When the IHT 7-year rule becomes a 14-year rule

Important information - the value of investments and the income from them can go down as well as up, so you may get back less than you invest.

Let’s look at an example.

Tim is divorced and, after making the following gifts, has an estate worth £1.8 million on his death.

• May of Year 1: He transfers £325,000 into a discretionary trust for his grandchildren. This is a chargeable lifetime transfer (CLT). Because it is within the nil-rate band, there is no immediate IHT to pay.
• May of Year 8 (seven years later): Believing the trust gift is now safely outside the scope of IHT, Tim gives £325,000 directly to his daughter to help her buy a larger home. This is a potentially exempt transfer (PET).
• May of Year 10 (two years later): Tim dies.

At first glance, many people assume the trust gift no longer matters because it was made nine years before Tim's death.

But because Tim died within seven years of making the gift to his daughter, that PET has failed and becomes chargeable for IHT.

To work out how much tax is due on the failed PET, HMRC first looks back to see whether any chargeable lifetime transfers – i.e. gifts into trust – were made in the seven years before the PET. Tim’s gift into trust in Year 1 falls into that window because it was made seven years before the gift to his daughter.

As a result, the earlier trust gift uses up Tim's entire £325,000 nil-rate band, leaving none available for the failed PET.

Instead of the gift to his daughter being covered by the nil-rate band, the full £325,000 becomes chargeable to IHT.

In effect, HMRC has been able to look back nine years from Tim's death rather than the usual seven to determine how much of Tim's nil-rate band remained available for the failed PET. Depending on when Tim died, HMRC could potentially have looked back almost 14 years.

The impact on the IHT bill is significant. Let’s assume Tim has only the standard £325,000 nil-rate band available and ignore the residence nil-rate band to keep the example simple.

If the earlier gift into trust wasn't taken into account, HMRC would only have considered the £325,000 gift to his daughter.

The failed PET of £325,000 would be covered entirely by Tim's nil-rate band, so no tax would be due on the gift. Because the nil-rate band has already been used against the failed PET, none remains to offset the estate. As a result, the estate would pay IHT at 40% on the full £1.8 million, giving a bill of £720,000.

Now let’s look at things including the gift into trust.

The earlier CLT has already used up Tim's entire £325,000 nil-rate band. That means the later £325,000 gift to Tim's daughter has no nil-rate band available. The failed PET is therefore fully chargeable to IHT.

Because Tim dies within three years of making the gift, taper relief is not available, so the failed PET is taxed at 40%, producing a tax bill of £130,000. The tax on the estate remains the same: £720,000. So, because of the interaction between the trust rules and the seven-year rule, the family's overall inheritance tax bill is £130,000 higher than it would otherwise have been.

As you can see from the table, in Tim's case the failed PET and earlier CLT mean the value taken into account for inheritance tax exceeds £2 million.

In this example, that doesn't create any additional tax because we've ignored the residence nil-rate band. This allows you to pass on an additional £175,000 IHT-free if you pass on your main home to your children or grandchildren.

However, estates worth more than £2m are subject to a tapering of the residence nil rate band. For every £2 above the £2m threshold, the residence nil rate band is reduced by £1.

This means some families could lose part or all of the residence nil-rate band, increasing the inheritance tax bill even further.

One tactic that financial planners sometimes use to reduce the risk of being caught by an effective 14-year rule is to separate large gifts into trust (CLTs) and individual gifts (PETs) by at least seven years and a day. That can help to avoid the CLT using up the nil rate band if the donor dies within seven years of making the PET.

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• Read: Is this the ultimate in selfless gifting to your child?
• Read: IHT gifting allowances: 8 key questions answered
• Read: Inheritance Tax taper relief explained