The rules for transferring assets to a UK domiciled spouse are fairly straightforward. However, things are trickier when one spouse is non-domiciled.
In general, lifetime and on-death transfers of assets between spouses/civil partners who are both UK domiciled are exempt from UK inheritance tax (IHT) without limit.
However, when one spouse is not UK domiciled, the spousal exemption is limited to £325,000.
Additionally, if some or all of the deceased’s nil rate band (also £325,000) is unused on his or her death, then this can also be transferred to the surviving spouse.
Finally, there is a Residence Nil Rate Band of £175,000 which can potentially be used too.
This gives a potential total of £825,000 in assets that can be passed free of UK inheritance tax.
Transferring assets to a non-domiciled spouse – A case study
In this example, William is UK domiciled and married to Karolina, who is Polish and is not UK domiciled.
On his death, William leaves his entire estate to Karolina. The estate is worth £1,500,000 and includes a property in the UK worth £400,000.
William has not made any gifts in the past 7 years.
In this case, William’s executors can claim his IHT nil rate band of £325,000, the spousal exemption of £325,000 and the Residence Nil Rate Band of £175,000.
This means that Karolina will receive assets worth £825,000 free of UK IHT.
The balance (£675,000) will be subject to IHT at 40%, meaning that HMRC would be due £270,000 from William’s estate.
Why is there a restriction on transferring assets on death to a spouse who is not UK domiciled?
The rationale for this limited exemption is that assets moving from a UK domiciled individual to a non-UK domiciled spouse are more likely to pass outside the UK IHT net altogether.
This is because IHT is charged on the worldwide assets of a UK domiciliary, but only on the UK assets of someone who is not UK domiciled.
Election for a non-domiciled spouse to be treated as UK domiciled
One solution to this issue would be for the non-domiciled spouse/civil partner to choose to be treated as UK domiciled for IHT purposes.
The benefit of this course of action would be that they would then be treated in the same way as a UK domiciled spouse/civil partner. I.e. the entire transfer would be exempt from IHT, irrespective of the amount.
The downside is that on the death of the non-domiciled spouse, their full estate (including assets outside the UK) would then be liable for UK IHT.
If we use the example of William and Karolina again, if Karolina had no assets outside of the UK, then her electing to be treated as UK domiciled for IHT may be advantageous as the full £1,500,000 estate could then go to her without any tax being due.
However, if she had property of her own outside the UK, in her native Poland for example, then this would then potentially be liable for UK IHT on her death if she elected to be treated as UK domiciled.
A decision to be treated as UK domiciled for IHT purposes is irrevocable.
However, the election automatically lapses once the electing spouse has been a non-UK resident for four successive tax years.
At this point, they would regain their non-UK domicile status for IHT purposes and their non-UK assets (including those inherited from the UK domiciled spouse) would fall outside the scope of UK IHT.
This type of planning could be particularly useful where a mixed domicile couple is resident outside of the UK.
It would also be of benefit where the electing spouse returns to their home country (or elsewhere) following the death of their UK domiciled spouse.
Professional advice should always be taken if such an election is being considered.