Tax-efficient charity: a chance to quadruple a donation

by Stephen Hewitt | Published 4 May 2020

Line graph showing cost to estate (0-25 on y axis) vs value of gift declared in a will (0-30 on x axis) with both as % of the baseline amount. The graph also plots superimposed the gift magnification factor (0-5 on y axis, right hand scale, no units).  There is a discontinuity in both lines at x=10 where the reduced rate of IHT starts to apply.
Figure 1: The effect of the 2012 Finance Act's lower rate of inheritance tax on the cost to the estate of declaring a particular size donation to charity (as opposed to declaring no donation), for an estate with no residence nil rate band. The red lines show that a will declaring a donation that falls between 4% and 10% of the baseline amount will cost the estate more than a donation of 10% of the baseline amount. The second line is called here the ‘gift magnification factor’ - how many times more the charity receives than the cost to the estate after tax. Its maximum is about 4.17 times, achieved when the donation is exactly 10% of the baseline amount and the cost to the estate is only 2.4% of the baseline amount.

Since 2012 in the UK it has been possible in some cases to donate a particular sum to charity in a will with the effect that the charity receives over four times as much as the cost to the estate after inheritance tax.

Below is an example showing an estate valued at £425,000 where the cost of the donation after tax is £2,400 and the charity receives £10,000

After the death it may be possible for beneficiaries under a will to execute a deed of variation which achieves the same thing.

The extra money comes from savings in inheritance tax as a consequence of the conditional lower rate of tax of 36% introduced by the Finance Act 2012.

However, for deaths after 5 April 2017 the ‘residence nil rate band’ (RNRB) has the potential to reduce or even eliminate this charitable magnifying effect, the extent depending on the estate.

The 2012 act inserted schedule 1A into the Inheritance Tax Act 1984, stating that if a will makes a charitable donation that is at least 10% of the ‘baseline amount’ from a ‘component’ of the estate then the taxable part of that component will be taxed at 36% rather than 40%.

It is the simple mathematical consequence of this that can produce the quadrupling or more generally what will be called here ‘gift magnification’ in at least some estates. Here ‘gift magnification’ means the ratio of the gain to the charity over the cost to the estate of making the gift. The cost to the estate is defined as the difference between the value of the estate after tax if it made no charitable gift and the value of the estate after tax and after making the gift.

The act expended over 180 words on the definition of a component and a similar number on the definition of the baseline amount.

The legislation is complex and this article will explore the mathematics only in the kind of simple estates discussed below, both with and without a residence nil rate band.

For these purposes it is sufficient to say broadly that the act split the estate into three conceptual components, the survivorship component, the settled property component, and the general component.

The estates considered here consist of only a general component. They do not include reliefs such as business property relief, or agricultural property relief. The only exemption considered is the charitable one. Whether the same maths applies to estates beyond the examples here is outside the scope of this article.

For the simple estates here, the baseline amount definition is in effect:

baseline amount = taxable estate - NRB + value of charitable gift

Here NRB is the nil rate band, including any transferable nil rate band, that is available to the estate. It does not include the residence nil rate band.

The ‘taxable estate’ includes the part of the estate that is below the nil rate band, because technically this can be considered to be taxable - it is simply taxed at a rate that is nil.

The charitable gift on the other hand is exempt and not taxable at all. For a given estate the baseline amount does not change when the charitable donation changes. Since charitable gifts are not taxed, every pound added to the charitable gift results in a pound less in the taxable estate, so the sum of the two remains constant.

For the simple estate considered next, with no RNRB, this means that the baseline amount is the value of the estate that would be taxed at 40% if no gift were made. This is not the case for an estate claiming RNRB, which is discussed afterwards.

An example with no residence nil rate band

Consider Mr Morris who was divorced and died in 2016. The estate consisted of a house, valued at £300,000 and investments and other assets valued at £125,000. In 2016 there was no residence nil rate band.

Table 1 shows the calculations of the taxation of his estate, both for the case with no gift left to charity and the case with the minimum gift to qualify for the lower rate of tax.

Table 1: Comparison of the same estate with no charitable gift and with the minimum gift to qualify for 36% IHT
No gift With gift
gift as % of baseline amount 0 10%
estate value £425,000 £425,000
nil rate band £325,000 £325,000
baseline amount £100,000 £100,000
charitable gift £0 £10,000
estate taxable at rate above nil £100,000 £90,000
tax rate 40% 36%
tax £40,000 £32,400
estate after gift and tax £385,000 £382,600
difference to not giving £0 -£2,400

Since the baseline amount in this case is £100,000 the minimum gift to qualify for the lower rate is £10,000.

The calculation shows in this case that the value of the estate after paying the gift and paying the tax is only £2,400 less than the value when no gift is made, yet the charity receives £10,000. This represents a gift magnification factor of 10,000/2,400 = 4⅙. The gift has been more than quadrupled.

Figure 1 shows the general case of such a simple estate, with no residence nil rate band. It plots the gift magnification factor against the gift as a percentage of the baseline amount.

As in the case of Mr Morris, the highest magnification factor is achieved by donating exactly 10% of the baseline amount and is 4⅙. The cost to the estate of donating 10% of baseline is 2.4% of baseline after inheritance tax.

The marginal rate of increase of the gift above this 10% threshold is not nearly as much. The estate is now taxed at only 36%, so every extra pound received by the charity costs the estate £0.64 after tax.

So as the donation increases above 10%, the overall magnification factor slowly declines.

In some cases it may be possible to donate exactly 10% of the baseline amount by writing the will or deed of variation to explicitly specify 10% of the baseline amount rather than a numerical value in pounds. The Society of Trust and Estate Practitioners (STEP) published a document on this, including a model clause. However the date of publication shown in the STEP document is 2013, which is before the residence nil rate band legislation was enacted.

HMRC also has such clauses documented in its internal manual IHTM45008, available on the web.

HMRC also provides an online Inheritance Tax reduced rate calculator.

The website says it can calculate whether a particular donation is enough to qualify for the lower rate or inheritance tax or alternatively it can calculate the minimum donation that would qualify.

The quiet subversion by the residence nil rate band

The Finance Act (no.2) 2015 and subsequent legislation that created the RNRB did not alter schedule 1A of Inheritance Tax Act 1984. The definition of the baseline amount remained the same.

Consequently the RNRB is deducted from the value of the estate for the purpose of calculating the amount taxable (at 36% or 40%) but it is not deducted for the purpose of calculating the baseline amount.

This broke the equivalence between the baseline amount and the amount of estate taxed at 40% if no gift were made. Instead, the baseline amount became higher by the amount of the RNRB claimed.

baseline amount = RNRB + value of estate taxable at 40% if no charitable gift were made

The result is that the minimum donation to qualify for the lower rate of tax can be more than 10% of the value of estate that would be taxable at 40% if no charitable gift were made. In fact it is possible to have a baseline amount above zero while the estate has no tax to pay at all.

This increase in the minimum donation relative to the value of the estate that is being taxed (at a rate above nil) means the gift magnification factor is reduced. For example the baseline amount could be six times the amount of the estate that would be taxable at 40% if no charitable gift were made. In that case it would be necessary to donate 60% of this taxable amount in order to reach 10% of the baseline amount. After that donation, there would then remain only 40% of the original taxable amount to benefit from the lower rate of tax.

The amount of the reduction of the charitable incentive depends on the size of the RNRB relative to the baseline amount.

Line graph showing cost to estate (0-25 on y axis) vs value of gift received (0-30 on x axis) with both as £'000. The graph also plots superimposed the gift magnification factor (0-5 on y axis, right hand scale, no units).  There is a discontinuity in both lines at x=22.5 where the reduced rate of IHT starts to apply.
Figure 2: The residence nil rate band reducing the charitable incentive of lower rate IHT in the example of Mr Stone. The plot shows the cost to the estate of a charitable gift versus the value of the gift. The value of the estate that would be taxed at 40% if there were no gift is £100,000. Yet the donation must be at least £22,500 (or 22.5% of this) before the transition to lower rate tax occurs. The ‘gift magnification factor’ for this donation of £22,500 is approximately 2.16. Compare this with Figure 1 for an estate without RNRB. The gift magnification effect for this donation is the same as when the donor in Figure 1 chooses to donate 22.5% of the baseline amount.
Line graph showing the maximum gift magnification factor or maximum ratio of charity's gain to estate's cost (0-4.5 on y axis) versus ratio of baseline amount to value taxable at 40% if no gift.
Figure 3: The maximum available gift magnification factor declines as the baseline amount increases relative to the amount of the estate that would be taxable at 40% if there were no charitable gift. For the estates considered here the difference between this taxable amount and the baseline amount is the RNRB.

Consider Mr Stone who was divorced and died in August 2018. The estate consisted of a house, worth £415,000 and investments and other assets worth £135,00. He left the house to his children and consequently the estate had a RNRB of £125,000.

Table 2 shows the calculations of the taxation of his estate, both for the case with no gift left to charity and the case with the minimum gift to qualify for the lower rate of tax.

Table 2: Mr Stone's estate claiming RNRB: comparison of the estate with no charitable gift and with the minimum gift to qualify for 36% IHT
No gift With gift
gift as % of baseline amount 0 10%
estate value £550,000 £550,000
nil rate band £325,000 £325,000
baseline amount £225,000 £225,000
residence nil rate band £125,000 £125,000
charitable gift £0 £22,500
estate taxable at rate above nil £100,000 £77,500
tax rate 40% 36%
tax £40,000 £27,900
estate after gift and tax £510,000 £499,600
difference to not giving £0 -£10,400

In the case of the minimum gift, the charity receives £22,500 and the cost to the estate is £10,400. This represents a gift magnification factor of about 2.16, which is about half the magnification available in the absence of a RNRB.

The graph in Figure 2 plots the cost to the estate and the gift magnification factor for a range of values of gifts to charity for Mr Stone's estate. The red lines highlight the range of donation amounts that will cost the estate more than making a higher donation of 10% of the baseline amount. For this estate the range is between £17,333 and £22,500 which is 10% of the baseline amount

Suppose Mr Stone had instead left his house to a nephew or niece. Table 3 shows the calculations for the same estate if no RNRB were available.

The cost to the estate of making the same donation would then be just £5,400.

Table 3: Mr Stone's estate if it could not claim RNRB: the same gift to charity would cost the estate around half as much after tax.
No gift With gift
gift as % of baseline amount 0 10%
estate value £550,000 £550,000
nil rate band £325,000 £325,000
baseline amount £225,000 £225,000
residence nil rate band £0 £0
charitable gift £0 £22,500
estate taxable at rate above nil £225,000 £202,500
tax rate 40% 36%
tax £90,000 £72,900
estate after gift and tax £460,000 £454,600
difference to not giving £0 -£5,400

Figure 3 shows the maximum available gift magnification factor declining with increasing relative size of the RNRB. The curve is the same as the curved part of the plots in Figures 1 and 2. The effect on the gift magnification factor of increasing the donation relative to the value on which tax is payable (at a rate above nil) is the same whether the increase is caused by someone choosing to donate more than 10% of the baseline amount or caused by the RNRB raising the baseline amount or by a combination of both.

An overlooked opportunity?

On 23 March 2011 in parliament the chancellor of the exchequer introducing the lower rate inheritance tax legislation said “I want to make giving 10% of your legacy to charity the new norm in our country”.

In fact the law that parliament subsequently passed did not reward a donation of 10% of the whole legacy. It rewarded a donation of 10% of just the baseline amount of one component. The baseline amount in many cases will be much smaller than the value of the estate because it will have the nil rate band of at least £325,000 subtracted from the value of the estate.

In addition what may not be obvious is that this donation of a nominal 10% in at least some cases and in the absence of a RNRB, will actually cost the estate only 2.4%, as described above.

Nine years after that speech, the “new norm” was not apparent.

By April 2020 the latest government figures published for estate returns were for tax year 2016-17. They showed that 2,020 estates had taken advantage of the lower tax rate.

This represents only 20% of the 9,890 estates paying inheritance tax that donated to charity. And it represents just 7% of the 28,200 estates that paid inheritance tax that year.

The RNRB legislation had not taken effect in that year.

Rob Cope, director of Remember a Charity, sees the tax incentive of the lower rate of inheritance tax mainly as a “lever” to start a conversation between someone making a will and their advisor on a subject that may be “taboo”.

He explained that there is evidence “where advisors have that conversation they can potentially treble the number of people who leave a gift in their will”.

“That's what for me is one of the biggest merits of that.”

Glossary

HMRC
Her Majesty's revenue & customs
IHT
inheritance tax
NRB
nil rate band
RNRB
residence nil rate band
STEP
The Society of Trust and Estate Practitioners

Disclaimer

This article does not represent advice. Although reasonable care has been taken in its preparation, the author does not accept any liability for errors or omissions nor for any loss arising from use of its information.

Related

External links