Malcolm Finney identifies an inheritance tax trap for certain mixed domiciled marriages.
The archaic concept of ‘domicile’ (broadly, the country which a person regards as home and typically, but not always, lives there on a day-to-day basis) continues to take centre stage when ascertaining liability to tax, whether that is income tax, capital gains tax or inheritance tax.
Deemed domicile
Historically, a person’s domicile status was (and continues to be) determined under our common law rules. However, for inheritance tax (IHT) purposes these common law rules were artificially extended by legislation under which a non-UK domiciled person under common law was ‘deemed‘ to be UK domiciled for IHT purposes. One such extension arose where a non-domiciled person who resided in the UK for 17 out of 20 tax years automatically became deemed domiciled in the UK.
The consequence of becoming deemed UK domiciled was that liability to IHT extended to worldwide assets, not just assets located within the UK (which applies to a non-UK domiciled person).
Indeed, from 6 April 2017 the deemed domicile rules were amended and now a person is deemed domiciled once such a person has resided in the UK for at least 15 (not 17) out of 20 tax years.
Inter-spouse transfers
However, not only is a UK domiciled or deemed domiciled person exposed to an IHT charge on worldwide assets, but so-called ‘inter-spouse’ transfers are adversely affected.
Often, tax planning (whether income, capital gains or inheritance tax) involves re-arranging assets owned by spouses (or civil partners), i.e. transferring assets from one to the other. Such transfers, for example, enable each spouse to own sufficient assets to utilise the various available tax exemptions (e.g. the nil rate band (£325,000 for 2018/19) for IHT purposes, or the annual exempt amount (£11,700 for 2018/19) for capital gains tax purposes).
Typically, such inter-spouse transfers give rise to no tax charges.
Where a UK domiciled spouse gifts assets to a non-domiciled spouse (e.g. an English domiciled husband to a non-domiciled Swedish wife), such transfers cannot be made without limit as would be the case with respect to transfers between two English or two Swedish domiciled (or non-domiciled) spouses. From 6 April 2013, that limit is £325,00; before this date the limit was a mere £55,000.
Example 1: Domiciled vs Non-UK domiciled spouses
Bert and his wife Myrtle are both domiciled in the UK. Bert owns their UK home worth £850,000.
Brian is UK domiciled, but his wife Agnetta is non-domiciled. Brian owns their UK home, also worth £850,000.
Bert and Brian have each been advised that it may be a good idea to transfer their home to their wife. They each implement this advice.
For Bert and Myrtle the transfer is inter-spouse exempt for IHT purposes and no charge arises.
Unfortunately for Brian and Agnetta, of the £850,000 transfer only the first £325,000 is exempt from an IHT charge; the next £325,000 is charged albeit at the nil (i.e. 0%) rate; with the balance subject to an IHT charge of £80,000 (i.e. 40% x £200,000) if Brian dies within seven years of making the gift (ignoring taper relief).
Had the wives owned the homes and transferred them to their husbands, neither couple would be exposed to any IHT charge; the charge only arises on transfers from a domiciled spouse to a non-domiciled spouse (but not vice versa).
The situation may be exacerbated where the UK domiciled spouse is the first to die with a significant estate the bulk (or all) of which passes to the surviving non-domiciled spouse.
Example 2: Death of the UK domiciled spouse
Thomas is domiciled in the UK and is wealthy. His estate amounts to £2 million. His wife Freida is less wealthy but non-UK domiciled.
Thomas dies and leaves the whole of his estate to Freida.
The IHT charge on Thomas’ death is £540,000.
Had Freida been UK domiciled, the IHT charge on Thomas’ death would be nil.
The number of ‘mixed’ domiciled marriages has significantly increased, and yet (albeit understandably), many married couples are unaware of the IHT ‘trap’ awaiting them. As a consequence, the opportunity to undertake appropriate planning is overlooked.
For example, lifetime transfers (i.e. potentially exempt transfers) may be undertaken sooner rather than later in the hope of surviving seven years; or an election may be made by the non-UK domiciled spouse to claim domicile status. However, this latter option may make matters worse and should be undertaken only after taking appropriate professional advice (this is not a ‘do it yourself’ option).
Practical Tip:
Make sure, where possible, that as a non-UK domiciled you do not accidentally become deemed domiciled in the UK under the 15-tax year test. The planning options then become much more difficult.
