps a refresher would be helpful.

There’s an unused nil-rate band where M is greater than VT:

• ‘M’ is the maximum that could be transferred on the first death at zero per cent – i.e. the nil-rate band at the first death (normally £325,000), minus any lifetime transfers that have ‘used up’ any of
  the allowance.

• ‘VT’ is the value of the transfer on death. Ignoring exempt assets, this is the value of taxable legacies, plus the deceased’s share of any joint assets.

The amount by which M is greater than VT (known as ‘E’) is expressed as a percentage of the prevailing nil-rate band at first death (‘NRBMD’). The percentage is the amount by which the nil-rate band prevailing at the second death is increased.

To put this into practice in the case of our client, the calculations are:

M = £325,000 (there were no lifetime transfers to use up any of her allowance)

VT = £20,000 (£10,000 of jewellery and £10,000 into the trust)

E = £305,000 (£325,000 - £20,000)

NRBMD = £325,000 (the prevailing allowance at the first death).

So the amount available to transfer is: £305,000 (E) / £325,000 (NRBMD) x 100 = 93.8461 per cent.

It’s the percentage that’s carried forward, not the monetary amount. For example, when our client dies, the allowance is £400,000; he’ll get 93.8461 per cent of £400,000 as an additional allowance.

The original error was only spotted because we were asked by the client’s accountant to offer a second opinion. Had we not, it’s possible that the mistake would have been accepted, set down in the files, and passed unquestioned right through to the subsequent death of the client. Based on current rates, it could have resulted in an additional £122,000 in tax.

Scott Gallacher is a director at Rowley Turton

He writes the regular IFA comment in Private Client Adviser