Thu 10 November 2011
Inheritance tax planning: the benefits of regular giving
For many, Inheritance Tax (IHT) planning involves using the annual exemption of £3,000 per annum and making gifts with the hope that they will meet the required seven year period for exemption to apply.
Such planning is however typically periodic and can be ineffective because planned future gifts are delayed or simply forgotten. It also does not address the problem of the estate increasing in value between gifts. This can often be unavoidable, if only because of appreciation in house values, but for those with incomes in excess of their day-to-day needs, help is afforded by Section 21 IHTA 1984 ‘Normal expenditure out of income’.
The key benefits of this relief are as follows:
- Gifts are immediately exempt.
- There is no prescribed limit, so long as the conditions are met.
The conditions are:
- The gift must be made as part of normal expenditure.
- The gift must be made out of income, taken year on year.
- After taking account of all gifts forming part of normal expenditure, the donor must be left with sufficient income to maintain their normal standard of living.
The legislation does not define ‘normal’, either as a specific amount or percentage of income, but requires the particular circumstances of each donor to be considered. There is therefore a strong subjective element.
The expenditure does not have to be fixed or be made to the same recipient each time, though HM Revenue and Customs (HMRC) do draw a distinction where gifts change between categories of recipient, for example, from family members to charities. Care should therefore be exercised when changing the recipient’s identity.
The values of gifts can also change but again care should be exercised. Gifts that are comparable in size are likely to be accepted as part of normal expenditure, but if there are significant fluctuations, the exemption might be challenged. Where appropriate, consideration should be given to fixing the value of the annual gifts by reference to a formula, for example where the source of income is known to vary.
There is no set period over which the assessment of ‘normal’ is to be made and the gifts do not have to be regular or annual, though such gifts are more likely to be accepted as normal. Thus where there is a commitment or resolution to make qualifying gifts over a sufficient period but this is defeated by unforeseen circumstances, for example death, then exemption is not necessarily denied.
Out of income
Most gifts out of income are made as transfers of money. These can be to pay for something or made direct to the recipient. Gifts of capital and of capital assets are not however likely to be exempt unless the asset in question is purchased out of income specifically for the recipient.
‘Income’ is not defined but the fact that receipts are regular does not make the receipts income for this purpose. Perhaps the most common example is the annual 5% withdrawal from a non-qualifying insurance policy. These are not chargeable to income tax within the specified income tax limits because they are considered returns of capital. The approach for IHT purposes is consistent with this, though the treatment is perhaps arguable if the capital value of the bond is maintained.
Normal standard of living
The key test is whether or not the donor needs to resort to capital to meet ordinary living expenses and so each claim to exemption will be determined by the individual donor’s particular circumstances. It is possible to take one year with another in determining whether or not this condition has been met, but in practice HMRC will take account of current income and expenditure on a tax year basis. A donor may wish to store up surplus income from a number of years in order to make gifts, but in such circumstances the exemption might not be forthcoming.
Conclusion and particular uses
This is a very valuable relief but great care must exercised, especially in cases where the intention is to gift the maximum amount, ie right down to the level of income actually required to maintain the standard of living. It is essential that good records are maintained so that executors can readily demonstrate that gifts were made ‘out of income’.
When used correctly the exemption can prevent the value of the IHT estate from increasing. The gifts can be used in any number of ways, perhaps the most common being the funding of life insurance premiums and stakeholder pensions for the younger generations, and in the larger cases for transfers into trust, which would otherwise attract IHT at an effective rate of up to 20%.