What are PETs, in an inheritance tax context?
Inheritance tax (IHT) is typically charged on transfers of value, usually gifts. These transfers can be immediately chargeable (when, say, a trust is set up) or exempt (such as a gift to a charity).
Many transfers however, are not immediately exempt but are potentially exempt – the ‘potentially exempt transfer’, or PET. This means that IHT is not payable now but could be at some time in the future.
Which types of transfers are PETs?
Broadly, a gift from one individual to another is a PET. An everyday example is where a parent makes a cash gift to an adult child. The person making the gift is the ‘donor’ or ‘transferor’ and the recipient is the ‘donee’ or ‘transferee’.
It is not necessary for assets to be transferred; there just needs to be an increase in the transferee’s estate. In the above example, if the parent forgave an existing loan to the child, this would also be a PET (although no money changed hands).
The gift must be from and to an individual. Therefore gifts from or to trustees, or companies, are not usually PETs.
How is the value of the PET calculated?
The calculation of the transferred amount is different to that on death.
When someone dies, the assets of the deceased are simply assessed at market value. However, a lifetime transfer (such as a PET) is calculated on a ‘loss to donor’ principle. In other words, how much has the estate of the donor decreased as a result of the gift?
These two methods of calculation are often the same, but they needn’t be. An obvious example of this is a gift of a few shares in a company which converts the transferor's holding from a majority to a minority holding. The loss to the transferor will be greater than the value of those few shares in isolation.
When does a PET become chargeable or fully exempt?
If the donor dies before the seventh anniversary of the PET, it will become fully chargeable (the ‘seven-year rule’). PETs that become chargeable to IHT in this way are commonly referred to a ‘failed PETs’.
If the donor survives for seven years then it becomes fully exempt and has no further bearing on the donor’s IHT position. Tax years are irrelevant here – if the gift is made on 1 January 2010, it becomes fully exempt on 1 January 2017.
What are the compliance and liability rules for PETs?
There is no IHT to pay on a PET (unless it fails), and no requirement for it to be reported when it is made.
However, should the PET fail HMRC must be notified. Strictly, the transferee should report the PET on form IHT100. In practice, details of the transfer will be included on the IHT forms filed by the deceased’s personal representatives (PRs) and this will be sufficient to satisfy HMRC.
The recipient of the gift is primarily liable for the IHT due on a failed PET, charged at 40% above the nil rate band (NRB) – this is the 0% allowance, currently £325,000. If this remains unpaid 12 months after the transferor’s death, the PRs have a secondary liability and could be approached for payment.
Whilst failed PETs are not usually paid out of the deceased’s estate, they will have a bearing on the IHT position. When allocating the deceased’s NRB, it is first applied to failed PETs and other lifetime gifts. Any remaining NRB can then be set against the death estate.
Are there any reliefs to reduce the IHT on failed PETs?
Where the failed PET was made more than three years before the death of the donor, the amount of IHT payable by the donee is reduced. This relief, which varies from 20% to 80%, is commonly called ‘taper relief’. It reduces the IHT, not the value of the gift – if there is no IHT to pay (because the gift was less than the NRB) then taper relief does not apply.
Where the subject matter of the gift has fallen in value between the date of the gift and the date of death, ‘fall in value relief’ can apply. This essentially charges IHT on the lower value, rather than the value at the date of the gift.
Are there any other types of PETs?
Some gifts to trusts can be PETs, although these are very limited and are mainly confined to gifts into disabled person’s trusts.
When an individual makes a gift but continues to benefit from the gift, this is called a ‘gift with reservation of benefit’ (GWR) and is not considered a true gift. It is not a PET at this stage. If, later, the donor stops benefitting from the asset, the reservation ends and this is considered a PET. An example is where a parent gifts a property to a child but continues to live there (a GWR). If the parent later moves out, there is a deemed PET at this point (and the seven year clock starts).