Inheritance Tax is one of the most misunderstood areas of expat financial planning. Many are unaware of the difference between ‘non UK domiciled’ and ‘non UK resident’, wrongly believing they won’t be taxed on assets outside of the UK or they are not liable for IHT as they do not live in the UK.
There are some very simple and inexpensive steps that can be taken in order to mitigate what can otherwise end up being a hugely stressful and expensive time for the people left behind.
The first step is to understand the difference between domiciled and non-domiciled so you know how you should be planning. Domicile is a complex UK common law concept. The basic rule is that a person is domiciled in the country in which they have their home permanently or indefinitely – the country you regard as your ‘homeland’. You can live abroad for many years and remain domiciled in the UK.
While changing your domicile is not impossible, it depends on your circumstances and intentions and needs to be a carefully considered and planned process. The onus is on you (or your family when inheriting your assets) to prove you were non-UK domicile at the date of death, in the event of a challenge from HMRC.
There are three types of domicile under English law:
1. Domicile of origin – a child takes their father’s domicile of origin (or of a single mother) at birth, not necessarily the country where you are born.
2. Domicile of dependence – applies to women married before 1974, children and mentally incapable persons.
3. Domicile of choice – can be acquired by moving permanently to another country.
To acquire a domicile of choice, you must be physically present and a tax resident in your new country, have formed the intention of living there permanently, and not foresee any reason to return to the UK. You need to sever as many ties as possible with the UK; even stipulating in your will that you wish to be buried there will count against your case. HMRC will look for any indication that you regard Britain as your homeland and may return one day.
It takes at least three years to shed UK domicile for inheritance tax purposes. You will be deemed domiciled in the UK for inheritance tax if you were UK domiciled at any time in the previous three years, or were UK resident for any part of 17 of the last 20 tax years.
Although the link to domicile of origin can be removed, it will be instantly reinstated if you return to the UK, and probably even if you move to a third country, until you can demonstrate you have established a new domicile of choice.
If you are non-domiciled then you are still liable for tax on assets in the UK and local taxes in the country you live will apply.
The second step is to understand the rules around inheritance tax. The current threshold for inheritance tax is £325,000 per individual, with tax then charged at either 40% or 36% (only applicable if 10% of estate is donated to charity) on the amount over the threshold. Since 2007, this threshold has increased to £650,000 for married couples and civil partners, providing the executors transfer the first spouse/partners unused inheritance tax threshold to the second partner when they die.
The third step is to plan effectively as soon as possible. So what can you do?
1. Leave everything to your spouse/partner.
If you’re married or in a civil partnership, you can give anything you own to your spouse or civil partner (unless your spouse was born outside the UK, in which case the amount you can give away might be limited), so your estate will not have to pay Inheritance Tax. There are different rules if your spouse or civil partner’s permanent home is outside the UK. The rules are very complicated so it is extremely important you take advice if this is the case.
The issue with this is that the Tax will then be paid when the spouse/partner dies making it really only a temporary solution.
2. Gifting it away.
If you give something to a friend or a family member who is not your spouse or civil partner, so that you no longer get any benefit from it, the value of the gift will still be included in your estate for Inheritance Tax – but only for the following seven years. So, for example, if you give one of your children some money, and you live for a further seven years, it won’t be taken into account when calculating the Inheritance Tax liability when you die. You can give away limited amounts every year and not have to pay Inheritance Tax. For example, you can give away up to £3,000 a year and you can give away money to your children and grandchildren when they get married.
Just be aware that there might also be Capital Gains Tax to pay on certain assets that you give away in your lifetime.
The issue with this is that there is no guarantee you will live for the next 7 years.
3. Leave something to charity.
Anything you leave to charity is free of Inheritance Tax so it can be a useful way of reducing your Inheritance Tax bill, while benefiting a good cause. And if you leave at least 10% of your estate to charity, it will cut how much Inheritance Tax is due on the rest. The rate at which Inheritance Tax is calculated is 36% rather than 40%. This rate is set against the balance of the estate to the extent that it exceeds the available nil-rate band. This might not be a huge saving, but it can mean that family and friends will receive more than they would do otherwise – while your favourite charities also benefit.
4. Use a life insurance policy to cover the tax bill.
If you take out a life insurance policy, it won’t reduce the amount of Inheritance Tax due on your estate. But the payout might make it easier for your surviving family to pay the bill. It could mean that they are able to prevent the family home from being sold. If you do this, make sure the life insurance payout goes into trust – if you don’t it will make your estate bigger and it thus have to pay more tax.
5. Put things into Trust.
If you put some of your cash, property or investments into a trust (which you, your spouse and none of your children under 18 years can benefit from), they’re no longer part of your estate for Inheritance Tax purposes. For example, you could set up a trust for your adult children, to pay for your grandchildren’s education, or support a family member with a disability. You can set up a trust right away or you can establish one in your will. Since the assets are no longer technically yours, they are not liable for IHT. Trusts are an extremely complex part of financial planning with a large number of different types and formats of trust, so we recommend that advice is always sought before any trusts are put in place.
In summery, IHT planning is not a one-size fits all solution. Always speak with your adviser to insure the planning put in place precisely meets your needs and is structured in the most suitable way for you. Follow our page for future articles where we will explain Trusts and Life Insurance in more detail. You can also visit our free online inheritance tax calculator to see exactly what your tax bill could be.