Inheritance tax is a half-hearted tax, with many loopholes and opportunities for avoidance. This was the damning view of the Institute of Fiscal Studies Mirrlees Report, when assessing the current UK tax system.

The report recommends sweeping changes to the current system replacing tax on the estate on death in favour of taxing the beneficiary on both inheritances and lifetime gifts.

This comes hot-on-the-heels of the Office of Tax Simplification’s (OTS) analysis that IHT requires a complete overhaul. John Whiting, tax director at the OTS, recently reinforced that view by confirming IHT and CGT are likely to form part of the OTS’s next major project in 2012. So what are the possible alternatives?

Abolition of IHT

IHT remains hugely unpopular in some quarters, with continued calls for it to be abolished. This is despite only three per cent of estates in 2008/09 actually paying this tax. The introduction of transferable nil rate bands in 2007 allowing spouses and civil partners to pass on their unused allowance, combined with a stagnation of property prices, has seen IHT abolition slip down the political agenda. The revenues raised by IHT are relatively modest in comparison with other taxes, representing just 0.5 per cent of all taxes in 2009/10. So is abolition a possibility?

Annual Wealth Tax

Some countries, such as France and Norway, impose an annual tax on wealth, in some cases on top of a tax on inherited wealth. But an annual tax on someone’s total estate presents problems as assets such as property and family businesses can be difficult to value. Such a tax would also discourage saving, as capital growth would potentially be subject to double taxation. These issues make it an unlikely replacement for IHT and it was discounted by Mirrlees.

Amend the existing IHT regime

The Mirrlees Report highlights some of the injustices which exist within the current IHT regime. As an absolute minimum it believes exemptions for agricultural property and business property should be restricted. Business property relief (BPR) is available on certain business assets and can provide unlimited relief from IHT at 100 per cent once certain business assets have been owned for a two year period. Business assets which qualify include shareholdings in unlisted companies, including AIM shares. Investors with a portfolio of AIM shares can escape IHT after they have owned the shares for two years. BPR, together with agricultural property relief (APR), is estimated to have cut IHT liabilities by £375m in 2010/11. The recommendation is that relief should be tightened to target genuine sole and majority business owners and active farmers.

Wealth transfer tax

A wealth transfer tax is the preferred alternative recommended by Mirrlees. It recommends a tax on the transfer of wealth payable by the recipient. The tax would be charged at progressive rates on both lifetime transfers and upon death. This would mean potentially exempt transfers (PETs) are removed and tax would be paid by the donee based on the total lifetime inheritances.

Trusts

This raises the question as to how a lifetime transfer to a trust would be treated? A gift to an absolute trust where the beneficiaries are known, is currently a PET. However, gifts to most other trusts are chargeable life transfers (CLTs) with 20 per cent IHT charged on transfers over and above the available nil rate band, coupled with ongoing ten yearly IHT charges upon the trust itself. This is because the eventual beneficiary of the trust is uncertain. Special rules would be needed for wealth transfers into trust.

One benefit of progressive rates on gifts payable by the recipient is that the tax payable can be reduced by spreading the gift between beneficiaries. Each beneficiary would then pay a lower rate of tax than if the gift had been made to a single beneficiary. Skipping a generation, for example grandparents gifting to grandchildren, would avoid a second charge had the gift been to the parent who later gifted to their children. But will replacing PETs with a lifetime wealth transfer tax result in wealthy individuals deferring making gifts until death? Currently by making a PET, wealth can be passed on without IHT being levied provided the donor survives for seven years. The proposed wealth transfer tax creates neutrality between lifetime gifts and gifts made on death. So if there is no advantage to lifetime gifting could individuals hold their wealth for longer?

Removal of CGT exemption on death

One of the disincentives to lifetime gifting is the current CGT exemption that applies on death. It is beneficial to hold assets which have made capital gains until death so that gain is effectively wiped out and the beneficiary inherits at the probate value. This exemption lost the exchequer £690m in 2010/11, a quarter of the revenue raised from IHT. The Mirrlees Report is unequivocal this should be removed. This may lead to the avoidance of stockpiling of assets heavy with capital gains and encourage the earlier gifting of wealth.

Issues to overcome

The introduction of a wealth transfer tax could be problematic, the principal one being it would rely on self assessment. The progressive rates are likely to be based on aggregated lifetime transfers, increasing the administrative burden to track gifts. One other difficulty is that liability to IHT is determined by an individual’s domicile. Domicile is derived from general law and is separate from someone’s residence or nationality.

Conclusion

It is easy to argue IHT is past its sell-by date, given its unbalanced provisions and it is by no means certain any future changes will mirror those recommended in the Mirrlees Report but those working with families considering wealth transfer options might want to act sooner rather than later as there can only be change ahead.