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Reduce Inheritance Tax

Don’t miss out on this “gift” of a valuable Inheritance tax (IHT) relief

It is surprising that one of the most valuable exemptions from IHT is also one of the most underused. The normal expenditure out of income exemption applies to gifts, which is usually cash but in some circumstances it can be chattels bought from income, which a donor makes during their lifetime. It is limited in amount only to the extent of a donor’s (net) surplus income.  When used alongside the IHT £3,000 annual exemption, it provides a useful tool to immediately place assets outside of a donor’s estate. 

Provided that a donor satisfies three qualifying conditions, there is no need to wait the seven years for this type of gift to be exempt for IHT purposes. 

Here are the qualifying conditions in more detail
For the exemption to apply, it must be shown that the gift satisfies all of the following criteria:

Made as part of the normal expenditure of the donor

The Revenue’s interpretation of this requirement is that gifts should form part of a regular pattern of payments. Alternatively, the exemption could be available where it can be shown that the donor had made a firm commitment regarding future expenditure. Advice here would be to document your intention with a letter to the intended recipient or their parent/guardian.

Examples of regular gifts could include Christmas and birthday gifts, annual family holiday, Insurance policy premiums, education costs, private healthcare arrangements and so on.

Sufficient income must remain to maintain the donor’s standard of living

Whether a gift is out of income is a subjective test.  The amount of made income, and any available surplus to allow gifts to be made, will vary depending upon the particular circumstances of the donor throughout their life. It is advisable that an income and expenditure analysis is prepared to ascertain the true position annually.

Gifts must be made out of income

The exemption only applies where expenditure is from surplus net taxable income. 

Care must be taken where income has been accumulated. Ideally, income should be identified in the year in which gifts are made to ascertain if there is enough income available to make the gifts, before considering earlier years. 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 that point is. HMRC considers that income becomes capital after a period of two years, although each case will depend upon its own facts. Examples of income include: salary, dividend income from shares, unit trusts, OEICs and investment trusts, interest paid on bank and building society accounts, interest from gilts and corporate bonds, pension income, rental income, self employment/partnership profits.

Here’s an example

Mrs Mercer had total net income (after tax) of

  2010/11 2011/12 2012/13
Net Income (after tax) 120,000 130,000   90,000
Regular Expenditure   75,000   75,000   75,000
Surplus Income   45,000   55,000   15,000

Mrs Mercer wishes to gift her surplus income to her children; Bill, Ben and Alice. This would immediately remove £115,000 from her estate for IHT saving approximately £46,000.

Mrs Mercer’s surplus net income has fluctuated year to year, which does not preclude her from meeting the qualifying conditions of exemption. The value of regular gifts does not have to be fixed, or even need to be made to the same donee each time. The amount gifted may be fixed by a formula such as a percentage of earnings or a figure such as “what is left over after paying the certain expenditure”.

It would be considered good practice for Mrs Mercer to write a letter to her chosen donee(s): “I have surplus income and it is my intention to let you have a cheque for this every Christmas.”  Documentation such as the income and expenditure analysis and letters to donee(s) always help when completing any forms required by the Revenue.

As with most IHT-related gifts, a donor must not receive any future benefit, either directly or indirectly, in order for the gifted amounts to fall outside of their estate.

Established case law is helpful to us in knowing pitfalls and problem areas to be avoided, see the three examples to the right of this page.

Summary

As long as a donor has the excess income available and can maintain appropriate records, the regular gifts out of income exemption can provide an important tool for reducing exposure to IHT liabilities.  If you are keen to talk about whether this exemption could work for you and your family, please get in touch with your usual contact.

Bennett [1995]

Established that a single payment can qualify if evidence of intended regularity can be shown, although in this case payments had been made for two years. Normal expenditure is to mean normal for the transferor and not typical of the average or reasonable man.

Nadin [1997] 

Where a deficiency of income over expenditure before gifts ruled out a claim for one year and the lack of evidence of commitment or resolution and lack of a pattern barred exemption for previous years. The gifts of cash in that case had been entirely irregular in time and amount.

McDowall [2004]

Concerned gifts made from excess income by an attorney wherethe transferor lacked capacity.There was no power to make thegifts and the right to recoverthem formed part of the estate.

 

 

Date: 25th July, 2013
Author: Liz Cuthbertson

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