Rachel Reeves looking at sweeping inheritance tax changes in Budget

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Chancellor Rachel Reeves plans to implement significant modifications to the UK's inheritance tax in her upcoming Budget, referencing ideas from a five-year-old plan aimed at revamping the tax system.

Reeves, who is working to address a £40 billion shortfall in government funds, has been reviewing a 2019 report from the now-closed Office of Tax Simplification, as per sources familiar with the chancellor's budget planning.

The chancellor is considering lengthening the "seven-year rule," which is a fundamental aspect of inheritance tax planning in the UK that pertains to gifting. According to insiders who shared this information with the Financial Times, she is thinking about extending it from seven years to ten years.

At present, any assets that a person gives away while they are alive will not be subject to inheritance tax (IHT) as long as they survive for seven years after making the gift. If the gifts are made between three and seven years before the individual's death, they will be taxed according to a decreasing scale called taper relief.

Increasing the rule to 10 years would complicate matters for affluent individuals looking to transfer their wealth without incurring inheritance tax, as they would have to live for a longer period to achieve that.

The Office for Tax Simplification (OTS), which was an independent organization created to provide guidance to the chancellor and was dissolved last year, suggested that the duration of the rule be shortened to five years and that taper relief be eliminated.

IHT brings in around £7.5 billion annually. As house prices increase and tax thresholds remain unchanged, more middle-class families find themselves subjected to IHT. In contrast, the ultra-wealthy frequently take advantage of a complicated system of deductions and exemptions to either lower or completely evade the tax.

The OTS report raised concerns about the inheritance tax exemption for Aim shares. The former director mentioned to the Financial Times, "We believe that Aim is the only market globally where investors can obtain a benefit for inheritance tax."

The Institute for Fiscal Studies and the Demos think tank have pointed out that the inheritance tax exemption on AIM shares should be removed by the chancellor. Nevertheless, these proposals have raised concerns that doing so might cause the market to collapse.

The chancellor has consistently opposed what she sees as affluent individuals exploiting loopholes to evade inheritance tax. Her team has been exploring options to increase taxes on those who are most financially capable.

In her 2018 book, The Everyday Economy, Reeves pointed out the gaps created by the Conservative government that allow affluent, healthy individuals with good advice to evade taxes.

She suggested that the tax should either be restructured or completely transformed into a tax applied to all gifts received during a person's lifetime. This approach would create uniform taxation on all gifts, making it more difficult for individuals to evade taxes.

For several weeks, labor officials have indicated that Reeves was planning to increase funding from inheritance tax. The Treasury, however, has chosen not to respond to any speculation regarding the Budget.

The 2019 OTS report suggested several changes regarding gifting, but these have not been implemented. Right now, affluent individuals are allowed to give as many "gifts from existing income" as they want without incurring Inheritance Tax, as long as these gifts are regular and do not impact the giver's quality of life.

The report suggested implementing a set percentage of income that individuals could give as gifts, eliminating the requirement for these gifts to be given regularly. Alternatively, it proposed getting rid of the current exemption rule and instead introducing a higher annual limit for personal gifts. This new allowance could be utilized for making gifts from either savings or income.

One possible reform being considered is to include defined contribution pension pots in inheritance tax (IHT) instead of allowing them to be exempt when someone passes away. Closing this gap could generate approximately £400 million in revenue during the 2029-2030 period, based on findings from the Institute for Fiscal Studies.

Another area that could be improved is the exemption from inheritance tax (IHT) for business properties and farmland. If these exemptions were completely eliminated, it could generate an additional £2 billion by the end of the projected timeframe.

The numerous gaps in the inheritance tax (IHT) framework often result in substantial estates being taxed at a lower effective rate. While the nominal rate is set at 40 percent, research from the Institute for Fiscal Studies (IFS) shows that the actual inheritance tax rate reaches a maximum of 25 percent for estates valued between £3 million and £7.5 million. Beyond £10 million, this rate falls to 17 percent.

The OTS also suggested eliminating the increase in capital gains tax that happens when a person inherits assets.

This regulation, present in the UK's tax framework since the 1970s, enables heirs to take possession of an asset at its market value on the date of the owner’s passing, instead of the price it was originally purchased for.