Inheritance Tax (IHT) is a complex area of taxation that affects many UK residents. In principle, IHT is a tax charged on an individual’s estate upon death and on certain lifetime gifts made by individuals. Cash gifts are generally the simplest form of giving from an IHT perspective, as they don’t involve the complexities associated with other types of assets like business or agricultural property.

Basic Rules for Cash Gifts

When you make a cash gift, it’s considered a potentially exempt transfer (PET) for IHT purposes. If you survive for seven years after making the gift, it becomes fully exempt from IHT. If you die within seven years, the gift may be subject to IHT, with the rate reducing on a sliding scale (known as taper relief) for gifts made between three and seven years before death.

Foreign Currency Gifts

If you give a gift in a foreign currency, it’s important to know that for Inheritance Tax (IHT) purposes, the value will be changed to pounds at the exchange rate on the date of the gift. Foreign currency bank accounts might be considered ‘excluded property’ and not subject to IHT, but foreign currency held as cash doesn’t qualify for this exclusion.

Ensuring the Validity of a Gift

For a cash gift to be valid for IHT purposes, the gift must be properly executed. This means:

1. The gift must be unconditional
2. The donor must not retain any benefit from the gifted money
3. The recipient must have full control over the gifted funds

To provide evidence of the gift, it’s advisable to make the gift under a deed of gift, or if the gift is made by simple delivery of cash, ensure there is witnessed documentation attesting to the gift.

Reservation of Benefit

One key area to be aware of when making cash gifts is the concept of ‘reservation of benefit’. This rule is designed to prevent people from giving away assets while continuing to benefit from them. If a reservation of benefit exists, the gifted asset is treated as still belonging to the donor for IHT purposes.

However, cash gifts are unique when it comes to preserving benefits. The ‘tracing provisions’, which normally extend the reservation of benefit rules to assets purchased with gifted property, do not apply to outright gifts of cash, which creates some interesting planning opportunities.

Case Study: Cash Gift for Property Purchase

Consider this scenario: Bill gifts £300,000 in cash to his nephew Neil. Neil then uses this money to buy a property, which Bill subsequently lives in. Surprisingly, HMRC does not typically apply the reservation of benefit rules in this situation, provided there was no prior agreement or understanding that the gift was conditional on Neil allowing Bill to live in the property.

However, this doesn’t mean the arrangement is entirely tax-free. The pre-owned asset (POA) tax rules may apply.

Pre-Owned Asset Tax

The POA tax was introduced to close perceived loopholes in the reservation of benefit rules. In the scenario above, while Bill may avoid IHT issues, he could face an annual income tax charge based on the market rent of the property.

This POA charge can be avoided if Bill doesn’t occupy the property until at least seven years after making the gift. For example, if Bill was working abroad, he could make the gift with the intention of occupying the property only after returning to the UK seven years later.

Joint Property Purchases

Another cash gift strategy relates to joint property purchases. For instance, if Helen intends to buy a £350,000 property with her sister Susan, Helen could gift £175,000 to Susan without conditions. They could then jointly purchase the property, each contributing £175,000 and owning 50%. In this scenario, neither the reservation of benefit nor the POA rules should apply.

Key Considerations When Making Cash Gifts

• Seven-Year Rule: Remember that gifts only become fully IHT-exempt after seven years.
• Record Keeping: Maintain clear records of all gifts, including dates, amounts, and recipients.
• Intention: Ensure there’s no explicit or implicit agreement about how the recipient will use the gift.
• Regular Gifts: You can make regular gifts out of your income without IHT implications, provided they don’t reduce your standard of living.
• Annual Exemption: You can give away £3,000 each tax year free from IHT (and can carry forward one year’s unused exemption).
• Small Gifts Exemption: You can make any number of gifts up to £250 per recipient per tax year.
• Wedding Gifts: Parents can each give £5,000, grandparents £2,500, and anyone else £1,000 as wedding gifts.
• Gifts to Spouses: Gifts between UK-domiciled spouses are entirely exempt from IHT.

Potential Pitfalls

• Gifting Too Much: Ensure you retain enough assets to maintain your standard of living.
• Unintended Consequences: Gifted money might affect the recipient’s tax position or eligibility for means-tested benefits.
• Lack of Control: Once gifted, you have no control over how the money is used.
• Divorce: Gifts to married children might become part of a divorce settlement.
• Care Home Fees: Local authorities might view large gifts as a ‘deprivation of assets’ if made before entering care.

Planning Strategies

• Staggered Gifting: Consider making a series of smaller gifts over time rather than one large gift.
• Use of Trusts: In some cases, using a trust can provide more control over gifted assets.
• Skipping a Generation: Gifting to grandchildren might be more tax-efficient in some circumstances.
• Gifting Assets Other Than Cash: In some cases, gifting assets that qualify for Business Property Relief or Agricultural Property Relief can be more tax-efficient.
• Pension Planning: Pensions can be a tax-efficient way to pass on wealth, as they typically fall outside your estate for IHT purposes.

Cash gifts can be an effective way to reduce potential IHT liability, but they come with complexities and potential pitfalls. Call our tax advisors for  professional advice before making significant financial decisions. With careful planning and understanding of the rules, cash gifts can play a valuable role in effective estate planning and potentially reducing your IHT liability.