Prospects for IHT under new Labour government

As Rachel Reeves, the new Labour chancellor, attempts to plug the Treasury’s £22 billion “black hole” while simultaneously awarding meaty public sector pay rises, expectations are growing that tax increases will be on the cards in her Budget this autumn.

Could inheritance tax (IHT) be a target, given the various IHT exemptions and allowances currently in place and ripe for reduction?

In its election manifesto, Labour pledged not to increase income tax, national insurance or VAT – but the document said almost nothing about IHT, beyond a commitment to end the use of offshore trusts to avoid payment of the tax.

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The previous Conservative government had already announced its intention to move the UK from its current domicile-based IHT system to a residence-based one from April 2025, and in recent days Labour has confirmed that will also go ahead.

In a nutshell, this means that once you’ve been resident in the UK for 10 years, your worldwide assets will potentially be liable to IHT if you die. Even if you leave the UK, that liability remains in place for 10 years.

More broadly, uncertainty and speculation as to how a wider IHT overhaul might feature in future Labour plans has been rife – and not just among industry experts and commentators.

For instance, wealth manager Rathbones commissioned research just before the election which found that 20% of high-net-worth individuals (HNWIs) had made changes to their financial plans because of speculation about tax rises from a new government.

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A report published by the think-tank Demos in mid-July highlights the rationale for a more extensive review of IHT.

It argues that the UK is entering a “New Age of Inheritance” as inherited wealth becomes an increasingly important driver of the economy, and therefore that wealth needs to be taxed appropriately.

Think, for instance, of parental and grandparental contributions to first-home deposits for family members. A study by the Institute for Fiscal Studies (IFS) found that in the period 2018-20, almost half of first-time buyers in their 20s received financial help, primarily from their parents, to purchase their property. Across all first-time buyers, these contributions averaged around £25,000.

The Demos report finds that the UK raises less through inherited wealth taxes than France, Germany, Japan, or the US, and is one of only three OECD countries to offer full and uncapped IHT relief on family-owned businesses.

It concludes that IHT in the UK needs to be reformed, not abolished, both to raise more revenue and to make the system fairer.

Business Relief

A key focus and source of much speculation in this respect is Business Relief (BR), previously known as Business Property Relief.

As Tom Kimche, head of advice at Netwealth, explains, BR was originally designed to prevent small business owners from needing to liquidate a longstanding business in order to pay IHT on the owner’s death.

“But there are now a lot of investment opportunities that allow investors to avoid IHT as long as they have held BR-eligible assets for two years,” he says. Most significantly these include qualifying AIM-listed shares, which receive 100% exemption from IHT after two years of ownership.

In addition, 100% or 50% of the value of certain businesses and business assets such as machinery, buildings or land may qualify for BR, making them currently exempt from IHT.

But reform of BR could be a tricky business. Kimche points out that while shares listed on AIM and therefore eligible for BR are one obvious potential target, “taking this relief away suddenly could result in large share price falls for larger AIM companies that tend to be used for this purpose in estate planning by older people”.

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Another suggestion (originally from the IFS) is to cap BR on business assets at £500,000 per person. Again, this could cause practical problems in implementation.

Moreover, although Demos says that 77% of those claiming BR in the UK in 2020-21 had business property worth under £500,000, and so would be unaffected by the change proposed by the IFS, it recognises the risk that larger businesses valued at over £500,000 could be adversely affected if the owners had to sell off parts of their business to fund tax payments. 

Pension tax treatment on death

At the moment, pensions are treated exceptionally generously in tax terms in a number of ways. Several, including the current 100% tax relief on pension contributions and the tax-free lump sum, are highlighted by Nicholas Nesbitt, partner at tax firm Forvis Mazars.

But he particularly picks out the treatment of defined contribution (DC) pensions on the death of the pension owner. Briefly, if this occurs before age 75, the pension pot can be inherited entirely free of tax; if the owner dies after the age of 75, the beneficiaries pay income tax at their marginal rate on withdrawals - which for many will be much less than 40%.

“Perhaps the most anomalous area of pension taxation is the treatment of pension funds on death – they can broadly pass on free of tax,” says Nesbitt. “When compared to IHT, which is a flat rate of 40% on assets worth more than the nil rate band of £325,000, it seems entirely possible that the government would look to tax pension assets on death. You do not have to go too far back to find this happening.”

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Tom Kimche at Netwealth suggests that one option for the government in this context may be “to cap the amount of pension that can be passed away tax-free, or to say that it can only be passed on tax-free to a spouse, as is currently the case for other investments”.

Of course, all these possibilities are only speculation at this stage. Nonetheless, it’s quite possible that changes to the taxation of inherited wealth will be introduced during Labour’s time in power.

If that happens and your finances could be affected, speak to a specialist financial planner who can advise on your options. IHT is hideously complicated and likely to remain so, no matter what changes are made to the rules.