The 10% problem with charitable legacies

Relief for charitable donation

The case of David Marks (Executor of Hilda Marks) v HMRC [2024] TC9352 involved a claim for the reduced rate of inheritance tax (IHT) of 36% based on at least 10% of the net death estate being donated to charity. A qualifying donation could be a legacy of a specific amount, a share of the residue, or a share of the estate that is quantified.Unlike with Gift Aid, which applies to lifetime donations, the charity does not benefit from a 25% uplift.

The 10% rule

The crux of the claim is the baseline amount, i.e. the figure to which the 10% threshold applies, which is defined as the chargeable transfer on death less IHT exemptions, reliefs and the nil rate band. Crucially, neither the residence nil rate band nor any transferable residence nil rate band are deducted.

The nil rate band will be used up by any lifetime transfers which were made in the seven years prior to death. Where a spouse’s nil rate band is unused, this will be available to reduce the baseline amount.

HMRC has a reduced tax calculator that can compute the amount needed to qualify for the 36% rate.

Example. Betty’s death estate is valued at £700,000, having made transfers of £100,000 in the last four years. She left her husband £200,000 and a legacy of £30,000 to a registered charity. The baseline amount is calculated as £275,000, i.e. the amount liable to IHT after adding back the £30,000 donation and accounting for the remaining nil rate band of £225,000 £(700,000-200,000-225,000). As the charitable donation exceeds £27,500, the IHT rate is reduced to 36% of £245,000 resulting in a charge of £88,200. Without the donation, the IHT charge due at a rate of 40% would be £110,000 (£245,000 @ 40%) i.e. £21,800 higher. The £30,000 charitable donation has therefore only “cost” the estate £8,200. (£30,000-£21,800).

More complex estates

According to the legislation at Schedule 1A Inheritance Tax Act 1984, estates are analysed into the following three components:

1. The survivorship component, e.g. property passing to a surviving joint owner.
2. The settled property component (assets in trust).
3. The general component, i.e. everything else.

For the purpose of determining whether the charitable donation is at least 10% of the baseline amount, each component is initially considered separately. While the reduced rate may only apply to certain components, it is then possible to elect to merge them provided the charitable donation is at least 10% of the aggregate baseline amount.

Case background

Sam Marks died in 2014 leaving a will trust which stipulated a life interest for his wife, Hilda, with the capital on her death to be split between the grandchildren and charity in the ratio 75:25. While at first sight 25% indeed seems to exceed the necessary 10% threshold, significant appointments out of the will trust before Hilda’s subsequent death in 2015 diminished the capital to such an extent that HMRC contended the threshold was not met.

Initial submission

The IHT400 and supporting schedule signed by the executors on 31 March 2016 showed the following values (ignoring the lifetime transfers which absorbed the nil rate band):

 

Component	£	£
Free estate		1,259,059
Will trust	116,251
Less donation	(29,063)
		87,188
		1,346,247

 

At this point it was accepted that only the will trust component qualified for the 36% rate.

A revised approach

In 2018, a revised IHT400 was submitted, claiming the reduced 36% rate in respect of both the free estate and will trust components. This was accomplished by interpreting the 25% charitable donation by reference to the value of the will trust at its inception, treating the appointments as advances by the trustees (who were deemed to have exceeded their powers). The problem of insufficient funds within the will trust was overcome by making a fictional transfer of £964,257 from the free estate:

	Initial	Transfer	End value		IHT rate	IHT
Component	£	£	£	£		£
Free estate	1,259,059	(964,257)		294,802
Will trust	116,251	964,257	1,080,503
Less: 25% charitable donation			(270,127)
				810,381
				1,105,183	36%	397,866

The charitable donation of £270,127 was easily more than 10% of the combined total of the free estate and will trust components, and hence the reduced rate of IHT applied to both.

HMRC’s position

However, HMRC determined that Sam’s will specified that the gift was to be 25% of the residuary estate, measured at the time of Hilda’s death. The 10% baseline calculation should therefore be based on the value of the assets held at death, so only the will trust component qualified for the 36% IHT rate. If this was correct, the additional IHT would be almost £130,000.

	Value		IHT rate	IHT
Component	£	£		£
Free estate		1,245,685	40%	498,274
Will trust	107,124
Less: 25% charitable donation	(26,781)
		80,343	36%	28,923
		1,326,028		527,197

The decision

The First-tier Tribunal looked in great detail at the drafting of Sam’s will and the creation of the will trust. While the will trust provided for the charity to receive 25% of the remaining residual estate on Hilda’s death, the residuary estate could be validly depleted by any number of appointments during her lifetime. The residuary estate was in fact reduced to such an extent that the charitable donation did not confer the right to a 36% IHT rate for the free estate. Although the trustees were unaware of the tax consequences of their actions, the appointments were made legally and unfortunately resulted in an inadequate charitable donation.

The grandchildren even offered to repay the lifetime gifts (to no avail) to facilitate the will trust to be able to pay out the intended charitable donation of over £250,000.

Lessons

This case serves as a reminder to ensure that intentions are clearly set out in a will and that proper advice is sought, particularly when making lifetime transfers or a life interest trust is involved. The initial drafting of the will should follow the model clause as set out by HMRC which allows for flexible charitable legacies which will meet the 10% test in all eventualities.

Poorly drafted wills may result in the desired charitable donation being insufficient.

Although not an option in this case, where the initial will does not result in a sufficient charitable donation, it is possible for the named beneficiaries to make a variation. Where certain conditions are met and the agreement is signed within two years of death, the variation is backdated to the date of death for IHT and the 36% IHT rate can be accessed

The variation will only be backdated where the recipient charity is notified and HMRC receives evidence of the notification.