A comprehensive guide on Potentially Exempt Transfers (PETs)

And why it's so important to consider this type of gifting now...

Pensions
Planning
Tax

When it comes to estate planning, one of the most effective ways to reduce Inheritance Tax (IHT) is through gifting assets during an individual’s lifetime. One strategy that can play a key role in this process is Potentially Exempt Transfers (PETs). Unlike other types of transfers, PETs are not immediately subject to IHT, but they do come with their own set of considerations, particularly around Capital Gains Tax (CGT).

In this blog, we’ll explore Potentially Exempt Transfers and how they differ from other gifting options, and why they may become even more relevant with proposed changes to Agricultural Property Relief (APR) and Business Property Relief (BPR). We’ll also address common misconceptions, key considerations, and alternative gifting options.

What are Potentially Exempt Transfers (PETs)?

Potentially Exempt Transfers (PETs) are a key consideration when it comes to lifetime gifting and Inheritance Tax (IHT) planning.

Broadly speaking, individuals take one of two approaches to manage their IHT liabilities:

Taking action during their lifetime, such as making gifts of cash or assets that they no longer require, or wish to see their beneficiaries take over.
Making provisions in their Will to distribute assets once they have died.

With lifetime gifting, transfers are treated for IHT purposes in three main ways:

Immediately exempt transfers – These include gifts that are fully exempt from IHT, such as those to a spouse or civil partner, or to charity, or gifts covered by small annual allowances.
Immediately chargeable transfers – Certain transfers, most commonly gifts into Trusts, are subject to IHT at the time of transfer if they exceed the available nil-rate band and any available reliefs. These are referred to as Chargeable Lifetime Transfers (CLTs).
Potentially Exempt Transfers – Most lifetime gifts are PETs. Unlike CLTs, a PET has no immediate IHT implication, regardless of the size/value of the asset given away. A PET only becomes fully exempt however if the donor survives for seven years after making the gift. If the donor passes away within the seven year period, the gifted asset will still be taxable as part of the donors estate. If this is the case, the rate of IHT payable may be reduced, depending on the amount of the gift and how many years the donor has survived after making the transfer (known as Taper Relief).

Why is it so important to consider PETs now?

With changes to Agricultural Property Relief (APR) and Business Property Relief (BPR) announced in Autumn Budget 2024, seeking tax advice and acting promptly has become even more crucial.

Under the current rules, assets that qualify for APR and BPR are commonly held until death on the basis they will not incur a charge to IHT at that time. Now, with the introduction of a lifetime cap for APR and BPR proposed, individuals will need to consider if leaving qualifying assets on death is still effective, or if a better option would be to make use of the rules PETs and give certain assets away now.

There is also growing concern that the Government may turn its attention to the rules for PETs, if we see a significant rise in people using them to counter the changes to APR and BPR. In response, they may consider increasing the survival period from seven years to a longer period, or even remove the concept of a PET altogether. .

While many may believe the rules around PETs will remain unchanged, the same was thought about APR and BPR. Acting sooner rather than later could help safeguard against potential changes and ensure people make the most of the current rules.

Will PETs become more popular with the changes to APR and BPR?

PETs are likely to become a more common strategy for mitigating IHT on agricultural and business assets, as a result of the proposed changes to APR and BPR.

The type of assets that qualify for APR and BPR may be hard to sell, or undesirable to sell for a number of reasons. If a person’s death will now trigger a large charge to inheritance tax then the cash will need to be found to pay that liability. Alternative measures, such as the use of PETs, will therefore need to be considered.

It is important to consider and take advice on the potential downsides of making a PET. While PETs may offer IHT benefits, they often come with CGT implications. Gifting an asset could trigger a capital gains liability, meaning that while one tax issue may be solved, another could be created.

Additionally, the person giving away the asset must fully relinquish any benefit from it. If they continue to benefit from the asset in some way, such as continuing to have access to and making use of it, or continuing to receive income or profit from it, then it is likely that the asset will continue to be treated as part of that person’s estate. A gift must be permanent and irreversible to make proper use of the rules for PETs, and so the decision to give away an asset should be considered in full before any action is taken.

When should PETs start to be considered?

We typically find two key stages where people consider PETs.

At retirement

This is often when individuals have stopped accumulating wealth and assets, and might consider whether they should start giving assets away. For this group of people, PETs can be highly effective. With a good chance of surviving the seven-year period, they can transfer significant amounts without immediate IHT implications, providing they can afford to do so.

Later in life

Most commonly people only start thinking about giving away wealth or assets at the later stages of their life. The reasons for this are obvious- they want to enjoy the wealth they have built up, or are nervous about giving something away that they may later want back, or perhaps they are even concerned about what their beneficiaries might then do with the gift they receive. The problem that is faced here is that the donor may be less likely to surpass the necessary seven years after making a gift.

In these cases, other estate planning options need to be explored in combination with PETs.

Ultimately, as with any tax rule that involves a time condition, the sooner a PET is made the more chance there is of it meeting the seven-year condition. Acting early not only increases the likelihood of a gift becoming fully exempt but also leaves more flexibility for the individual to move onto other areas of inheritance tax planning.

What are the most common misunderstandings regarding PETs?

Taper relief

Taper relief is often misunderstood as a significant tax-saving measure. Many believe that if someone survives just three years after making a gift, a large portion of IHT on the gift will be reduced. In practice however, very few people benefit from Taper relief.

For example, if a person makes a gift and does not survive the seven-year period, the gift becomes a “failed PET,” and IHT may be payable on it. While the donee (the person who received the gift) is typically responsible for paying this tax, the donor can specify in their Will that the gift is “tax-free,” meaning the tax would instead be paid from the donor’s estate.

When calculating IHT after death, “failed PETs” are taxed first, using up the donor’s nil-rate bands in priority to the rest of their estate. Taper relief only applies to failed PETs in excess of the available nil-rate band. As a result, unless someone has given away gifts exceeding their nil-rate band in the seven years before they pass, the relief does not come into play.

Capital Gains Tax (CGT)

CGT and IHT are intrinsically linked. Actions taken to reduce IHT often have implications for CGT, and Potentially Exempt Transfers are no exception.

Unless the gift is exempt from CGT, such as cash, making a PET triggers a disposal of the asset for CGT purposes. For example, gifting a second property is treated by HMRC as if it has been sold at market value, which can result in a capital gain.

Holdover relief

Holdover relief is available when gifting business assets or making CLTs into a Trust. It allows the CGT liability to be deferred, meaning no CGT is payable at the time of the gift.

The person receiving the asset will inherit its original cost, rather than its current market value. This means that if they sell the asset later, they may face a larger CGT bill, based on the gain from the original cost.

Individuals looking to use the PET rules who are at risk of not meeting the seven year rule may risk creating an overall higher tax liability, than if they continued to hold an asset until death. For example, if a PET is made and holdover relief claimed, but then an individual passed away within seven years, the gift becomes a “failed PET,” and some or all of the IHT saving may be lost. The person who received the gift has now inherited the original base cost of the asset whereas if the asset had passed to them on death then they would have received a tax-free uplift for CGT purposes.

Holdover relief requires careful consideration, especially when balancing the potential IHT savings that can be made when making a PET, against the deferred CGT implications for the recipient.

When considering any form of gifting, including Potentially Exempt Transfers (PETs), it is essential to take a step back and assess personal financial needs. Wealth is built through hard work, but it is important to ensure that sufficient resources remain for a secure and comfortable future.

While planning for the next generation and reducing potential tax liabilities is commendable, it is equally important to enjoy the wealth accumulated. Striking the right balance between giving to others and providing for one’s own needs is key.

What other gifting options are there?

In addition to Potentially Exempt Transfers, there are several other ways to gift assets and reduce an estate for IHT purposes. These options include:

Spousal transfers: Gifts between spouses or civil partners are completely exempt from IHT.
Gifts to charities: Donations to registered charities are exempt from IHT.
Gifts out of income: If surplus income is not required for living expenses, it can be gifted tax-free, provided it forms part of a regular gifting pattern. For example, setting up a standing order to family members. It must be possible to prove that this income is genuinely surplus and not needed for personal financial needs.
Annual exemption: Up to £3,000 can be gifted per tax year without it counting towards the estate. If the exemption was not used in the previous tax year, it can be carried forward, allowing a gift of up to £6,000 in one year.
Marriage or Civil Partnership gifts: Gifts made on the occasion of a marriage or civil partnership are also exempt. The exemption amount varies: up to £5,000 for children, £2,500 for grandchildren, and £1,000 for others.

While these exemptions can help manage your estate, it’s important to note that they don’t necessarily reduce an existing IHT liability—they simply prevent it from increasing.

Do PETs have to be declared?

PETs can be declared in two ways:

If the donor has passed away, the Executors have to declare to HMRC what PETs have been made in the seven years before death.
If the PET triggers a CGT liability, for example an individual has made any disposal for capital gains purposes, then this needs to be declared via a tax return in the year this has occurred. Certain disposals of property require a more immediate tax return to be filed.

Closing thoughts

Potentially Exempt Transfers are a valuable tool in estate planning, offering a way to reduce IHT liabilities by gifting assets during one’s lifetime. It is vital however to balance the potential IHT benefits with the implications for CGT, as gifting assets may trigger a CGT liability. While PETs are becoming increasingly popular, particularly in light of proposed changes to Agricultural Property Relief and Business Property Relief, careful planning is essential to ensure that the tax advantages outweigh the risks.

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.

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