Normal Expenditure out of Income

Background

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.

What is ‘normal’ expenditure?

HMRC raise the following points.

• The dictionary definition of ‘normal’ 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 (ie 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 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 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.

Gifts made out of income

HMRC raises 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 whether 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 considers 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 considers this a contentious area.
  
  
• The introduction to this article referred to the phrase ‘taking one year with another‘. This appears in S21(1)(b) and provides for the case where a person’s income fluctuates from year to year but overall he/she has enough income to make normal gifts and meet their standard of living on an ongoing basis. In these cases, HMRC may review the income and expenditure over a number of years to see if the income test is satisfied. Although income can be carried over from year to year in these circumstances, HMRC will examine cases where the taxpayer wishes to carry forward more than two year‘s income.

Maintaining a normal standard of living

HMRC raises 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.

Case law

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:

• that it was made as part of her normal expenditure, and
  
  
• that (taking one year with another) it was made out of her income, and
  
  
• that, she was left with sufficient income to maintain her usual standard of living.

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."

Claiming the exemption

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.

Planning

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:

• Payment of pension contributions for family members. The tax benefits are discussed in Inheritance tax and pensions
  
  
• 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.

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.