RegulationJun 24 2016

Hitting a moving target

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He may be an unlikely culprit but Napoléon Bonaparte is partly to blame for inheritance tax (IHT). The first type of death duty dates all the way back to 1694, but later, in 1796, a further tax on estates was used to help fund the war against Napoleon’s France.

This brief history lesson could make IHT seem like a quaint relic from a long-forgotten age, but more than 200 years later it is still a great earner for HM Treasury. The government looks set to collect around £30bn from estates over the next six years alone.

Napoleon was unlikely to be thinking of estate planning when he said, “Victory belongs to the most persevering”, but regular reviews are the only way to ensure plans that are in place today meet tax planning objectives tomorrow.

It is rare that an estate plan will involve just one solution. The impact of IHT on an estate can be reduced today, but plans also need to deal with rising asset values. Excess income also needs to be taken into account to avoid accumulation and exacerbation of the IHT problem.

This is where the gifts from surplus income exemption – which is widely underused – come in.

Gifts from surplus income

A gift will benefit from a full and immediate IHT exemption if, or to the extent that, it complies with certain conditions, namely:

– The gift was part of the normal expenditure of the transferor;

– That, taking one year with another, it was made out of his or her income;

– That the transferor was left with sufficient income to maintain his or her standard of living.

Normal expenditure

The question of whether a gift forms part of an individual’s normal expenditure will depend on the facts and circumstances of each case. For example, someone with a modest income, but low expenditure and frugal tastes may be able to give a fairly high percentage of their income away.

A person with a substantially higher income, but larger commitments may be unable to make any gifts out of their income without reducing their standard of living.

A single payment may qualify where a pattern of continuity is established. For example, the first contribution under an insurance policy, or any payment made under a contractual obligation would indicate an intention of regularity. If there is no such evidence, but further similar gifts are made, the first gift of the series can qualify retrospectively for exemption.

You should note that normal does not mean regular or annual.

In Bennett and others v Inland Revenue Commissioners (1995) it was held that the term ‘normal expenditure’ denotes expenditure which, at the time it took place, was in accordance with the settled pattern of expenditure adopted by the transferor. The existence of such a settled pattern might be established in one of two ways: either by reference to a sequence of payments by the transferor out of past expenditure, or by proof of a prior commitment or resolution adopted by the transferor regarding their future expenditure.

The exemption is unlikely to be available for individuals who are gravely ill. In the Bennett case, the judge indicated that normal expenditure should be in accordance with the settled pattern of expenditure adopted by the donor.

A deathbed resolution to make periodic payments for life, and a payment made in accordance with such a determination, will not satisfy the exemption.

Out of income

It is generally understood that out of income means after tax and includes income from Isas. The capital element of purchased life annuities is not regarded as income so it does not qualify.

The exemption is granted to the extent that surplus income is available. For example, when an individual is paying large contributions to a life policy or regular premium unit trust that in its entirety would not qualify, the exemption can apply to a proportion of the contributions.

Additionally, if an individual has established a pattern of regular gifts out of income, but falls on hard times, HM Revenue and Customs is unlikely to reassess previous exemption claims.

Also, if or when the pattern of regular gifting recommences, it could be considered in conjunction with the previous pattern.

In order for the ‘maintaining the standard of living’ condition to achieve the exemption, the individual should be left with sufficient income to continue their lifestyle, and not be obliged to realise capital assets in order to supplement his or her income.

Withdrawals from investment bonds are treated as a return of capital despite gains being assessed with reference to income tax. Therefore the exemption cannot be used where the individual uses bonds to fund their everyday expenditure.

The normal expenditure out of income exemption can be also applied to income taken from an Isa portfolio.

Should this income accumulate, ultimately it will be subject to IHT once the nil- rate band is exceeded, so it makes sense to deal with this accumulated income head on.

Prior to the pension freedoms, gifting income from an income drawdown worked selectively.

However, now IHT almost never applies to pensions, and income tax only applies to deaths after the age of 75, this strategy is less valuable.

Unlimited gifts

Gifts from normal expenditure have no caps or limits at all. HMRC accepts that these can be gifted IHT-free on the basis that they would normally have been subject to some form of taxation.

Gifts can be made direct into trust with no immediate tax charge (although periodic and exit charges could apply to the trust in future), or into products such as junior Isas, Isas or self-invested personal pensions that are subject to normal limits.

Documenting gifts

Relief on gifts is always claimed by the executor, and documentation is vital to ensure that all the appropriate exemptions are secured. HMRC’s form IHT403 – gifts and other transfers of value – is a useful guide to how investors should keep records of income and expenditure to make it easier for the executors to show that the gifts should qualify for the exemption.

A self-declaration is a very good starting point. Some suggested text is below.

Example of wording for a self-declaration

Investors should always check this wording with their legal adviser.

To my executors:

Please take this document as a declaration that I, (name), have made the unreserved gift of £ (amount) to (name of recipient) on the (date) on the understanding that it qualifies for immediate relief from inheritance tax under the normal expenditure from income exemption as detailed in Section 21 of the Inheritance Tax Act 1984.

I submit that this gift:

1. Is made as part of my normal expenditure;

2. Is made from my income rather than capital;

3. That after all gifting under this exemption, I am left with sufficient income to maintain my normal standard of living.

I further certify that this gift, together with other similar gifts, (delete as appropriate) I have made, and intend making in the future, will leave me with sufficient income to maintain my usual standard of living.

[(Signed) (Dated)]

Danny Cox is a chartered financial planner at Hargreaves Lansdown