The inheritance tax (IHT) exemption for ‘normal expenditure out of income’ is extremely generous. There is no fixed upper monetary limit; a transfer of value (e.g. a cash gift) is exempt to the extent that it satisfies the exemption conditions.
Furthermore, a gift that satisfies the conditions is immediately free of IHT. This is a big advantage compared to potentially exempt transfers, which require the person making the gift to survive at least seven years before it becomes an exempt transfer.
What are the conditions?
The exemption applies where the taxpayer can show that the gift satisfied three conditions:
- the gift formed part of their normal expenditure.
- it was made out of income.
- it left them with enough income for them to maintain their normal standard of living.
All three conditions must be satisfied for the exemption to apply.
Is that ‘normal’?
On the ‘normal’ condition, HM Revenue and Customs (HMRC) will usually want to see a pattern of giving over a ‘reasonable’ period, which they generally consider to be three or four years (see HMRC’s Inheritance Tax manual at IHTM14242).
However, a standing order from the donor’s bank account, accompanied by a copy of a letter to the recipient confirming the first gift and the intention to make subsequent gifts by standing order, might be helpful evidence that expenditure is ‘normal’ over a shorter period.
‘Good’ and ‘bad’ years
HMRC may also seek evidence that the transferor made the gift ‘out of income’, such as where their income fluctuates from year to year. It might be possible to carry forward surplus fluctuating income from a ‘good’ year to a ‘bad’ year.
However, HMRC could challenge claims to carry forward surplus income to enable gifts in later years, particularly surplus income which has arisen more than two years previously (IHTM14250).
Keeping up appearances
The third condition (i.e., maintenance of the transferor’s usual standard of living) broadly requires that the individual shouldn’t be obliged to realise capital assets (e.g., selling a family heirloom) to supplement their income.
Furthermore, a change in usual living standards due to reasons outside the donor’s control (e.g., upon redundancy or retirement) will not necessarily be fatal for exemption purposes.
Example: Regular gifts to offspring
Kathy, aged 80, has net income after tax of £48,000, made up of pensions and investment income. She leads a modest lifestyle and has been able to set aside a regular sum of £2,250 per month (i.e., £27,000 per annum), out of which Kathy makes regular monthly gifts of £750 each to her son and daughter (i.e., £18,000 per annum in total).
HMRC should accept that the gifts were part of Kathy’s normal expenditure out of income in those circumstances.
For record keeping purposes, individuals seeking to take advantage of the exemption might find HMRC’s form IHT403 helpful. This is one of the supplementary forms to accompany the IHT400 account on an individual’s death. It is generally used to inform HMRC of any gifts made by the deceased. Page 8 of the form contains a helpful spreadsheet to record income, expenditure, surplus income and gifts made out of the individual’s income in the previous seven years. Form IHT403 can be downloaded from the Gov.uk website (tinyurl.com/IHT403-HMRC).
The above article was first published by Business Tax Insider (February 2022) (www.taxinsider.co.uk).