IHT Exemption: No Waiting Required!
Mark McLaughlin outlines an inheritance tax exemption for gifts, which might be particularly attractive to individuals wishing to make gifts without waiting for the normal seven-year period before gifts become exempt.
When it comes to tax reliefs and exemptions, one of the most generous is the inheritance tax (IHT) exemption for ‘normal expenditure out of income’. This is because the exemption is only limited broadly by an individual’s personal circumstances and the amount of surplus income available to give away.
Satisfying the conditions
The IHT exemption is for ‘normal expenditure out of income’ (IHTA 1984, s 21). An individual can benefit from the exemption to the extent that certain conditions are satisfied. These are broadly:
• 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 standard of living.
These conditions seem straightforward. However, in practice, everyone’s personal circumstances vary, and it can sometimes be difficult to determine whether the exemption is due. In addition, HM Revenue and Customs (HMRC) apply the rules rigidly, in accordance with its own interpretation of the legislation and case law.
No seven-year wait
If all the conditions are satisfied, the exemption can shelter significant gifts for IHT purposes.
Normally, where one individual makes a gift to another (e.g. father to daughter), the gift is a potentially exempt transfer (PET) for IHT purposes, which only becomes an exempt transfer if the donor survives at least seven years. By contrast, if the above exemption applies there is an immediate reduction in the donor’s estate; the seven-year waiting period does not apply (although HMRC may seek to establish whether the exemption conditions were satisfied if the donor dies within seven years and there is IHT at stake).
Example: Regular gifts to grandchildren
Freda is 80 years old. Her net income after tax is £54,000 per annum, comprising pensions and investment income. Freda lives a modest lifestyle and has been able to save a regular sum of approximately £2,500 per month (i.e. £30,000 per annum) for some time.
Freda makes regular gifts of £1,500 per month (i.e. £18,000 per annum), divided equally between her two adult grandchildren. Assuming HMRC accepts that the gifts were exempt as being part of Freda’s normal expenditure out of income, she could still make use of her annual IHT exemption (i.e. £3,000 for 2018/19) in respect of other gifts.
Is that ‘normal’?
What does ‘normal’ mean in this context? HMRC’s view (in its Inheritance Tax manual at IHTM14241) is: ‘It is possible that a number of gifts made by one person may not qualify. It is also possible for a single gift to qualify if it is or is intended to be the first of a pattern and there is evidence of this.’
HMRC will usually look for a pattern of giving over a ‘reasonable period’, which they would normally consider to be three to four years (IHTM14242).
However, it may be possible to establish a pattern of giving over a shorter period. For example, a standing order from the donor’s bank account, accompanied by a copy of a signed ‘gift memorandum’ or letter to the recipient confirming the first gift and the intention to make subsequent gifts by standing order, may be helpful evidence if a claim for the normal expenditure out of income exemption is likely to be made. HMRC does not necessarily equate ‘normal’ with ‘regular’ or ‘annual’, although gifts made on a regular basis are more likely to pass the normality test.
Is it income?
HMRC may also seek evidence that the ‘out of income’ condition is satisfied, such as where the donor’s income fluctuates from year to year. It may be possible to carry forward surplus fluctuating income from a ‘good’ year to a ‘bad’ year. However, claims to carry forward surplus income to enable gifts in later years may be challenged by HMRC, particularly surplus income which has arisen more than two years previously (IHTM14250).
It is important to distinguish surplus income from capital. For example, if an individual with a steady annual income of £50,000 made gifts of £250,000 in a tax year, HMRC would probably conclude that the gifts were not made out of the donor’s income or would not leave them with sufficient income to maintain their usual standard of living.
Good record keeping could be an important factor in claiming the normal expenditure out of income exemption. HMRC provides a useful form (IHT403) for donors in terms of helping to demonstrate that gifts were made out of their surplus income. The form IHT403 (‘Gifts and other transfers of value’) includes (on page 8) a spreadsheet to record income, expenditure, surplus income and gifts made out of the donor’s surplus income. The form is available to download from the Gov.uk website (tinyurl.com/HMRC-IHT403).
By Mark McLaughlin