Mark McLaughlin highlights a valuable inheritance tax exemption, and offers some practical tips when considering a claim.
Most forms of tax relief or exemption have an upper limit, such as the income tax personal allowance, or the annual exemption for capital gains tax purposes.
However, there is an inheritance tax (IHT) exemption which has no upper monetary limit. The exemption is only limited broadly by the individual’s personal resources, and the amount of spare income available to give away. It is available for lifetime gifts (but not transfers on death), and can apply to all or part of the gifts. For such a generous exemption, it is perhaps surprising that more people do not make use of it.
How does it work?
The IHT exemption is for ‘normal expenditure out of income’ (IHTA 1984, S 21). A gift will benefit from the exemption to the extent that certain conditions are satisfied. These are broadly as follows:
•The gift was part of the normal expenditure of the person making it;
•It was made out of his or her income (taking one year with another); and
•The person making the gift was left with sufficient income to maintain his or her usual living standards.
And that’s it! Well, not quite. Everyone’s personal circumstances will vary, and in practice it can sometimes be difficult to establish that the exemption is due; more on this later. In addition, the brevity of the legislation has allowed HM Revenue & Customs (HMRC) to place its own interpretation (or ‘spin’) on the exemption conditions. However, where all the conditions are satisfied, the exemption can shelter significant gifts for IHT purposes.
Example – Regular gifts
Joseph is 82 years old, and has a steady net income after tax of £60,000 consisting of pensions and investment income. Joseph is able to save a regular monthly sum of £2,500 per month (i.e. £30,000 per annum).
Joseph has been making regular monthly gifts of £1,000 per month (i.e. £12,000 per annum) divided equally between his son and daughter. Assuming HMRC accepts that these gifts were exempt as being part of Joseph’s normal expenditure out of income, he could still make use of his annual IHT exemption (i.e. £3,000) in respect of other gifts.
Satisfying the conditions
The exemption for normal expenditure out of income is clearly very useful and generous, so HMRC can be expected to apply the above conditions quite rigidly. For example, HMRC may seek proof that the gifts satisfied the ‘normal expenditure’ condition. HMRC’s stated approach is that a regular pattern of giving needs to be demonstrated, normally over a period of three or four years. However, there has been some helpful case law on the ‘normality’ test.
In Bennett & Others v CIR  STC 54, Mrs Bennett executed an authority in 1989 addressed to the trustees of her late husband’s will trust, authorising them to distribute equally between her three sons ‘all or any of the income arising in each accounting year as is surplus to my financial requirements of which you are already aware’. Payments were made to each of the sons of £9,300 on 14 February 1989 and £60,000 on 5 February 1990. Sadly, Mrs Bennett died suddenly on 20 February 1990. In allowing the taxpayers’ appeal against the Revenue’s refusal to allow the normal expenditure exemption, the court held that Mrs Bennett’s considered determination for the rest of her life to give to her sons all her surplus income from the trust beyond what she reasonably required for maintenance had been implemented by the execution of the authority and the trustees’ actions. Mrs Bennett had therefore adopted a pattern of expenditure in respect of the surplus income, and the payments to her sons were within the exemption.
Interestingly, a judge in the Bennett case (Lightman J) said: “for an expenditure to be ‘normal’ there is no fixed minimum period during which the expenditure shall have occurred”. He added 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”.
However, to reduce the possibility of arguments with HMRC, it may be wise to plan ahead. For example, HMRC accepts that a single gift (e.g. a payment under a deed of covenant) or other regular commitment (e.g. payment of the first of a series of premiums on a life policy) may be accepted as normal (www.hmrc.gov.uk/manuals/ihtmanual/ihtm14242.htm). See also ‘make it normal’ below.
Aside from the ‘normal expenditure’ condition, the other two exemption conditions must be satisfied as well. For example, the ‘out of income’ condition means that the gift of a capital asset (e.g. jewellery or shares) does not qualify, unless it was a ‘gift-in-kind’ bought out of income specifically with the intention of making the gift. Care is also needed if income fluctuates from one year to another.
The third condition (i.e. that the person making the gift should be capable of maintaining his or her usual standard of living from remaining income after making the gift) is applied at the time of making a gift. Thus a change in usual living standards due to reasons outside a donor’s control (eg redundancy) will not necessarily be fatal for exemption purposes, if an earlier commitment had been made when the surplus income was available. HMRC’s guidance gives the example of a donor having taken on a commitment to pay regular insurance premiums (initially affordable out of income), but later having to pay nursing home fees, which were unforeseen when the policy was taken out (www.hmrc.gov.uk/manuals/ihtmanual/ihtm14255.htm).
HMRC has published detailed guidance on the normal expenditure out of income exemption in its Inheritance Tax manual (at IHTM14231 and subsequent paragraphs), which can be accessed via HMRC’s website (www.hmrc.gov.uk/manuals/ihtmanual/IHTM14231.htm). This guidance does not carry the force of law, but it is helpful in terms of being aware of how HMRC defines the exemption conditions and seeks to apply them in practice.
Apart from being aware of HMRC’s approach, what other steps can be taken when making gifts and considering a claim for the normal expenditure out of income exemption? Possible action points include the following:
•Make it ‘normal’ – As mentioned, the gift must be part of the normal expenditure of the person making it. But what is ‘normal’? HMRC’s guidance indicates that it is possible for a single gift to qualify for the IHT exemption, if it is (or is intended to be) the first of a pattern, and there is evidence to that effect (www.hmrc.gov.uk/manuals/ihtmanual/IHTM14241.htm). There is no guidance on what evidence HMRC will accept, but (for example) setting up a regular standing order would seem a sensible step.
•Record gifts – Financial records of gifts, such as bank statements, will obviously help to demonstrate that payments have been made. In addition, documentary evidence that such payments were actually gifts would be helpful, such as a simple, signed ‘Gift Memorandum’ or letter to the intended recipient (remember to keep a copy). The document should confirm that the gift (and any similar gifts made) will leave the donor with sufficient income to maintain his or her usual standard of living.
•Keep Income and expenditure records – Some help is available in terms of documenting that gifts were made out of the donor’s surplus income – from HMRC! One of HMRC’s forms (Schedule IHT403* ‘Gifts and other transfers of value’) includes on page 6 a useful spreadsheet (‘Gifts made as part of normal expenditure out of income’), which could be used on an ongoing basis to record income, expenditure and surplus income each year.
HMRC guidance instructs its officers to obtain details of all gifts made over a reasonable period, details of the person’s net income over the relevant tax years, and details of the person’s usual living expenses for those years (IHTM14234). The following statement in HMRC’s guidance may be helpful to those seeking the exemption: “In borderline cases you should give the taxpayer the benefit of any reasonable doubt”.
*Schedule IHT403 is available from HMRC’s website: www.hmrc.gov.uk/inheritancetax/iht403.pdf