Section 21 Inheritance Tax Act 1984 allows an exemption from Inheritance Tax (IHT) on gifts made by way of a donor’s normal expenditure out of income where certain conditions are met. As there is no limit on the amount of exemption that can be claimed, this is a useful exemption for clients who have “excess” income year on year and are looking to reduce their IHT exposure through lifetime giving.
Under the current rules, a transfer of value will be exempt if it is shown that:
- It was made as part of the donor’s normal expenditure
- It was made out of the donor’s income (taking one year with another)
- The donor was left with enough income to maintain their usual standard of living (after allowing for all transfers of value forming part of their normal expenditure).
What is normal expenditure?
For expenditure to be normal, it must be typical of the donor according to a settled pattern of expenditure. A “settled pattern” of expenditure can be established in two ways:
By reference to a sequence of payments by the donor over a period of time
By proof of a prior commitment or resolution adopted by the donor regarding future expenditure.
Does the expenditure have to be of a fixed amount?
No, but it should normally be comparable in size to other gifts made to the same donee/class of donees. It is generally accepted that expenditure may fluctuate, especially if the source of income is variable (i.e. gifts of dividend income or the payment of school fees for grandchilden).
Is there a fixed minimum period of expenditure required?
No, but it will be harder to identify a pattern where a single gift is concerned.
Can gifts be made to more than one done?
Yes, but it a pattern can be more easily established if the donees are from one particular class of beneficiary (i.e. children or grandchildren)
What constitutes a prior commitment or resolution?
Donors should document their intention to make regular payments, in writing.
Expenditure out of income
This IHT exemption does not apply to any gifts that have been made out of capital.
Whilst income is not defined for the purposes of this exemption, HMRC views income as the net income after payment of income tax and it should be determined for each year in accordance with normal accountancy principles.
Please note however income does not necessarily have the same meaning as it does for income tax purposes and there are certain payments which HMRC does not consider to be income for the purposes of the exemption, such as insurance policies where the individual takes an annual 5% capital withdrawal from an investment bond.
What does “taking one year with another” mean?
Section 21(1)(b) of the IHTA 1984 allows income from an earlier tax year to be carried forward to provide for an individual whose income fluctuates from year to year. HMRC considers that the income of the year in which gifts are made should be considered first before considering earlier years.
When does income become capital in nature?
There are no set rules about when income accumulated from earlier years becomes capital. If there is no evidence to the contrary, HMRC will consider that income becomes capital after a period of two years.
Maintaining the donor's standard of living
For the IHT exemption to apply, the donor must be left with enough income to maintain their usual standard of living after allowing for all gifts forming part of their normal expenditure. Assessment of this condition will depend on the circumstances in each case.
Do you have to prove that the donor has maintained their usual standard of living to claim the exemption?
No, nor is it relevant if the donor has used their capital to maintain their usual standard of living.
Can you claim a partial exemption under normal expenditure out of income?
Yes, if the income that remains after making the gift/s is not sufficient to maintain the donor’s standard of living, part of the gift may still qualify for the exemption.
Are other gifts not made within the exemption (potentially exempt transfers or chargeable lifetime transfers) taken into account when considering whether the donor was left with sufficient income to maintain their standard of living?
No, these gifts are ignored.
Practical hints and tips to consider
When the exemption should be claimed
Gifts that are normal expenditure out of income should be disclosed to HMRC following the death of the donor and the claim for the IHT exemption should be made at the same time. Gifts that would be subject to an IHT charge if the exemption is not allowed must be disclosed to HMRC one year after the end of the month of the death.
Keeping records
The burden of proof is on the taxpayer to show that the exemption is due following a death. To assist their executors in claiming the exemption, Donors should document their intention to make regular payments, in writing and keep a detailed record of the gifts made, the date of each gift and who it was paid to. Donors should also keep detailed records of their income and expenditure for each tax year in which the gifts are made as normal expenditure out of income.
Taking appropriate advice
For any IHT planning to be effective, it is important to ensure that you have taken robust professional advice. There are, for example, special exemptions for certain life policies, annuities and loans which should be considered in detail before relying on this exemption. Our Private Wealth team at Weightmans LLP can assist with all aspects of estate planning from the technical advise to implementation in a clear, sensitive and effective manner.
For guidance on any issues relating to inheritance tax, contact our inheritance tax solicitors.
