A guest blog from Rachel Steeden, Stewardship.

Reduced rate of inheritance tax: avoiding the pitfalls

Published on 29 September 2023

In 2012, the Government introduced a reduced rate of inheritance tax - 36% instead of 40% - which applies where 10% or more of a person’s net estate is left to charity, either under the deceased’s Will or following a Deed of Variation by the beneficiaries.

This is a generous relief which in effect splits the cost of the charitable donation between government and the non-charitable beneficiaries. Unfortunately though, it is complex to apply in practice and, in the process of administering legacies left to Stewardship’s Donor Advised Fund, I have frequently come across cases where the charitable gift has either not been drafted correctly to achieve the reduced rate and/or the estate accounts have been incorrectly calculated.

This article sets out some of the most common pitfalls and how to avoid them.

1. Use the model clause

In drafting a Will or Deed of Variation designed to qualify for the reduced rate, professional advisers should always consider using the model clause prepared by the Society of Trust and Estate Practitioners and recognised by HMRC in their Inheritance Tax Manual, which is available free of charge. The clause includes options for a minimum and maximum legacy, as well as provisions to deal with more complicated situations where there is survivorship or settled property. And crucially, as this wording guarantees that a legacy will always meet the 10% test, it should save both time and effort in securing the reduced rate.

Handily HMRC also provides a reduced rate calculator to help professional advisers work out the minimum charitable donation needed to meet the 10% test.

2. 10% of the ‘baseline’ amount, not residue

The baseline amount is calculated under the statutory formula at Inheritance Tax Act 1984, Sch 1A. In effect, the baseline amount is the net estate after deducting any reliefs and exemptions (such as business or agricultural relief) and any nil rate band or transferable nil rate band. In order to qualify for the reduced rate of inheritance tax, 10% of this baseline amount must be left to charity.

Depending on the value of any specific or pecuniary legacies under the Will and the value of any exemptions or reliefs available, the baseline amount may be more or less than the residue of the estate. For example, if a Will contains specific legacies which exceed the value of any available nil rate band or other relief, a charitable legacy of ‘10% of residue’ will be less than 10% of the baseline amount and will not qualify the estate for the reduced rate.

Example 1

X leaves a net estate of £1m, with available nil rate band of £325,000 and no other exemptions or reliefs. X leaves an art collection worth £500,000 to his nephew. The residue is divided as to 10% to an animal charity and as to 90% between his nieces.

The baseline amount for X’s estate is £675,000 (£1m minus £325,000), so the minimum qualifying charitable donation is £67,500. The residue of X’s estate is £500,000 and so the amount passing to charity is £50,000. This is less than the minimum qualifying charitable donation, so the estate (other than the nil rate band and the charitable donation) will be subject to inheritance tax at 40%.

Example 2

As above, except that the art is only worth £300,000. The residue of X’s estate is £700,000 and so the amount passing to charity is £70,000. This is more than the minimum qualifying charitable donation of £67,500, so the estate (other than the nil rate band and the charitable donation) will be subject to inheritance tax at the reduced rate of 36%.

3. Don’t deduct the residence nil rate band

In calculating the baseline amount, the professional adviser must deduct any available nil rate band or transferable nil rate band but must not deduct any available residence nil rate band or transferable residence nil rate band.

If an adviser mistakenly deducts the residence nil rate band, the adviser will underestimate the value of the baseline amount and so calculate a charitable donation which is too low to qualify the estate for the reduced rate of inheritance tax.

Rachel Steeden is an experienced private client lawyer now working as part of Stewardship’s Philanthropy Services Team to help (U)HNW donors make effective and tax-efficient gifts.