Farmers and the Government have fallen out in recent weeks over the changes to inheritance tax (IHT) agricultural property relief (APR) in the budget. Farmers fear for the future of their sector for the reasons my colleague Tom Hewitt set out in his recent post https://blog.burges-salmon.com/post/102jn5c/iht-and-protecting-small-family-farms. The Government's view is that only the very wealthy will be affected because farms worth up to £3m will still pay no tax at all. I want to test that theory where it appears to rely on the IHT “residence nil rate band” (RNRB). 

APR works by reducing the value of “agricultural property” for IHT purposes by up to 100% (i.e. to nil). Since IHT is a tax on value, APR has until now effectively exempted many farms from tax. The new system will cap 100% relief at the first £1m of agricultural property. I refer to this as the “APR cap” in this article. 

After the first £1m has been relieved in full, APR will be available on any remaining agricultural property at 50%. That means that its value is reduced by half before tax at 40% is applied, which is where the idea of the “20% effective tax rate” comes from.

It seems inevitable at this stage that some form of APR cap will be implemented so it makes sense to try and understand the detail of how it will work.

The theory

The Government's claim seems to be based on the following assumptions:

1. a couple who are working farmers and married or in a civil partnership, call them Will and Kate
2. a farm worth no more than £3m
3. including a farmhouse worth at least £350,000
4. all (or most) of which is owned jointly by the couple
5. children who will inherit the farm
6. all of the assets qualify for a combination of APR and business property relief (BPR) on their full value

There are lots of technical reasons why 6 might not be true. For example, the farmhouse might be disproportionately high in value or not be of a “character appropriate”, as the legislation puts it. It is also possible that the couple might be elderly and no longer able to work the farm so that their house is no longer a “farmhouse” at all and does not qualify for APR. It could even be due to a combination of development value and diversification into “non-trading” activities (such as letting). There are also more practical reasons: most farmers own something non-agricultural, such as a savings account. In the context of a £3m working farm and the available nil rate bands it is likely that most of these issues can be ignored. For simplicity's sake, I will do so in this article.

The Government's back-of-an-envelope IHT calculation might look like this:

You can see this relies on the RNRB and the nil rate band. 

The nil rate band is a tax free allowance for IHT which everyone gets. It applies to the charge on death but also to any gifts made in the seven years before death which are brought into charge on death under the “seven year rule”. If it is unused it transfers to a spouse or civil partner. For example if Will leaves everything to Kate and pays no tax thanks to the “spouse exemption”, she will receive his nil rate band. In this example, Kate's estate can then use two nil rate bands against the tax charge when she dies.

The RNRB is similar to the nil rate band but applies only to assets passing on death. It is limited to the value in a home which is passed to children (strictly, “lineal descendants” in the language of the legislation). If unused, it transfers in the same way as the nil rate band.

How things go wrong

The simple analysis set out above conceals some nasty traps which are easy for the ordinary taxpayer to fall into. Here are some of the most egregious (there are others).

1 - “Basic” Wills

Suppose Will and Kate have made “basic” Wills leaving everything to each other on the first death and then to their children on the second death. They have probably been nagged to do this for years by their accountant, land agent and solicitor. Under the old rules, straightforward Wills like that would have been very sensible. No tax would be due on either death and the family would have the minimum of legal complexity.

With the new APR cap the result looks like this (assuming Will dies first):

The problem is caused by the RNRB “taper”. The RNRB is taken away for estates worth over £2m at a rate of £1 for each £2 by which the estate exceeds £2m. The estate is valued “gross” before APR is applied. In this example, Kate dies owning £3m of assets, so all of her RNRB, and the RNRB transferred from Will, is tapered away.

*Notice that Will's APR cap is also lost. The Government has not made the APR cap transferrable between spouses and civil partners in the same way as the nil rate band and RNRB. The reasoning behind that decision has not been made public. In this specific example, the result is the same as if it had transferred, thanks to APR at 50% on Kate's assets above the first £1m. However, there will be plenty of cases where that is not true.

By the way this is even more complicated if Will and Kate have not made Wills at all, because of the way the “intestacy rules” work. 

If Will and Kate speak to their solicitor, they might be advised to make new Wills. They could leave £1m of agricultural assets to the children when the first of Will and Kate dies (or perhaps to a trust if the children are young) and the remainder to the surviving spouse. In this example, the gift will use Will's APR cap and so be tax free. Kate will have a total of £2m of assets when she dies and so the RNRBs will be available in full. 

The problem is that Will and Kate will have to give ⅓ of their business to the children before both have died. They need income to live on and most likely cannot afford to make gifts on this scale.

Some might question the fairness that couples should be forced to order their affairs in this way, just to qualify for tax reliefs which are supposedly available to all.

2 - All of the value in one name

Suppose Kate inherited the farm from her mother before she married Will. The farm is in Kate's name and they have never bothered to update the title, although they have worked it together for all of their married lives. This is a very common scenario.

The outcome in these cases is the same as above (assuming “basic” Wills). Whichever order the couple die in, the survivor will have £3m of assets and the APR cap will have been wasted on the first death.

Note this problem arises even if one of the couple has more than ⅔ of the farm by value in their name (assuming “basic” Wills).

If Will and Kate take professional advice they will probably put the farm into joint names and they might make new Wills as above if they can afford to make gifts of part of the farm on the first death.

3 - Will and Kate are not married

In this scenario, the nil rate bands and RNRBs do not transfer between Will and Kate. This could probably be addressed with bespoke, professionally drawn Wills. However, claiming all of the available reliefs will involve leaving part of the home to the children when the first of Will and Kate dies. That is the only way to claim both RNRBs in this scenario. Many people are uncomfortable with the idea of being co-owners of their own home, even with their own children and this would seem to penalise the unmarried.

4 - No children

If Will and Kate have no children at all (and no other “descendants”, like grandchildren) they cannot claim the RNRBs. Why are they in a worse position because they are unable or unwilling to have children?

Some good news

Don't forget that APR at 50% still applies

Suddenly, Will and Kate discover that prices have risen in their area and the value of their farm is now £3,700,000. 

Say they are in their 80s by now and worried about making gifts in their lifetimes because of the double tax charge caused by capital gains tax on the gift now and inheritance tax on the gift later (if they die within seven years).

You might think that the RNRBs would be tapered away so they would pay the £140,000 from example 1 plus the tax on the extra £700,000 value. Fortunately, APR fills the gap in this scenario and in effect they only pay tax on the value above £3m. The numbers look like this:

Make gifts if you can afford to do so

It is possible that Will and Kate's position can be substantially improved by making new Wills. In this scenario, Will is trying to maximise Kate's chance of having RNRBs to use on her death. When he dies, he leaves his £1m APR cap plus his nil rate band of £325,000 to the children plus as much extra as will be covered by APR. It looks like this:

In theory, there will be no IHT for an estate up to £3,825,000 in value. This assumes that the couple can afford for the first to die to leave the maximum tax free gift of £1,650,000 to their children. For many couples, struggling to make a profit on a smaller farm, passing on nearly half the farm at that stage will be a hard decision.

What next?

This post may encourage farmers to review their Wills and wider estate planning as soon as possible. In cases where it is now too late to change Wills, “deeds of variation” may help. 

It may be that the policy behind the rule against transferring the APR cap on the first death to a surviving spouse will be set out soon. Thinking that through may encourage the Government to change course. 

The Government could also consider scrapping the RNRB completely and increasing the nil rate band to £500,000 to compensate. That would probably result in a very slight dip in the tax take but in most cases it would be revenue-neutral. It would save a great deal of complexity, end some pretty indefensible outcomes and remove a trap for the unwary taxpayer.