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IHT Gifts Out of Income -Technical Paper
The ‘Normal Expenditure out of Income’ exemption from Inheritance Tax is set out in Inheritance Tax Act 1984 (The Act) Section 21 and states in paragraph (1):
“A transfer of value is an exempt transfer if, or to the extent that, it is shown-
- that it was made as part of the normal expenditure of the transferor, and
- that (taking one year with another) it was made out of his income, and
- that, after allowing for all transfers of value forming part of his normal expenditure, the transferor was left with sufficient income to maintain his usual standard of living”
Seemingly, on the face of it, this is a straightforward exemption, but as with all things tax related one needs to dig deeper to gain understanding. Three key questions arise from this section of The Act, namely:
- What is normal expenditure?
- What is income?
- What does ‘maintain standard of living’ mean?
Normal Expenditure
The principle case for examining normal expenditure is Bennet v IRC [1995] in which the judge (Lightman J) viewed that the term normal “connotes expenditure which at the time it took place accorded with the settled pattern of expenditure adopted by the transferor.”
The case judgement quoted the Oxford English Dictionary as defining ‘normal’ as “constituting, conforming to, not deviating from or differing from, the common type or standard; regular, usual”.
Lightman J summed up the requirement for expenditure to be seen as normal:
"What is necessary and sufficient is that the evidence should manifest the substantial conformity of each payment with an established pattern of expenditure by the individual concerned - a pattern established by proof of the existence of a prior commitment or resolution or by reference only to a sequence of payments."
Furthermore, he also referred to A-G for Northern Ireland v Heron (1959) 63 TR 3 where ‘normal expenditure’ was deemed to refer to the type, and not the amount, of expenditure.
This is important as it means each case has to be considered on its own merits relating solely to the transferor and not ‘the common man’. As such what may be normal for one individual may well not be normal for another.
Cross referencing to Her Majesty Revenue and Customs (HMRC) Inheritance Tax Manual (The IHT Manual), Section 14243 also looks at this first condition and clearly shows that clients can rely on the outcome and ruling of Bennet v IRC in establishing what is normal expenditure for their own circumstances.
Equally importantly, the same section states that any challenge to the view of Lightman J or the way this has been applied will be referred to HMRC’s Technical Department. This implies a greater degree of scrutiny would be applied by HMRC to any gift out of normal income exemption claim where a different view on what constitutes normal expenditure is taken.
Commentators on the use of this exemption frequently refer to the requirement for regularity and that this is seen as being at least on an annual basis. However, looking at the IHT Manual (section 14244) it is clear that this is not the case and indeed The Act makes no reference to timescales as regards regularity.
Also, in Bennett v IRC, the High Court held that if it were proved that the transferor had a settled intention to make regular gifts for a long period of time, it was not necessary that transfers had in fact been made over a long period.
Section 14244 of the IHT Manual states that ‘normal does not mean “regular” or “annual”.’ By way of example if a transferor was in the habit of making a large gift (out of income) on the occasion of nephews and nieces attaining their 21st birthday then this could be seen as being normal under The Act and HMRC’s interpretation. (www.hmrc.gov.uk/inheritancetax/pass-money-property/exempt-gifts.htm#3)
So, from this, it is clear that for expenditure to be seen as ‘normal’ there must be a settled pattern of giving, so that for example a one off gift, never to be repeated, will fall outside of the relief.
In effect there must be a commitment, which does not have to be legally binding, provided that there is evidence of an intention to make regular payments over a period of time.
What is Income?
Most types of income are clear that they are income - building Society interest; dividends from shares; pensions; income from employment etc. However, it is important to be aware that merely because a source of revenue to an individual is taxable to income tax does not, in itself, make it income. This is particularly important where the source of any gift arises from regular payments out of a single premium insurance bond or indeed the maturity proceeds of an endowment.
Whilst both of these are taxable to income (with the endowment most frequently being exempt from any additional income tax liability) the payments are not income but are capital receipts and as such cannot be used to fund any gifting which is then claimed to be exempt under the normal expenditure exemptions.
It is equally important to be aware that income from an annuity is not necessarily income in the true sense. A Purchase Life Annuity will provide an income to the recipient of which only part is income – the other is return of capital. Thus, only the interest (taxable) portion can be used as income for this exemption.
In addition a particular transaction which links the purchase of an annuity to the funding of a life policy (commonly known as a back-to-back arrangement) is specifically disallowed for the purposes of this exemption unless the two transactions can be seen to be separate. This is typically done by the annuity provider and life policy providers being different but most importantly the life policy must be fully underwritten and provided on terms which are irrespective of the purchase of the annuity.
There is also an important consideration in respect of income which has accumulated over time. The question here is whether or not accumulated income becomes capital at some point in the future.
In (2003) Sp C 382 – McDowall’s Executors v IRC the case looked at the issue of accumulated income (and whilst not rigorously tested) the decision stated that accumulated income which had not been reinvested or used elsewhere retained its income character. Thus income which is identifiable as unspent and placed on deposit retains its income characteristic.
Equally legitimate sources of income for use with this exemption may not be taxable (and, hence, not show on a clients annual self assessment tax return). An example of such a source would be investment or savings income from an Individual Savings Account.
Income is generally taken to be that assessed under ‘normal accountancy rules’ and as such is taken to mean net of tax income.
Maintaining Standard of Living
Section 14251 of the IHT Manual says that for the standard of living criteria clause under The Act to be met then ‘after allowing for all gifts forming part of their normal expenditure the transferor must have been left with enough income to maintain their usual standard of living. Even gifts out of income will not qualify for exemption if the transferor had to resort to capital for living expenses’.
In addition the Manual says that the test against the standard of living is that prevailing at the time of the transfer and subsequent lowering of a standard of living due to extraneous reasons such as loss of employment would not preclude the allowance of the exemption.
When Does the Gift Occur
A gift occurs once there has been a transfer of value from the donor’s estate. This may be particularly relevant in the case of cheques being used as the method of making the gift. In this case it is the date on which the cheque clears the payee’s bank account which is the relevant date of the transfer. (Re Owen (deceased); Owen v IRC [1949]).
Making the Claim
Whilst all of this gives guidance as to what a gift out of income needs to be in order to qualify for the exemption, in order to advise a client on what actions they should take to enable a claim for such an exemption it is important to consider how a claim is made.
As this is an exemption from IHT during a donor’s lifetime it is not until the donor is deceased that an actual claim is made. Thus it is the executors who will make the claim. (I am assuming that if advice is being given to a client about gifts out of income then they will (a) have an estate large enough to give rise to an IHT liability and (b) have a valid Will in place.)
The HMRC Inheritance Tax Account form IHT 400 requires (via question 30) form IHT 403 to be completed to claim exemption from IHT for all gifts.
This creates two possible problems for executors. Firstly, are they aware from the estate paperwork that gifts have been made, and if so that they meet the gift out of income exemption requirements? Secondly, in respect of Section 20, 21 and 22 of IHT403 are they able to provide the income and expenditure information requested?
Referring to these sections of the IHT 403 it is clear that for Executors to successfully make a claim for gifts out of income they will need access to a great deal of information going back potentially a full seven tax-years, and possibly longer.
Advising Clients
Having established the criteria for a gift out of income exemption, and also having considered how a claim is actually made it is now possible to combine this into actual practical advice for a client.
This seems to fall into 4 areas.
1. Establishing the criteria for a regular gift.
2. Establishing that the gifts are being made out of excess income
3. Establishing that the clients standard of living is unaffected by these gifts
4. Providing sufficient documentary evidence for the client’s executors to use to make a successful claim for the exemption.
Meeting Criteria for Regular Gift
Advisers will need to establish with the client what it is they wish to achieve and what the relevant ‘qualifying criteria’ might be for a gift.
Where a life policy is being held in trust then the creation of the life policy and the consequent requirement for the payment of regular premiums to maintain that life policy would seem to be sufficient confirmation of intent.
It would be useful for the donor to also write a letter to the trustees of the policy advising them that it is their intention to continue to pay the relevant premiums on the policy for the life of the policy or client.
Indeed where there is any element of regular gifting to a trust (whether that is to fund a life policy or an investment) it would be advisable for a letter to be sent from the donor to the trustees laying out their intentions as regards ongoing future payments.
This documentary trail would provide the ‘proof’ of intent to make regular gifts and is clearly a straightforward process for those gifts where the occurrence of the gift is known (e.g. to meet a monthly premium / investment requirement).
Where a series of gifts are to be contingent upon a future event then this requires more thought. For example, if a client intends to make a gift to their children on their attaining their 25th birthday then it is important that there is some sort of commitment given on the first occasion that this gift is to be repeated with siblings.
Again, a paper trail is going to be helpful. In making the gift, a covering letter to the recipient explaining that the reason for the gift is the attaining of the child’s 25th birthday and that it is also the intention to repeat this exercise in respect of all siblings then this provides an indication of intent. A copy of this letter should of course be kept with other estate papers.
It will also be important to ensure that the claim for a gift out of income exemption for IHT is necessary. This would be not only because of the size of the estate but also to ensure no other suitable exemption is available for what the client is intending.
Clients might also be advised to send copies of these letters to their own inspector of taxes as a record of intent, but there is no guarantee that this will support any future claims as HMRC will not provide any prior acceptance of an IHT relief claim.
Meeting Criteria for ‘out of income’ and ‘standard of living’
The criteria for the gift to be from surplus income and also for the client’s standard of living not to be compromised are, in my view, linked with regards to establishing the necessary proof.
Clearly the client needs to be able to prove that they do have excess income with which to make the gifts (as opposed to being able to afford to make the gifts because they have surplus capital).
Reviewing the format of the IHT 403 form (Section 20, 21 and 22) a client should be advised to put together the necessary records to be able to complete these sections in as much detail as possible. Rather than merely complete the sections with actual totals it would be advisable to provide all the underlying detail. This evidence could be further supported by retaining copies of annual self assessment returns which will confirm annual taxable income but will not confirm any additional non taxable income arising from sources such as Individual Savings Accounts. This should be recorded as well.
The collating of expenditure information is, in my experience as a financial planner, generally much more difficult. Whilst clients will have a reasonable idea of their main household bills such as mortgage / rent; utilities and general insurance through checking their direct debit lists on their bank accounts they tend to have less idea of how much is actually spent on essential living items such as food and clothing.
It is, therefore, important to spend time with a client working through their expenditure budget. Utilising the services of a Certified Financial Planner (CFP) may well be beneficial at this stage. A CFP will be conversant with generating client based cash flow forecast and income / expenditure statements and an experienced CFP will understand the types of expenditure one would normally expect to see and also if the amounts the client believes they are spending are reasonably accurate.
It is surprising how many clients forget that they have running costs for cars and how little they think they spend on food and clothes.
A robust quick test of an income / expenditure analysis is to break it down on a monthly basis and from this establish how much a client’s bank account balance should be increasing by each month. This should equate to the excess income from which the proposed gifts are to be made.
It is also important to be aware that as we have (and continue to be) an increasingly cashless society there is a strong paper trail through client bank records of what expenditure is being made by a client. HMRC can (and do) ask for copies of bank statements – sometimes going back many years – when reviewing an estate return. From this it is not too difficult to put together a picture of income and expenditure and it is important that this matches to a reasonable degree what is being claimed on the IHT403.
The conclusion from this is that it is important for a client to endeavour to be as accurate as possible in compiling records for their executors.
A client should be advised to complete a draft IHT403 at the time the first gift is made and to update it each year thereafter, on a tax year basis.
Whilst gifts made over 7 years prior to the death of a client will automatically fall out of the estate for IHT under the potentially exempt transfer rules this does not mean that records should be destroyed once a 7 year period has elapsed. This is because the longer the set of records available the clearer the evidence will be that there has been a regular commitment to make the relevant gifts as well as providing evidence that a clients standard of living has been maintained.
Conclusion
In summary then, in order for a client to achieve the best possible opportunity for their executors to make a successful gift out of income exemption claim then the client should be advised:
- Establish and document clearly the basis of making a regular gift.
- Ensure that the done understands that a gift is part of a regular series of gifts (even where the donee is only receiving one payment) and provide the done with written confirmation of this.
- Ensure that the client compiles (and retains) documentary evidence to support the income their income and expenditure and records this on a draft IHT403.
- Ensure that the client keep copies of all these records with their estate paperwork.
By implementing these actions the client can ensure that their executors are fully aware of the regular gifts and have the necessary proof to enable them to make the gift out of income exemption claim on behalf of the estate, which is the purpose of giving this advice to the client.
Reference Sources
Inheritance Tax Act 1984
Bennet v IRC [1995]
A-G for Northern Ireland v Heron (1959) 63 TR 3
HMRC Inheritance Tax Manual (http://www.hmrc.gov.uk/manuals/IHTmanual/index.htm)
IHT403
Tolleys Tax Guide
Halsburys Law of England Vol 24
