Normal expenditure out of income is a valuable exemption which is often overlooked when undertaking tax planning. There is no seven year clock and it does not disturb any other exemptions, nor does it constitute a chargeable transfer. It can be used to prevent an inheritance tax (IHT) problem arising or getting worse.
What must be considered when dealing with normal expenditure out of income?
The legislation, in section 21 of the Inheritance Tax Act 1984, exempts transfers if, taking one year with another, it can be shown that the gifts:
- formed part of the donor’s usual expenditure
- were made out of income, and
- left the donor with suffi cient income to maintain their normal standard of living
The exemption is only available for gifts made out of surplus net income. It should be emphasised that this does not apply to gifts made out of capital. For example, 5% investment bond withdrawals (even if held under a discounted gift trust) and the capital element of a purchased life annuity payment. Also, the donor could not give away income and then rely on capital to meet their normal expenditure.
Bennett and others v IRC (1995)
In this case, the court identifi ed several points to consider:
- ‘normal expenditure’ means when it took place it was part of the settled pattern of expenditure adopted by the donor;
- a ‘settled pattern’ can be shown from the expenditure of the donor over a period of time or by showing that the donor assumed a commitment or adopted a fi rm resolution, in relation to future expenditure and has then made gifts in accordance with that commitment;
- there is no fi xed minimum period to establish the relief, however, it needs to be more than one payment;
- where there is no formal commitment or resolution, it may be necessary to show a series of payments (three will usually suffi ce, two possibly);
- there can be some variation in the pattern, but to claim the relief it must be shown that the donor intended a pattern to exist and to remain for a period of time, barring unforeseen circumstances;
- the amount of the transfer does not have to be fi xed; the amount does not need to be to the same person each time; the amount may be fi xed by a formula such as a percentage of earnings or a fi gure such as ‘what is left over after paying nursing home fees’;
- HM Revenue & Customs (HMRC) interpret net income as meaning income after tax and normal outgoings.
As the claim for the normal expenditure out of income exemption is made on death it is important to keep records. IHT 403 incorporates a schedule, on page 8, which may be used to substantiate the claim. It is available at https://www.gov.uk/government/publications/inheritance-tax-gifts-and-other-transfers-of-value-iht403.
Clear evidence should be kept to support a claim for this exemption. We have produced a record sheet for this specifi c purpose, reference MKT535.
To determine whether a report is required, the donor needs to add together any gifts made under this exemption in the preceding seven years with any chargeable lifetime transfers made in the same seven year period. If the total exceeds the donor’s nil rate band, they will need to report all the gifts to HMRC using form IHT100.
HMRC will review the exemption at this time to confi rm it meets the requirements and confi rm their conclusion in writing.
Where the total is within the donor’s nil rate band, HMRC will only consider the exemption after the death of the donor. The executors of the deceased’s estate will need to include a claim that the regular gifts should be treated as exempt as ‘gifts out of income’ using form IHT400 as well as form IHT403.
Typical planning objectives
These could include:
- Can be used to regularly save into a policy written in trust
- As the test is based on the donor there is the potential to move large sums out of their estate
- Can be used to prevent an IHT problem arising or preventing one from getting worse
- Can be used to fund pension contributions for family members
This document is based on Canada Life’s understanding of applicable UK tax legislation and current HM Revenue & Custom’s practice, as at March 2020 and could be subject to change in the future. It is provided for professional advisers only. Any recommendations are the adviser’s sole responsibility.