Conventional wisdom dictates that where an estate includes property qualifying for agricultural relief (AR) or business relief (BR) from IHT, a married testator would make specific gifts of AR or BR property to, say, his children and leave the non-qualifying residue to his wife. Of course, there are many refinements to take account of the many complexities of death, taxes and domestic life - the family home, transferable nil rate bands and residential nil rate bands, the use of trusts etc. This approach avoids “wasting” AR or BR relief by giving qualifying assets to an exempt individual such as a surviving spouse, who isn’t subject to IHT in any event. In many circumstances this is the right option. However, what for some testators might be “wasting” AR or BR for others may be viewed as a magically increased Nil Rate Band. Let me explain.
"...what for some testators might be “wasting” AR or BR for others may be viewed as a magically increased Nil Rate Band..."
Firstly it is important to have the right circumstances and the right combination of business and non-business assets and, as with all magic tricks, you definitely should not try this at home. The opportunity or challenge depending on your viewpoint lies in the rules set out in IHTA 1984 s39A which govern the interaction of BR/AR and gifts that are partly exempt (such as where a will leaves assets to children, who are chargeable, and to the spouse, who is exempt). In essence, where there is no specific gift of the AR or BR assets, the rules spread the benefit of that relief across the estate for IHT purposes. It does this by applying a fraction which, very broadly, divides the value of the estate after AR/BR (less the value of any specific gifts qualifying for AR/BR after relief) by the value of the estate before AR/BR (less the value of any specific gifts qualifying for AR/BR before the relief). For example, if you had £1m of assets qualifying for 100% BR and £1m of non-business assets (a total estate of £2m), with no specific gifts of AR/BR assets, the value transferred by each specific gift would be reduced by one half for the purposes of calculating the IHT due. Keep this formula in mind as it will become important later!
Now let us suppose that we have a will drafted so as not to make any specific gifts of BR/AR assets and instead making a gift of “the maximum amount of cash which I can give on the terms of the Nil Rate fund without incurring any liability to IHT on my death” to the children with the residue passing to the surviving spouse – a bad will, if you like. The effect of s39A causes an interesting and perhaps unexpected result. Obviously to give effect to the will, we must calculate the maximum amount that can be given IHT-free. Remembering the formula from before and assuming that we only have a full nil rate band of £325,000 for ease of explanation, the value of the gift needs to be such that when the fraction (in my example ½ ) is applied leaves £325,000. Taking my example above, in the estate with £1m business assets and £1m non-business assets, this means that were you to give £325,000, with the application of the rule in s39A that gift would only ‘count as’ £162,500. Therefore, the gift must be grossed up according to the s.39A formula and would actually result in the estate gifting £650,000 IHT-free to a non-exempt person. This could be even greater should the value of the business increase relative to the other assets in the estate.
Now, while the non-exempt party may indeed receive a larger portion of the non-business assets, it cannot be denied that the spouse inherits the business assets, utterly “wasting” the AR/BR relief, right? Well, not necessarily so. Since the spouse will meet the ownership condition for BR/AR on the death of the testator, those assets should qualify for relief in their hands and can be given away without IHT, preserving the relief while also giving away a larger proportion of the non-business assets without incurring IHT – a double bite at the cherry.
It is important to remember that this effect could result in a much larger gift than expected, possibly leaving the surviving spouse with far less than intended. If the specific gift is made into a discretionary trust of which the spouse is a beneficiary, the spouse may be provided for from that trust assuming that the trust and will are drafted appropriately.
There are, of course, many permutations to consider and it is easy to see how the operation of this formula could provide no significant benefits or indeed a disadvantage. Appropriate caution should be exercised. However, in some cases with some combinations of assets and parties, the received wisdom of avoiding s.39A entirely may result in missing out on the opportunity for a sizable IHT saving – a magically expanded nil rate band, if you will. It is certainly worth seeing if the stars do align and whether there is an opportunity to maximise the impact of these valuable reliefs in a different way.