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9 min read 31 Mar 23
Section 21 of the Inheritance Tax Act 1984 deals with the normal expenditure out of income exemption. It is an extremely important exemption for IHT planners.
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:
1. It formed part of the transferor’s normal expenditure
2. It was made out of income (taking one year with another), and
3. 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, and it’s necessary to consider these three conditions in turn.
HMRC raise the following points.
Gifts must be comparable in size. HMRC does 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.
HMRC raises the following points:
HMRC raises the following points:
The leading case is Bennett and others v Inland Revenue Commissioners [1995] STC 54. In very broad terms, the details were as follows:
Background
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.
Dispute
HMRC stated that the gifts of £9K and £60K did not qualify for the normal expenditure out of income exemption of Mrs B.
Decision
The normal expenditure out of income exemption applied because these three points were all satisfied regarding each gift:
The judge summed up the requirement for expenditure to be normal:
A more recent case is McDowall and others (executors of McDowall, deceased) v Commissioners of Inland Revenue and related appeal [2004] 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.
Background
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.
Decision
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.
Details of the deceased’s income and expenditure should be provided to HMRC using page 8 of form IHT403 (alternatively, a separate schedule can be provided).
Details of the gifts should be provided on pages 2 to 7 of form IHT403.
Section 21 of the Inheritance Tax Act 1984 deals with the normal expenditure out of income exemption. It is an extremely important exemption for IHT planners.
Two ways in which the exemption might be used:
When carrying out IHT planning for a client with surplus income, 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, eg 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.
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