Main residence nil rate band - good in parts?

Jill MacMahon looks at the implications of the new Inheritance Tax allowance following publication of the summer Finance Bill.

After the euphoria of the Conservative election win, the Chancellor was left in a dilemma. The country needs more tax revenue to the plug the various financial black holes that exist in the economy, but nevertheless the Tory Manifesto promised additional Inheritance Tax allowances for people wishing to leave the family home to their children in their Wills.

Critics of the plan focussed on the fact that the well-off were being given further tax advantages at a time when those on benefits were seeing further cuts. A more subtle analysis pointed out that the availability of the additional Inheritance Tax allowance would encourage elderly parents to hang onto the big family home, causing stagnation in the property market and no doubt difficulties for the families involved as well.

So when the Chancellor delivered on his promise of a new Inheritance Tax allowance in the summer budget, he was forced to add a postscript to his original plan.

The Government has therefore promised that it will introduce further legislation in 2016 to ensure that the new Inheritance Tax allowance is also available for those who downsize or exit the property market altogether. Quite how this will be done is not yet known – the Government hopes that ideas will be generated by a consultation on the subject, reporting in September 2015.

But in the meantime, what will this new allowance – the “main residence nil rate band” (“MRNRB”) mean for the tax payer? It is by no means a piece of legislation that is easy to implement. Nor will it be introduced in one fell swoop. Rather, its introduction will be spread over a number of years, minimising the cost to the Treasury. What was headlined as a “Million Pound Inheritance Tax Threshold” will only come about for couples in tax year 2020/21, when the staggered increase of the MRNRB will reach its peak and combine with the existing nil rate band of £325,000 to give a total individual allowance of £500,000 – worth of course £1,000,000 to a couple. Notice that the existing nil rate band has not increased at all and will remain at the same level until April 2021. By this time, it will have been in force for 12 years.

How will the new MRNRB operate? In April 2017, the first tranche of the allowance will come into force with a value of £100,000. If a person leaves a residence of theirs to a direct descendant (and a residence will include a downsized residence or proceeds of sale of a residence owned as at 8th July 2015), they will benefit from the MRNRB as well as the ordinary nil rate band. They must however leave the property to a child or remoter descendant, or alternatively to an adopted child, a stepchild or foster child or any of their offspring. Additionally, if a guardian leaves a property (or proceeds) to a ward, that will qualify as well.

Of course, people will leave their assets to their children in many ways other than by a direct gift. If they leave those assets outright to their children at the age of say, 25, and die when the children are younger, the property will be held on trust for their offspring. This will not prevent the allowance from applying. Alternatively, they may leave their assets on a special trust for a child with a disability (under section 89 of the Inheritance Tax Act 1984). This will benefit from the MRNRB as well. The same goes for a property left on a life interest trust or other form of “immediate post-death interest”. But what it does not include is assets left to children on a discretionary trust. These trusts are very popular for dealing with inheritances for children with disabilities, children in rocky relationships or difficult or unreliable offspring. As things currently stand, such a gift will not benefit from the MRNRB. Whilst I understand why the Finance Bill has been framed in this way, I think it is iniquitous that the children who might be most in need of protection and least able to generate adequate income for themselves stand to lose out on the benefit of the MRNRB.

It is true that the trustees of a discretionary trust can, after the parent’s death, transform the trust into another type of legal creature which would benefit from the MRNRB. For example, it could be turned into a section 89 Disabled Persons Trust – or an immediate post-death interest, but these alternatives may not be available or advisable. My view is that a discretionary trust which is drafted in a way that only allows “direct descendants” to benefit should qualify for the new allowance and the legislation should be amended to reflect this.

There is another interesting aspect to the new allowance. This is the fact that it is retrospectively “gifted” to spouses or civil partners who die before 6th April 2017. So if Mrs Smith’s husband died five years ago, and she dies in 2021, she will have not only her MRNRB but also that of her late husband to use in conjunction with her estate. A spouse or civil partner who dies before 6th April 2017 will be able to pass on 100% of their allowance to the second spouse to die without having had to qualify in the normal way with regard to owning a residence. Those who die after that April date will have to satisfy the criterion of owning a residential property. However, the legislation is intended to be relatively flexible so, if more than one property is comprised in the estate, the executors can choose which property will benefit from the allowance.

One of the reasons cited by the Government for introducing this allowance is that property price increases have pulled many more people into the Inheritance Tax net than before, and this story would have been set to repeat itself over the coming years. The Government has calculated that this new allowance will keep the number of estates paying Inheritance Tax in five years’ time the same as the number paid the tax in the year 2014/15.

But not everybody will receive the full benefits of this new MRNRB – those whose estates are valued in excess of £2 million will see the allowance tapered. For every £2 by which the estate exceeds the £2 million mark, £1 will be lost from the MRNRB.

One thing is clear and that is that the Government did not want to “keep it simple, stupid” by raising the Inheritance Tax allowance to £500,000 per person. This rather convoluted MRNRB will only apply to those leaving assets to children (and not through discretionary trusts). If a person dies without using their MRNRB, it will only transfer to a surviving spouse or civil partner and not to an unmarried co-parent. At least it will include those who downsize or sell their property. But those who want to leave assets to parents, siblings or nieces or nephews will only have the standard nil rate band to set against their estate.

This situation is likely to encourage lifetime tax planning by those who cannot benefit from the MRNRB. They are the ones who now face the prospect of being left with just the standard nil rate band which will dwindle in value as inflation takes its toll over the next six years. Parents will have that same standard nil rate band, but the pill is sweetened for them by the availability of the MRNRB.

Wouldn’t it have been easier (and fairer) Chancellor, to have raised the standard NRB for everyone?