Give what you can afford IHT: Normal expenditure out of income

Many people have excess yearly income, which can usefully be classed as gifts of income and as such can form excess ‘normal expenditure’ out of income within IHTA 1984, s 21(1).
In effect, if it can be shown as an excess of income surplus to requirements for the usual standard of living and gifted, it is exempt from inheritance tax.

Analysing the exemption

The affecting legislation in IHTA 1984, s 21 states most importantly (italics added);

1. A transfer of value is an exempt transfer if, or to the extent that, it is shown—
2. that it was made as part of the normal expenditure of the transferor, and
3. that (taking one year with another) it was made out of his income, and
4. that, after allowing for all transfers of value forming part of his normal expenditure, the transferor was left with sufficient income to maintain his usual standard of living.’

In this connection, HMRC’s form IHT403 (‘Inheritance Tax: gifts and other transfers of value’), page 8 requires completion of yearly income and expenditure for up to eight years where
there is consistent yearly gifting.

Regularising payments

A single gift by way of payment under a deed of covenant or other regular commitment, such as payment of the first of a series of premiums on a life policy, should be accepted as normal income
gifts by HMRC.

However, it may be that the gifts are clearly not intended, or able to be continuous from day one, such as where:

1. life policies provide that after payment of the first premium, the policy may be converted into a fully paid one; or
2. policies may also be taken out when the transferor’s expectation of life was very short (e.g., terminal illness)

Example: Various gifts

In the four years before his death, wealthy entrepreneur Graham, who was dying of cancer, made gifts from his excess business income of £1,000 to each of his two daughters on their respective
birthdays and £500 to each at Christmas. Graham also had been paying regular monthly premiums of £100 into a school fees policy written in trust for the benefit of his grandchildren. He also won £1m on a scratch card and immediately gave his eldest daughter £200,000 to pay off her debts. He had also gifted 5,000 shares in his trading company, representing a 50% interest in the company, to his sister who already held the other 50% interest.

The birthday and Christmas gifts form a pattern of giving, as do the life policy premiums, so these are exempt under section 21, the first in a series. The one-off gift of cash to his daughter is not exempt as it does not fall within a pattern of gifting and does not in any case constitute an income source; however, it is a possible potentially exempt transfer (PET), which may benefit from part of his IHT nil rate band exemption if available, or it may even be treated as a ‘failed PET’ and be taxable with possible tapering relief. The gift of shares to his sister is not exempt, being a capital asset and also not part of a pattern of giving but it may benefit from business property relief if the relevant conditions are met or, failing that, Graham’s nil-rate band exemption. Otherwise, as a ‘failed PET’, it would be taxable on his sister with 20% tapering relief after four years. Any one-off gift before death cannot qualify, even if the taxpayer can provide strong evidence that it was genuinely intended to be the start of a pattern, and there was a realistic expectation that further payments would follow.

Practical tip

It is wise to submit an accompanying letter of intention of donation where gifts of excess income are expected to be continuous or timeous, which also provides proof in support for the IHT403 summary.