Inheritance tax and normal expenditure out of income

Gifts out of income

The exemption under S21 Inheritance Tax Act 1984 will apply if it can be shown that the gift: 

1. formed part of the donor’s normal expenditure,
2. was made out of income, and
3. left the donor with enough income for them to maintain their normal standard of living. 

What is normal expenditure? 

Normal expenditure is not defined in legislation and therefore takes its natural meaning. HMRC Inheritance Tax manual outlines the dictionary definition of normal which includes standard, regular, typical, habitual, or usual.  
 
Normal means normal for the donor, rather than an average person. This means that there is no limit on the exemption, provided the donor has sufficient income.  
 
Legalisation doesn’t dictate a minimum number of gifts or period over which gifts must be made. Normally it will be clear whether there is a pattern of giving, but it is not always that simple. HMRC guidance states that a reasonable period would normally be three to four years. The manual adds that a longer period can be considered if this helps the donor to demonstrate that gifts were part of a normal pattern. 
 
In the leading case, Bennett and others v IRC 1995 referenced at IHTM14244 the court identified that a pattern could be established in one of two ways:  

• by examining the donor’s expenditure over time; for example, giving 10% of income to charity or family members each year, and
• the donor being shown to have assumed a commitment, or adopted a firm resolution, regarding their future expenditure with which they have then complied. 

Provided the donor can show that their intention is “a pattern of gifts” and there was evidence that further payments would be made a single gift may qualify. 

What does “made out of income” mean? 

Gifts must be made out of net income and not capital. Income is not defined in legislation and doesn’t follow what is defined as income for income tax. Instead, it’s determined for each year in accordance with normally accountancy rules. This means that certain income which isn’t subject to income tax may still be covered by the exemption.  
  
It is usually clear whether payments received are income in nature. Common sources of income are: 

• Employment income (salary).
• Self-employed income.
• Pension income. 
  • Income from pension annuities and defined benefit schemes.
  • Withdrawals from flexible pensions, excluding the tax-free cash element.
• Rental income.
• Savings income.
• Dividend income.
• ISA income. 

It is possible that payments received on a regular basis may appear to be income but are in fact capital. Withdrawals from investment bonds, whilst subject to income tax, are classed as returns of capital.  
 
When considering the payments from a purchased life annuity, HMRC allows part of each payment to be treated as a return of capital. Therefore, only the difference between the payment and the calculated return of capital will be classed as income.  
 
At some point HMRC determines that accumulated income becomes capital. There is no fixed rule on when this occurs but HMRC’s guidance states “we consider that income becomes capital after a period of two years.” (IHTM14250) 
 
However, each case depends on its own facts. Factors to be considered include the amount of time the income has been held before being gifted, the method of accumulation and the donor’s actions. In McDowall and others it was found that the exemption could, in principle, apply to gifts that were made from income that was accumulated for three years before the gifts were made. 

What is "normal standard of living"? 

The donor must be able to maintain their normal standard of living after making the gifts. This means that this condition is intricately linked to the “made out of income” condition as you need to consider whether after the donor’s usual expenditure there is surplus income left to make the gifts. 
 
When considering the donor’s normal standard of living you look at when the gift was made and establish: 

• whether the donor could meet their normal living expenses from their income which would be left after considering the gift made in that year, and,
• if not, if they could do so by taking one year with another. 

This means the exemption may still be available following a change in the donor’s lifestyle, for example, redundancy or retirement. 
 
HMRC’s approach is that commitments made before a change in circumstances may continue to qualify. For example, if the donor took on a commitment to pay regular insurance premiums but later in life needs to be pay nursing fees, continuing to pay insurance premiums which must now be paid from capital doesn’t necessarily mean the exemption is lost. But if the fall in income is foreseen the exemption will not apply. 

Factors to consider 

When determining whether the exemption is available HMRC’s approach is to consider all relevant factors.  

Frequency 

Normal does not necessarily mean regular or yearly, though regular giving is more likely to meet the normality test. HMRC’s manual suggests that averaging the yearly amount of the donor’s gifts of a particular type will help when considering this point. 

Amount 

Gifts should be comparable in size, though small variations in amounts are allowable. Sometimes gifts may relate to costs that fluctuate (for example, school fees) or where gifts are made from an income source which varies in size (for example, company dividends).  
 
It is also possible for a gift to be partially exempt, in which case the excess amount of the gift will either be chargeable or exempt.  

Nature of the gifts 

Usually, the gifts will be money since gifts must be out of income for the exemption to apply. But a capital asset purchased out of income could qualify (for example, purchasing a car for a donee).  

Identity of donees

Gifts don’t always need to be made to the same person. Regular gifts to family members or charity organisations may be exempt. For example, gifts totalling £5,000, each year, could be given to grandchildren with the amount given to each individual grandchild varying each year. 

Reasons for the gifts 

The reasons for making gifts can indicate whether a gift falls within a pattern of habitual giving. A donor may make regular gifts to their family but not every gift within that category may be eligible for exemption. For example, a large one-off gift to a child to set-up a business is different from regular birthday gifts to children. 

When the exemption doesn’t apply 

HMRC’s Inheritance Tax manual offers guidance on when the exemption won’t apply:

• Transfers made on death.
• Transfers on the termination of a qualifying interest in possession settlement.
• Deemed potentially exempt transfers, such as when a gift with reservation ceases to be subject to a reservation.
• Apportionments made to individuals under the close company apportionment rules in Inheritance Tax Act 1984 s 94.
• Gifts of capital assets unless, exceptionally, income was used to fund the gift (see above). 

Also, if the donor is using an annuity to pay the premiums on their life policy if the policy and annuity are found to constitute a back-to-back arrangement, the payment of the premiums, from the annuity income, will not be regarded as normal expenditure from income. (Inheritance Tax Act 1984 s 21(2)-(4)). 

Record keeping 

As the claim for the normal expenditure out of income exemption is made on death records of income, spending patterns and gifts made should be kept.  
 
HMRC form IHT403 includes a detailed schedule which can be used to log gifts as they are made. This can then be used to support the claim. 
 
Additionally, in the case of McDowall and others it was noted that where gifts are made from accumulated income, supporting evidence is required for HMRC to accept the exemption applies. 

What are the reporting rules? 

As the exemption is not determined until death it should be assumed that, for the relevant reporting limits, the exemption doesn’t apply. That means in any seven-year period if these regular gifts from surplus income when added to any chargeable lifetime transfers made exceed the donor’s nil rate band, IHT100 is required. HMRC will review and confirm whether the exemption will apply to the regular gifts.