Section 21(1) of Inheritance Tax Act 1984 specifies three conditions that must be met if the normal expenditure out of income exemption is to apply to gifts.
The first is that the gift must be made as part of the normal expenditure of the donor. Whether the gift is normal expenditure will depend on what is normal for that donor, not what is normal for an average person. See Box One.
The key to deciding whether a gift is part of normal expenditure will often depend on whether it falls into a settled pattern of giving. In 1995, case law (Bennett and others v IRC) established that this could be demonstrated in two ways.
The first is that the expenditure is such that a pattern can be clearly seen, for example 10 per cent of all income to family.
The second is to have adopted a firm resolution regarding future expenditure and then complied with that resolution. Examples given in the court case included a vow to give all earnings beyond those needed for subsistence to those in need.
Although there is no set period over which the pattern of giving must be established, HMRC would generally consider three or four years to be a reasonable period to use. In some cases HMRC may accept a single gift as being part of ‘normal expenditure’ if there is sufficient evidence that the single gift was the first in an intended pattern of future gifts. This would be unlikely to include a ‘death bed’ resolution to make periodic payments for life.
When considering whether a gift is normal HMRC will take various factors into account:
- Frequency: Gifts made regularly are more likely to be considered normal.
- Amount: Gifts of similar value are more likely to be considered normal. Two potential exceptions to this rule are gifts that are reliant on a variable source of income, for example sales commission or share dividends, and gifts related to a variable cost such as nursery or other child care fees.
- Nature: Although the gift must be made from income this does not mean the gift has to be income. For example, a car purchased from income and gifted may fall into a normal pattern of giving. It may be much harder to justify gifts of shares as being from income rather than capital.
- Recipients: Gifts made to the same category of recipient can usually be considered together. One example might be Christmas gifts to nieces and nephews being considered as a whole rather than being considered individually.
- Reason: This can be used to determine normalcy. For example, a gift from a parent for a house deposit may be very different from regular, smaller birthday gifts, even if these gifts are being made to the same person.
Life assurance premiums are specifically excluded from counting as normal expenditure if the life assurance policy was taken out in connection with an annuity purchase, sometimes known as a back-to-back plan. Without this provision, it would be possible for an individual to buy an annuity on their own life for a lump sum and then use the annuity payments to pay premiums on a life assurance policy for the benefit of someone else.
If the same insurance company provides the life insurance and the annuity then the life expectancy of the individual would not be relevant to the insurance company. This would allow the life company to offer normal life assurance premium rates to someone in poor health and therefore allow the capital used for annuity purchase to effectively be passed on using the normal expenditure out of income exception.
Made out of income
The second condition is that, taking one year with another, the gift is made out of income. Whether a gift is made out of income is not necessarily determined by whether the payment in question is potentially taxed as income or capital.
For example, although effectively deferred until encashment, annual 5 per cent withdrawals from a life assurance policy are taxed as income, yet for the purpose of this exemption would be considered capital rather than income.
The inclusion of ‘taking one year with another’ allows for fluctuating income. It might be that although there is insufficient income this year there was income available from the previous year which could be used. If income received more than two years ago is being carried forward then it is possible that this accumulated income could be considered to have become capital.
The legislation specifies that the tax-exempt proportion of a purchased life annuity does not count as income. This is consistent with this amount being exempt from income tax because it is considered to be a return of capital rather than income.
Usual standard of living
The final condition is that there needs to be sufficient income to cover both living expenses and the gifts being made. What counts as the usual standard of living will depend on the individual at the time that the gift was made, or potentially when the commitment was entered into. If there was a subsequent unforeseen drop in income, such as due to redundancy, then this may mean the exemption is not completely lost, even if the gifts subsequently mean the remaining income is insufficient to maintain the usual standard of living. Box Two sums up the trio of conditions.
Conclusion
For individuals with high levels of income, this exemption can be very effective. Unlike the £250 small gifts allowance or the £3,000 annual allowance, there is no upper limit on the amounts that can be gifted using this exemption. However, for this exemption more than any other it is particularly important to keep accurate records so that, if required, it is possible for the estate administrators to show that all the conditions have been complied with.
This is a very brief summary of a notoriously complex subject and no action should be taken or refrained from being taken based on this article. In particular, other inheritance tax exemptions may apply.
