Welcome to the June 2017 newsletter from Chamberlains
So the uncertain times continue. But, as Benjamin Franklin said, in life nothing is certain except death and taxes. And we’re unfortunately suffering from both of them. And both attack us in unexpected ways. Sometimes they can even overlap, in the case of Inheritance Tax – but perhaps we can help a little with that and give warnings to avoid problems.
And we’re getting into the tax return season, so I’d like to pick out a few points that can confuse even the most savvy among us.
Finally, I’ll say a brief word about our fee protection service which helps with enquiries from HMRC.
BASICS OF INHERITANCE TAX
When your great aunt Helen dies (let’s invent a nice rich widowed aunt for you!), a declaration will need to be made by her executors, and you, as a responsible person may involved in that. This will include a valuation of her estate – all her bank accounts (scattered up and down the High Street to make sure that each is covered by the deposit protection limit of £85,000 per bank), her investments, her home, her art works, her vintage Bentley, etc., etc. It will also include details of substantial gifts made in the last seven years – Potentially Exempt Transfers (“PETs”). Some will be covered by her £325,000 nil rate band and by great uncle Alfred’s £325,000 since he’d left his estate to her – a total exemption of £650,000; the rest will be taxed at 40%.
Just to pause a moment on these gifts: everyone is allowed to make a gift of up to £3,000 each tax year, or £6,000 if you missed last year. Extra gifts are also allowed for weddings, and if you’re fortunate enough to have surplus income, you can also make “gifts out of income” to the extent that they don’t affect your lifestyle. This is obviously somewhat subjective – something to be discussed with your accountant!
In fact you can give away as much as you like – when I say “allowed” I simply mean that there’s no IHT effect on these lower level gifts. However, if you don’t survive for the full seven years, a proportion of the larger gifts is counted as part of your estate in working out how much IHT to pay – 100% of it for the first three years, and (possibly) a reducing amount for each further year.
Fortunately, Helen was well advised, and in addition to making these pre-death gifts she left a will – and most of it’s going to you! If she hadn’t left a will, she’d be “intestate”, and her possessions would be inherited according to law rather than by her wishes – and the whole process becomes more complicated, more work for solicitors, and probably longer for things to be sorted out.
If a person without a will (let’s call her Mary) has no surviving spouse (or legal equivalent), the first port of call is to her children (including legally adopted ones, but not stepchildren). They share everything equally –or, if they’ve died, their children inherit in their place. If there are no children, the estate is shared equally between any living parents. If there are no parents, Mary’s brothers or sisters would benefit in equal shares – unless they’ve already died, in which case their children inherit in their place. If Mary had no children, her parents had died, and she had no brothers or sisters, it’s just possible that her grandparents are still alive – in which case they’d inherit. Failing that, it would go to aunts or uncles, and then half-aunts or half-uncles. And if none of any of them are available to inherit, the whole estate goes to the Crown as ownerless property, or “bona vacantia”.
It’s much easier to make a will – and then you know who’s going to get what. You may like to check https://www.gov.uk/inherits-someone-dies-without-will for an interactive version of my explanation.
So, going back to your great aunt Helen, she had an estate valued at £1,900,000 at her death, the “probate value”. Including her home. She’d kindly gifted you £100,000 just over five years ago in addition to the normal £3,000 – but this is a “failed PET”. It’s within the nil rate band, so it simply reduces the exemption against the rest of the estate. Transfers are treated in chronological order, so failed lifetime gifts use up the nil rate bands before the rest of the estate. (If she’d given you say £700,000, £50,000 more than the £650,000 provided by the nil rate bands, the extra £50,000 would be taxable at 40%, ie. £20,000, but this would be discounted by 60% (£12,000) because of being more than 5 years ago – so you’d need to pay £8,000 tax. And yes, it’s normally you who’d pay in this case, not the executors from the rest of the estate.)
The IHT on her estate would be calculated as follows:
Probate value of estate £1,900,000
Failed PET £100,000
Total estate £2,000,000
Less: Nil rate bands £650,000
Taxable residue £1,350,000
Tax at 40% £540,000
If she had had any children, the nil rate band would have been increased because of the new allowance for the family home that’s being brought in over the next few years – but that’s a bit complicated for here. If her will had included any gifts to charities, these would have reduced the value of the estate and no tax would have been paid on them. Indeed, if gifts to charities had been more than 10% of the value of the estate, IHT on the rest would have reduced to 36% instead of 40% – so sometimes this can be a useful point for tax-planning.
Evidently £540,000 is a lot of tax to have to pay – and it’s due at the end of the sixth month after Helen’s death. However, the taxman accepts that some things may take time to sell, for example the house, or you may want to live there but can’t afford to pay immediately – so you can pay annually over 10 years on these things if you ask to do so. Interest is payable (currently at 2.75%) on the unpaid IHT after the first six months, and the full balance of tax and interest needs to be paid when the relevant thing has been sold.
There are other types of things that escape IHT, for example a family business, including farms. This is known as Business Property Relief, and it also extends to certain investments. Again, that’s getting a bit complicated for this newsletter, but maybe I’ll give some more details if anyone’s interested.
TAX RETURNS – Interest and Dividends
We’ve done a few tax returns now, and there are two recurrent points different from past years – the treatment of interest and dividends. I’ve talked about these before, but they still cause confusion. This last tax year you’ll have been receiving interest gross from most sources. This is because basic rate taxpayers are allowed to receive £1,000 interest tax free and HMRC didn’t want to be swamped with tax reclaims for tax deducted by the banks. (NB Higher rate taxpayers only have £500 tax-free and additional rate taxpayers – income over £150,000 – have £0 tax-free.)
This can mean that some taxpayers now have to pay tax if they have healthy bank balances (you’d need £50,000 to receive £1,000 if you managed to find someone to pay you interest at 2%) – whereas previously the bank deducted interest before it reached them. This affects a lot of people, but the amounts of tax involved are generally fairly low. However, dividends are more significant.
Dividend certificates used to show the amount of the dividend, say £90, and a tax credit of one-ninth of this amount, £10. This was a “deemed” tax credit – the company hadn’t deducted it and didn’t pay any extra tax to HMRC apart from its normal corporation tax. On your tax return you’d show the net amount of £90 but the tax computation would show the gross figure of £100, including the tax credit. Dividends have for a long time been taxed at odd rates, and this tax credit was enough to cover the tax due on the £100, so long as you were a basic rate taxpayer. Unfortunately, if your total income was below the annual allowance, you weren’t able to reclaim the tax credit. (This is different to bank interest where you could reclaim any tax deducted by the bank.) If your total income extended beyond the basic rate band, you’d have needed to pay 32.5% minus the tax credit – which worked out at 25% of the net dividend.
This last tax year, you may have noticed that dividend certificates didn’t mention tax credit – but this doesn’t mean that the company has stopped deducting it, because it was only ever “deemed”. As far as the company is concerned, it pays the same dividend as before – but there’s now no deemed tax credit for you to offset against any tax liability. Fortunately the first £5,000 dividends are now tax-free (whatever your level of income), so many people will benefit from the new system.
However, amounts over this will be charged at 7.5% more than before. Dividends that didn’t stray into higher rate tax previously suffered no extra tax; now they’ll be charged 7.5% after the first £5,000. And higher rate taxpayers will have to pay 32.5% rather than 25% on the dividends they receive.
Owners of many small businesses pay themselves by dividends rather than salary – but this has now become less tax-efficient. It’s still generally a good tactic, but they’ll find themselves paying tax that they’d previously avoided. Previously it was possible to pay themselves about £8,000 salary (within their tax-free annual allowance and below the starting-point for national insurance) plus dividends of just over £30,000 to stay within the basic rate band – and they’d have had no tax to pay. Now if they pay themselves the same, they’ll have tax of 7.5% on the £25,000 over the first £5,000 dividends, ie. a new £1,875 tax.
Fortunately we don‘t see many of these, but HMRC has an ever more sophisticated IT system. Despite its various problems, it receives information automatically from many sources and the gnomes deep inside the massive machine raise a little red flag if they see that someone’s tax return doesn’t include something that they’ve been told about elsewhere. (It’s not just current things – I’ve recently had an enquiry about someone’s tax returns from 2012 and 2013.) A real live human will then react to the flag and write to the poor unsuspecting taxpayer to ask what’s been going on. “And sir, if you’ve missed this off your return, what else haven’t you been telling us about?”
And so it begins, and they can make themselves quite a nuisance. Generally we can fight them off or co-operate so well that any penalties are reduced to a minimum. But this inevitably takes up our time and we normally need to charge extra for researching the issue, liaising with the taxpayer and dealing with HMRC. For this reason, we have for some years offered clients the opportunity to cover themselves as part of a pooled scheme. They pay Chamberlains a modest fee and we can then claim our fees from the scheme provider if one of these nasties raises its ugly head. We’ll be sending out details in July, but please let me know if you don’t hear or if you’d like to know before then.