The Madness of UK Inheritance Tax

Written by Rory Dorman, ACA

Few taxes are more regressive (and arguably more downright unfair) than UK inheritance tax, or that is the opinion of this humble scribe. A decade or so ago I wrote a blog entitled “Why I pay lower tax than my cleaner”, paraphrasing a contentious quote from Warren Buffett designed to spark a debate into how the US could improve tax rate inequality. I would like to shine a similar spotlight onto UK inheritance tax, and explain why those with the deepest pockets tend to suffer a much lower rate of inheritance tax relative to their overall wealth, versus those with less deep pockets; and hence why it seems distinctly (and unfairly) regressive to me. But before we get too caught up in the morality of taxes, I should add that this is not necessarily bad news for MASECO’s well-heeled target audience, as planning opportunities abound, which I shall also dive into.

UK inheritance tax is understandably unpopular. His Majesty’s Revenue and Customs do a pretty decent job of clipping the ticket on wealth creation, taxing both income and gains as they are realised; and then they take a second bite out of the cherry on death, essentially a form of double tax. Combined with the fact that the £325k “allowance” has remained stagnant since 2009, and will not be reviewed until 2031, it is easy to see why it is famously the UK’s most hated tax. But that is before the regressive nature has really been investigated.

Regressive taxes are structured so that the effective tax rate decreases as income increases. For obvious reasons they are not wildly popular! UK inheritance tax is charged at a flat rate of 40% above a £325k threshold (doubling to £650k for married couples). So how can that be regressive, I hear you ask? Allow me to explain. The UK also has a mechanism called a Potentially Exempt Transfer (PET) whereby lifetime gifts can be made free of UK inheritance tax, provided the donor survives seven years from the date of the gift. To qualify as a PET, the gift needs to be made “without reservation of benefits”, which in English means the donor cannot be seen to be benefiting from the gift. If it is the principle home, for example, the donor needs to pay a market rent on the property to their fortunate children, who are of course only too happy to become owners of the property, while also receiving a generous stipend along the way, thank you very much!! But this type of planning is obviously only open to those with the cash flow to pay their children a market rent, having already gifted their property. And of course the annual rent bill (legitimate income to the children) only serves to accelerate the wealth transition down to the next generation.

Now compare and contrast this with the hard-working professional, who only just manages to pay down his or her mortgage ahead of retirement, and then lives off more meagre savings and pensions into their twilight years. They have no ability to pay a market rent on the family home, and so lack the ability to gift it down to the next generation. So instead they maintain all of their wealth until their second death, at which point the tax cavalry come charging in to take a very chunky bite out of the estate, leaving the children wondering how a lifetime of parental industry and success leaves so little to pass down. If it was up to me, we would move to a system based on US lines, which offers much more generous allowances (c. $26m for married couples at the time of writing), but truly progressive in that those leaving the largest estates behind them (beyond the $26m threshold) end up writing the largest cheques. And as they rightly should, in the opinion of this humble scribe.

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