INHERITANCE TAX – PLANNING
Synopsis: The normal expenditure out of income exemption is relatively well known but is often overlooked. We provide a reminder on the conditions for this valuable relief, and highlights some practical eligibility issues.
Date posted: Tuesday, January 14, 2014
For many clients who do not need access to their capital, inheritance tax planning involves making use of the annual exemption of £3,000 per annum and/or making larger gifts out of capital in the hope of surviving the ensuing seven year period. However, for those with incomes in excess of their day-to-day needs there is another important exemption which, while relatively well-known, is probably under-used. This is the ‘normal expenditure out of income’ exemption contained in section 21 IHTA 1984. The key benefit of taking advantage of this exemption (where it is appropriate to do so) is that not only is a reduction in the estate obtained with immediate effect, there is no prescribed limit on the amounts that can be gifted provided the conditions laid down in s21 are met. The relief can therefore prove to be extremely generous in the right circumstances. Broadly, the conditions for obtaining relief are:
• the gifts must be made as part of the donor’s ‘normal expenditure’;
• the gifts must be made out of income; and
• having made the gifts, the donor must retain sufficient income to be able to maintain his usual standard of living.
We will consider each of these in more detail below.
‘Normal expenditure’
The legislation does not define ‘normal’ either as a specific amount or percentage of income. The test therefore involves a largely subjective assessment of the habits of a particular donor. There are a number of points worthy of note here.
Firstly, the amounts gifted can fluctuate. This means that it is perfectly possible for a donor who routinely experiences fluctuations in income to establish a pattern of giving away ‘surplus’ or a percentage of income (see also Bennett v CIR below).
The gifts do not necessarily have to be made annually to be construed as regular. So, if a particular donor is able to establish a regular pattern of gifting when, for example, grandchildren start or leave university, the gifts made at those times would qualify for relief provided that the other conditions in s21 are satisfied.
While a settled pattern of gifting is normally preferable (HMRC guidance refers to a period of three to four years), there is no minimum period for which gifts must be made for the exemption to apply. Indeed, a commitment or resolution to make qualifying gifts over a sufficient period will satisfy the condition. This could take the form of an express instruction or memorandum or something more formal – such as a contract to pay premiums on a life insurance policy written in trust.
This forgiving nature of the exemption was illustrated in the case of Bennett & others v CIR [1995] STC 54. In 1989 Mrs Bennett requested that the trustees of her late husband’s will trust (or which she was the primary beneficiary) to distribute all income surplus to her requirements to her three sons in equal shares. Payments were made to each of the sons of £9,300 on 14 February 1989 and £60,000 on 5 February 1990, prior to Mrs Bennett’s sudden death on 20 February 1990.
The Court held that on the facts Mrs Bennett had adopted a pattern of expenditure in respect of the surplus income, and the payments to her sons were therefore within s21 IHTA 1984.
Mr Justice Lightman helpfully confirmed that ‘there is no fixed minimum period during which the expenditure shall have occurred’ for it to be construed as ‘normal’; adding that the existence of a settled pattern of expenditure might be established either by reference to a sequence of payments, or by proof of a ‘prior commitment or resolution’.
Gift must be made out of income
According to HMRC, income means net income after tax and calculated using normal accounting rules. It is usually clear whether payments received count as income, however, some payments received on a regular basis may appear to be income but are in fact capital in nature. Common examples of this include, the annual 5% tax deferred withdrawal from a non-qualifying insurance policy and the capital element of a purchased life annuity.
It is also important to note that income will not necessarily retain its nature indefinitely. HMRC updated their views on this aspect of the criteria in 2011 and their current approach, as set out in IHTM14250 is that:
‘Income from earlier years does not retain its character as income indefinitely. At some point it becomes capital but there are no hard and fast rules about when this point is. If there is no evidence to the contrary, we consider that income becomes capital after a period of two years. Evidence to the contrary could impact either way as income:
- may immediately be invested in a capital product and become capital or
- may be retained as income for more than two years with a specific purpose in mind.
Each case will depend on its own facts but, in general, the longer the period of accumulation, the more likely it is that the income has become capital.’
The correct treatment of accumulated income for these purposes was considered recently in the case of McDowall and others (executors of McDowall, deceased) v Commissioners of Inland Revenue [2004] STC (SCD) 22. Although in this case the gifts were disallowed (because they were made by the donor’s attorney and therefore outside the scope of his powers), the implication was that income that is accumulated with a view to gifting it as income at some later date, may retain its income character for a much longer period than is suggested by HMRC in their guidance (although supporting evidence of this intention will be vital if the exemption is to be successfully claimed in such circumstances).
Maintain usual standard of living
The third condition for the exemption is that, after making the gifts, the donor must be left with enough income to maintain their usual standard of living. This means that, even if made out of income, gifts will not qualify for the exemption if the donor has to resort to capital to meet his normal living expenses.
Normal living expenses for these purposes will usually be what was normal at the time the gift was made. This means that if circumstances change, the exemption may still be available as long as the fall in income couldn’t have been foreseen. HMRC use the example of a donor who takes on a commitment to pay regular insurance premiums, initially affordable out of income, but later on has to pay nursing home fees, that were unforeseen when the policy was first taken out. However, HMRC guidance advises its Inspectors to use their judgment in accepting or refusing the exemption in full or in part for continuing regular gifts where there has been a permanent change in circumstances.
The question of what qualifies as income remains important for this third condition. Withdrawals from an insurance investment bond (including one held subject to a Discounted Gift Trust arrangement) are not income for these purposes and so should not be used to replace gifted income where the donor is planning to claim the exemption. That said there is no reason why a donor should not use capital to pay for living expenses if he has sufficient income to maintain his usual standard of living after making the gift but simply chooses to accumulate it or spend it on other things.
Claiming the exemption
The exemption is generally claimed on form IHT403 following the donor’s death (although there may be instances where a ruling is required during the donor’s lifetime – for example where the transfer would otherwise give rise to an immediate IHT liability) and it is therefore vitally important for donors to keep a full record of the amounts gifted as well as a year on year breakdown of income and expenditure which will be needed to substantiate the claim. The form IHT403 is helpfully set out to include a table in which it is possible to input income and expenditure of various types so as easily identify the appropriate surplus (or deficit) income figure for the tax year. Consequently, many donors find use of the form on an ongoing basis during lifetime to be an uncomplicated way of keeping the necessary records.
COMMENT
The normal expenditure out of income exemption can be extremely valuable in the right circumstances but care must exercised and good records maintained – especially where significant amounts are involved, the amounts gifted fluctuate considerably year on year and/or the donor’s circumstances have changed since the pattern of gifting (or the commitment to make gifts) commenced.
However, when used correctly the exemption can be very effective in preventing the value of the estate from increasing through the accumulation of surplus income. The exemption can be used in a variety of ways, ranging from the funding of stakeholder pensions for grandchildren (which have the added benefit of attracting tax relief) to larger transfers into trust, which could otherwise attract an immediate IHT charge of 20%.