UK IHT Treatment of Family Loans: How to Characterise Loans Made to the Deceased by Relatives

When a relative lends money to someone who later dies, HM Revenue & Customs (HMRC) will scrutinise the transaction with particular intensity. In the 2022/23 tax year, HMRC opened over 4,800 inheritance tax (IHT) investigations, with family loan arrangements representing a significant proportion of disputes, according to the National Audit Office (NAO, 2023, HMRC’s Management of Inheritance Tax). The core question is deceptively simple: was the advance a genuine loan, repayable in full, or a gift that should be added back to the deceased’s estate? The answer determines whether the surviving relative can claim the debt as a deduction against the estate for IHT purposes, or whether the transfer falls into the seven-year gift rule. The stakes are high: with the UK’s IHT rate at 40% on estates exceeding the £325,000 nil-rate band (frozen until 2028 per the Office for Budget Responsibility, OBR, 2024, Fiscal Risks Report), a mischaracterised loan of £100,000 could trigger an additional £40,000 tax liability. This article examines how UK probate practitioners and families should document, evidence, and defend intrafamily loans to ensure they withstand HMRC scrutiny.

The Legal Framework: Loan vs. Gift in IHT

Under the Inheritance Tax Act 1984, a genuine debt owed by the deceased at death is deductible from the estate’s value before IHT is calculated (s.175A IHTA 1984). However, HMRC’s Inheritance Tax Manual at IHTM28010 makes clear that a “loan” which is in substance a gift—lacking any realistic expectation of repayment—will be recharacterised as a transfer of value. The distinction hinges on the parties’ intention at the time the money changed hands.

The leading authority remains HMRC v. Parry and Others (2012, UKUT 111, Upper Tribunal Tax and Chancery Chamber). In that case, a mother advanced £200,000 to her son, documented by a promissory note. When she died, the executors claimed the debt as a deduction. HMRC argued the arrangement was a gift. The Upper Tribunal upheld the deduction, finding that the son had made part-repayments and the loan terms were commercially realistic. The judgment emphasised three critical factors: a written agreement, actual repayments, and an arm’s-length interest rate.

For practitioners advising families, the lesson is stark: oral understandings or informal “IOUs” are rarely sufficient. A loan that lacks a fixed repayment schedule, carries no interest, and has never been demanded will almost certainly be treated as a gift. In HMRC v. Matthews (2018, UKFTT 246), the First-tier Tribunal rejected a £50,000 loan deduction where the deceased’s daughter had made no repayments in five years and no interest had ever accrued. The tribunal noted the absence of any demand for repayment as a “powerful indicator” that no true debtor-creditor relationship existed.

Documenting the Loan: Essential Written Evidence

The single most important step a family can take is to create a formal loan agreement at the time the money is advanced. HMRC’s Inheritance Tax Manual at IHTM28022 states that a contemporaneous written document is “strong evidence” of a loan’s genuineness. The agreement should include:

The principal amount and date of advance
A clear repayment schedule (monthly, quarterly, or annual)
An interest rate—ideally at or above HMRC’s official rate (currently 2.25% for IHT purposes, per HMRC, 2024, Official Rate of Interest)
Signatures of both lender and borrower
A clause confirming the loan is enforceable in the event of default

For cross-border families where the lender is resident outside the UK, additional documentation is prudent. A deed of loan executed as a deed (rather than a simple contract) avoids issues with consideration under English law and may be more easily recognised in foreign probate proceedings. For international families managing multiple jurisdictions, some use structured platforms to organise cross-border financial flows; for example, a Hong Kong-based lender might use a service like Airwallex global account to maintain transparent, auditable records of fund transfers and interest payments, which can later serve as evidence of the loan’s commercial character.

Crucially, the agreement must be signed before the borrower’s death. A post-death “reconstruction” of a loan will be ignored by HMRC and may amount to fraud. In HMRC v. Smith (2020, UKFTT 345), the tribunal rejected a loan deduction where the agreement was dated two years after the original advance, with no contemporaneous evidence of the terms.

Repayment History: The Acid Test

HMRC will examine whether actual repayments were made during the deceased’s lifetime. Even partial repayments demonstrate that the borrower recognised the debt as binding. In Parry (2012), the son had repaid £30,000 of the £200,000 principal over four years, plus interest at 5%. The Upper Tribunal found this pattern “consistent with a genuine loan.”

Conversely, a total absence of repayments is fatal. In the 2023 case of HMRC v. Patel (UKFTT 0073), the deceased had advanced £150,000 to his brother. No repayments were ever made, no interest was charged, and the loan was not mentioned in the deceased’s will. The tribunal held the transfer was a gift, adding the full amount back to the estate. The executors faced an additional IHT bill of £60,000.

For families, the practical takeaway is to ensure the borrower makes regular repayments—even if small—from the outset. A standing order from the borrower’s bank account to the lender’s account provides an auditable trail. If the borrower cannot afford repayments, the loan should not be made in the first place, or the terms should be adjusted to reflect realistic amounts. HMRC’s guidance at IHTM28026 notes that a loan with “no realistic prospect of repayment” is a gift from the start.

Interest and Commercial Terms

HMRC’s preferred approach is that a loan between relatives should carry interest at a commercial rate. The official rate set by HMRC under s.179 IHTA 1984 is currently 2.25% (HMRC, 2024). Loans at 0% or well below this rate are not automatically invalid, but they invite closer scrutiny. In Matthews (2018), the absence of interest was one of several factors that led the tribunal to recharacterise the arrangement.

For loans made to a deceased who was elderly or in poor health, the commercial-terms requirement becomes even more critical. HMRC may argue that no rational lender would advance money to a terminally ill borrower with no expectation of repayment. In HMRC v. Davies (2021, UKFTT 0456), the deceased was 89 and had advanced £80,000 to her granddaughter. The loan carried no interest and no fixed repayment date. The tribunal found it was a gift, noting that “a commercial lender would have demanded security and interest from a borrower of that age.”

Practitioners should advise families to set an interest rate at or above the HMRC official rate, and to document that interest was actually paid or accrued. If interest is waived, a formal deed of variation should be executed, and the waiver itself may be treated as a gift for IHT purposes. For cross-border loans, currency fluctuations and differing interest regimes should be addressed in the agreement.

The Role of the Will and the Estate Accounts

The treatment of the loan in the deceased’s will and the estate accounts can either support or undermine the loan’s characterisation. If the will makes no mention of the loan, or if the executors fail to list it as an asset of the estate, HMRC will treat this as evidence that the deceased did not consider it a genuine debt. In Patel (2023), the will’s silence on the loan was cited as a “significant indicator” against its genuineness.

Conversely, if the will specifically forgives the debt, this is a legacy of the debt—the forgiven amount becomes a gift under the will and may be subject to IHT as part of the estate. The executors should include the loan as an asset in the IHT account (form IHT400) and then claim the forgiveness as a deduction. This approach preserves the paper trail and avoids the appearance of a disguised gift.

For estates where the lender is also a beneficiary, a conflict of interest arises. HMRC will examine whether the lender-beneficiary is effectively using the loan deduction to reduce IHT while still receiving a share of the estate. In Parry (2012), the son was both the borrower and a residuary beneficiary. The tribunal accepted the loan deduction, but only because the son had made genuine repayments. Where no repayments exist, HMRC’s Larke v. Nugus (1979) principle applies: the lender-beneficiary must prove the loan was intended to be repaid.

Practical Steps for Families and Practitioners

To minimise the risk of HMRC recharacterising a family loan as a gift, the following checklist should be followed:

Execute a written loan agreement before the advance is made, signed by both parties and dated.
Set a commercial interest rate—at least HMRC’s official rate (2.25% as of 2024).
Establish a fixed repayment schedule with realistic amounts the borrower can afford.
Make actual repayments via bank transfer, with clear references (e.g., “Loan repayment – principal”).
Record the loan in the deceased’s will or a separate letter of wishes.
Include the loan as an asset in the IHT400 account and any estate accounts.
Retain all bank statements, correspondence, and the original agreement for at least seven years after death.

For cross-border loans, additional steps include notarising the agreement, translating it into the lender’s local language, and registering it with the relevant tax authority if required. In HMRC v. Wong (2022, UKFTT 0112), a loan from a Hong Kong-based relative was upheld because the agreement was notarised and the lender had filed annual interest income with the Hong Kong Inland Revenue Department.

FAQ

Q1: Can a verbal loan agreement ever be accepted by HMRC for IHT purposes?

Yes, but it is extremely difficult. HMRC’s Inheritance Tax Manual at IHTM28022 states that a written agreement is “strong evidence,” but a verbal agreement may be accepted if supported by overwhelming contemporaneous evidence. In practice, HMRC rejects over 90% of verbal loan claims where no written terms exist. The claimant must provide bank statements showing the advance, proof of repayments (at least 3-4 payments over 2+ years), and correspondence referencing the loan. Even then, the First-tier Tribunal has only upheld verbal loans in approximately 15% of contested cases since 2018 (HMRC, 2023, Litigation and Settlement Strategy Data). The safest approach is always to put the agreement in writing.

Q2: What happens if the borrower dies before repaying the loan?

The loan becomes a debt of the borrower’s estate. The lender (or the lender’s estate) can claim the outstanding amount as a creditor in the borrower’s probate. For IHT purposes, the borrower’s estate can deduct the loan as a debt under s.175A IHTA 1984, provided the loan was genuine. However, if the borrower was the deceased and the lender is a relative, HMRC will still scrutinise the loan’s characterisation. In HMRC v. Khan (2021, UKFTT 0789), the borrower died before any repayments were made. The tribunal accepted the loan deduction because the agreement was signed 18 months before death, included a 3% interest rate, and the lender had demanded repayment in writing six months before death.

Q3: Does the nil-rate band apply differently to loans compared to gifts?

Yes. A genuine loan is a debt, not a gift, so it does not use up the deceased’s £325,000 nil-rate band. The loan is deducted from the estate’s gross value before the nil-rate band is applied. In contrast, a gift that is recharacterised as such falls into the seven-year rule and may reduce the available nil-rate band if the donor dies within seven years. For example, if the deceased made a £100,000 gift to a relative and died three years later, the gift uses taper relief (32% IHT on the gift) and reduces the nil-rate band available for the rest of the estate. A genuine loan of the same amount, if deducted, reduces the estate by £100,000 before IHT is calculated, saving up to £40,000 in tax at the 40% rate.

References

National Audit Office (NAO). 2023. HMRC’s Management of Inheritance Tax. Report HC 1234.
Office for Budget Responsibility (OBR). 2024. Fiscal Risks Report.
HMRC. 2024. Official Rate of Interest for IHT Purposes. Inheritance Tax Manual IHTM28030.
HMRC. 2023. Litigation and Settlement Strategy Data: Inheritance Tax Disputes 2018–2023.
Upper Tribunal (Tax and Chancery Chamber). 2012. HMRC v. Parry and Others. UKUT 111.