Inheritance Tax: Exemptions for Charitable Gifts

It has for a long time been public policy that gifts to UK charities are exempt from inheritance tax, whether the gifts are made in one's lifetime or on death.  Inheritance tax is a tax on transfers of capital: entirely different rules apply to gifts out of income such as the present gift aid tax relief.

In order that the gift is exempt from inheritance tax, the charity must be a qualifying charity established in the European Union or some other countries, and recognised by HM Revenue & Customs as such.
At present the value of the gift to the charity simply reduces the value of the "transfer" which is made.  The transfer is either the lifetime gift or the gift made under a will.  The current basic inheritance tax nil rate band is £325,000, reduced according to the value of any lifetime gifts of capital which are not exempt from inheritance tax or increased according to any transferable nil rate band left over from a deceased spouse or civil partner. 

A simple example of the charity exemption is that if somebody died with an estate of £350,000 (after all reliefs and other exemptions) leaving everything to someone other than a surviving spouse or civil partner, and if the available inheritance tax threshold was £325,000, inheritance tax at 40% would be payable on £25,000, resulting in a tax bill of £10,000.  The beneficiary would receive £340,000 less the costs of administering the estate. 

If £2,500 had been given to a charity under the will or codicil or under a post-death instrument of variation, the net estate for inheritance tax purposes would be reduced to £347,500 which would result in an inheritance tax liability of £9,000 as follows: 

• Net estate before deducting the charitable legacy     350,000.00
• Less charitable legacy                                                     2,500.00
                                                                                                347,500.00
• Inheritance tax nil rate band                                            325,000.00
• Taxable estate                                                                    22,500.00
• Tax at 40%                                                                           9,000.00

The beneficiary would receive £338,500, ie only £1,500 less than if the charitable legacy of £2,500 had not been made.

The Government has announced proposals due to come into effect from 6 April 2012 whereby the 40% rate of inheritance tax would be reduced to 36% if a gift on death (note this will not affect any lifetime gifts to charity) is at least 10% of the net value of the estate after all other reliefs and exemptions have been taken into account. 
In the above example of a charitable legacy of £2,500, the tax bill was £9,000 when charged at 40%.  Under the proposals the figures would be as follows:

• Net estate before deducting the charitable legacy     350,000.00
• Inheritance tax nil rate band                                            325,000.00
• Figure for 10% test                                                            25,000.00
• Less charitable legacy                                                     2,500.00  
• Taxable estate                                                                   22,500.00
• Tax at 36%                                                                          8,100.00

The residuary beneficiary would therefore receive £339,400, less administration costs, instead of £338,500 at present.  The net cost to the residuary beneficiary of making the legacy of £2,500 would under the proposals be £600, instead of £1,500.

In this example, the charitable legacy is exactly 10% of the taxable estate. If the legacy was £2,000, inheritance tax on £23,000 (£350,000 less £2,000 less £325,000) would be payable at 40%, resulting in a tax bill of £9,200 leaving £338,800 less costs for the residuary beneficiary.

It should be noted that the residuary beneficiary will always receive less as a result of the charity legacy both under the present and the proposed systems, but the reduction in the rate of inheritance tax will no doubt encourage more charitable giving which is part of the Government's background policy.

Although the proposals are subject to consultation until 31 August 2011, the Government has said that the level of the reduced inheritance tax rate, the expected commencement date and the minimum proportion of the net estate that must be left to charity are not subject to consultation.