Normal expenditure out of income exemption
Section 21 of the Inheritance Tax Act 1984 deals with the normal expenditure out of income exemption.
If a gift (or, more precisely, a ‘disposition’) is exempt, then for IHT purposes it is irrelevant whether or not the donor survives for seven years.
For the exemption to apply, it must be shown that a transfer of value meets three conditions:
- It formed part of the transferor’s normal expenditure
- It was made out of income (taking one year with another), and
- It left the transferor with enough income to maintain his/her normal standard of living
Note that part of a single gift may qualify for the exemption.
It is necessary to consider these three conditions in turn.
What is meant by ‘normal’?
HMRC raise the following points.
- The dictionary definition includes standard, regular, typical, habitual or usual. For these purposes ‘normal’ means normal for the transferor and not for the average person. All relevant factors must be considered (i.e. frequency and amount, the nature of the gifts, the identity of the recipients and the reasons for the gifts).
- Normal does not necessarily mean regular or annual although gifts made on a regular basis are more likely to meet the normality test.
- It is possible to make a number of gifts which do not qualify, and it is also possible to make a one gift which does qualify (if it is, or is intended to be, the first of a pattern and there is evidence of this).
- A gift clearly made for some special purpose does not qualify.
- There is no set time span to establish a pattern of giving although three to four years would normally be reasonable in the opinion of HMRC (though see the Bennett decision below).
- Where a single gift is made close to death, HMRC will require strong evidence that the gift was genuinely intended to be the first in a pattern and that there was a realistic expectation that further payments would be made. A single gift by way of regular commitment, such as payment of the first of a series of premiums on a life policy may be accepted as normal.
- Gifts must be comparable in size. HMRC do however recognise that gifts may be made by reference to a source of income which is itself variable e.g. annual dividends from company shares. Similarly, gifts may relate to specific costs such as grandchildren’s school fees which may also vary in amount.
What is meant by gifts made out of income?
HMRC raise the following points.
- A gift of capital assets such as jewellery or shares does not qualify unless it was specifically purchased by the donor from income with the intention of making the gift.
- Income is not defined in the IHT legislation but should be determined for each year in accordance with normal accountancy rules. It is not necessarily the same as income for income tax purposes. Income is the net income after payment of income tax.
- Common sources of income are employment and self-employment, rents from property, pensions, interest and dividends. Payments received regularly may appear to be income but are in fact capital in nature. An example would be receipts from a discounted gift trust. Similarly, 5% withdrawals from an insurance bond would be capital.
- HMRC will initially look at the income of the year in which gifts were made to establish if there was 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 this point is. If there is no evidence to the contrary, HMRC consider that income becomes capital after a period of two years. Each case will depend on its own facts but, in general, the longer the period of accumulation, the more likely it is that the income has become capital (this matter was considered in the case of McDowall outlined below).
- If there is a claim that the exemption applies on gifts made out of several years of accumulated income, then HMRC consider this a contentious area.
What is meant by maintaining a normal standard of living?
HMRC raise the following points.
- Gifts out of income will not qualify for exemption if the transferor had to resort to capital to meet normal living expenses.
- HMRC will ignore gifts that are not part of the transferor’s normal expenditure and test the condition as if such abnormal gifts have never been made.
The leading case is Bennett and others v Inland Revenue Commissioners  STC 54. In very broad terms, the details were as follows:
July 1964 – Mr B died leaving shares in a family company to a will trust. Mrs B who lived modestly was entitled to income for life.
Period to November 1987 – gross income of the trust fund was approx £300 p.a.
November 1987 – trustees sold the shares for a significant sum. Thereafter the income of the trust increased enormously.
Late 1988 – Mrs B decided that for the rest of her life she wanted her sons to have the surplus income beyond the limited periodic payments she required. She instructed her solicitor to prepare a legal document.
January 1989 she executed a document “I hereby authorise and request you as Trustees to distribute equally between my three sons … all or any of the income arising in each accounting year as is surplus to my financial requirements of which you are already aware.”
What happened next?
Trustees provided Mrs B with her payments & made distributions to her sons.
1988/89 – £9K was paid to each of the three sons (though trust income considerably exceeded that)
1989/90 – £60K paid to each of the sons (again trust income was higher)
The reason for the limited payments to the sons was that the trustees adopted a prudent approach which involved finalising accounts and agreeing tax liabilities before distributing surplus income.
February 1990 – Mrs B died suddenly and unexpectedly.
HMRC stated that the gifts of £9K and £60K did not qualify for the normal expenditure out of income exemption of Mrs B.
The normal expenditure out of income exemption applied because 1. 2. & 3. were all satisfied regarding each gift
The judge summed up the requirement for expenditure to be 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.”
A more recent case is McDowall and others (executors of McDowall, deceased) v Commissioners of Inland Revenue and related appeal  STC(SCD) 22.
This is useful as it considered the second condition that a gift is made out of income.
The gifts in question were made under a power of attorney and the first set of appeals was unsuccessful because it was held that the attorney had no power to make the gifts. The Special Commissioners though made a decision in principle on the second set of appeals that the gifts, if validly made, would have been normal expenditure out of income.
The deceased’s Attorney had made five payments of £12,000 to each of the deceased’s five children from the deceased’s current account. It would appear that the money had been accumulated in a deposit account over a period of about three years before its transfer into the current account.
The Special Commissioners concluded that the gifts were made out of income and that they were exempt. This turned on their view that ‘it was identifiably money which was essentially unspent income and not invested in any more formal sense’. It was also important that the Attorney had considered the matter and had taken the view that the payments were being made out of income. Other gifts had also been made but were not regarded as gifts out of income.
Note that this decision does not provide authority that all income which has not been formally invested retains its character as income indefinitely.
When carrying out IHT planning with surplus income then it is paramount that the exemption is considered. For the avoidance of doubt, expenditure will include income tax and all regular expenditure of an income nature (but not capital expenditure such as a home extension). Where the exemption is used over a number of years, it does not matter if in one of those years there was a deficit so long as ‘taking one year with another’ there was a surplus and gifts were made out of that surplus. Expenditure need not be fixed and the recipient need not be the same on each occasion. In addition, the amount of the gift may be fixed by a formula, e.g. a percentage of earnings.
Areas to be aware of? The capital element of a purchased life annuity is not regarded as income for the purposes of the exemption. Likewise, where an individual purchases a single premium ’care’ plan where the provider pays periodic care fees direct to the nursing home, then HMRC view is that these payments are likely to be a return of capital and not income. Also, if an individual pays life policy premiums and purchases an annuity linked in a ‘back-to-back’ arrangement, then the gifts by way of payment of premiums on the policy are excluded from the exemption.
A record should be kept each tax year to provide the necessary evidence in case of death within the following seven years.
HMRC helpfully provide a pro forma:
Two ways in which the exemption might be used.
- Payment of pension contributions for family members.
- The tax benefits are discussed here: http://www.pruadviser.co.uk/content/knowledge/technical-centre/pensions_iht_planning/#1
- Client places an insurance bond in a discretionary trust then uses the exemption to make further (exempt) gifts into trust in order that the trustees may increment the bond. Rather than chargeable lifetime transfers (CLTs), the client would be making exempt gifts into discretionary trust.
Source: Graeme Robb – Prudential