Make the most of a valuable IHT exemption

December 24th, 2012

Exemptions from inheritance tax (IHT) on gifts made during lifetime can take various forms but the great appeal of making exempt gifts is that they fall immediately outside the donor’s estate for IHT (and, as such, the usual seven year waiting period does not apply).

Some of the most common exemptions are the £3,000 annual exemption, the £250 small gifts exemption, and gifts between spouses which, irrespective of the size, are also exempt if the spouse receiving the gift is UK domiciled.

However, one very useful exemption that you may be less familiar with is the ‘’normal expenditure out of income’’ exemption.

The ability to make regular IHT exempt gifts out of income can be a highly effective method for reducing the taxable value of an estate and is likely to be of most use if you have surplus income.

Some possible uses of this exemption might include:

  • Paying regular premiums to an investment written in trust
  • Paying regular premiums to a life assurance policy, such as whole of life or term assurance, written in trust.
  • Funding someone else’s ISA (although because the ISA holder has to make the contribution, the money may have to be gifted to them first before it is invested)
  • Making a payment to a Third party’s pension (subject to contribution limits); or
  • Paying costs for another such as grandparents looking to provide for their grandchildren’s education fees.

In order to qualify for this exemption though, three criteria must be met:

It must be made out of income – not capital
It must be a regular gift; and
It must not reduce the standard of living of the donor

We will now consider each of these in turn.

Income

Although not defined in legislation, the usual interpretation for this purpose is income which has been subject to income tax with the most common examples being surplus income from earnings, pensions or bank interest.

It is important to remember though that the capital element of a purchased life annuity and the yearly 5% withdrawals from an investment bond do not satisfy the ‘out of income’ requirement and should not be used to ‘replace’ income to maintain the standard of living of a donor either.

Regular gift

The normal expenditure out of income exemption requires that gifts must form part of a habitual pattern of gifting. This can be shown from the history of gifts actually made by the donor or, alternatively, where there is no such history, the exemption may still be claimed where it can be shown that the donor had made a commitment or resolution to future gifting (for example, by taking out a regular premium 10 year term assurance policy written in trust). HMRC will typically look at a period of at least three or four years to establish a regular pattern of gifting using this exemption.
Usual standard of living

This is another subjective test but the important point here is that after allowing for all regular gifts that form part of their normal expenditure the donor must be left with sufficient income to maintain their usual standard of living.

So, for example, if someone has net ‘after tax’ income of £70,000, but only £50,000 is needed to maintain their usual standard of living, this leaves surplus income of £20,000 that can be gifted each year using this exemption.

The exemption will not be available if the donor has to resort to capital to maintain their usual standard of living.

Interaction with other exemptions

Where the donor is making a number of gifts, the normal expenditure out of income exemption will apply before the marriage exemption and before the annual exemption.

So, using the same example above, if someone has spare ‘after tax’ income of £20,000, but they want to make a gift to their son of £23,000 on his birthday, the balance of £3,000 could  be covered by the annual exemption.
What can go wrong?

Because this exemption is claimed retrospectively by the donor’s personal representatives, after they have died on IHT form 403 – and given that this form asks for some detailed information – it is strongly advised that the donor maintains a record of all gifts made using this exemption, together with details of their income and expenditure as insufficient records when requested may invalidate the exemption.

In addition, and unlike outright gifts or gifts into absolute (bare) trusts, the position for gifts into discretionary trusts and (since 22 March 2006) interest in possession trusts is not straightforward. This is because gifts of cash to these types of trusts have to be reported to HMRC if the donor’s available nil rate band is exceeded – and this will normally result in the trustees having to pay IHT at the lifetime rate of 20% on the excess.

HMRC have stated, however, that “Where denial of the exemption would mean that there is a liability to IHT, an account should be delivered so that the availability of the exemption can be agreed.”

So, if the value of the current transfer (gift) when aggregated with all other chargeable lifetime transfers made by the donor in the previous seven years exceeds the nil rate band (currently £325,000), an account should still be delivered to HMRC – although as long as the exemption is subsequently agreed, there should then be no lifetime IHT to pay on the transfer in question.

Levels and bases of and reliefs from taxation are subject to change and their value depends on the individual circumstances of the investor