The pros and cons of a lesser-known IHT exemption

Paul Thompson, tax & estate planning consultant at Canada Life, examines the normal expenditure out of income exemption.

We are all familiar with the £3,000 annual exemption from inheritance tax (IHT). At least, we should be – it has been £3,000 since 1981. Had it kept pace with the retail prices index (RPI), it would be around £9,000 by now.

But there is another exemption available that can, in effect, automatically keep pace with inflation – the normal expenditure out of income exemption. This is perhaps one of the more useful exemptions taxpayers have at their disposal and yet it is probably one of the least used.

Exempt transfer

Section 21(1) of the IHT Act 1984 states that a transfer of value is an exempt transfer if, or to the extent that, it is shown:

(a) That it was made as part of the normal expenditure of the transferor, and
(b) That (taking one year with another) it was made out of his income, and
(c) 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.

The case of Bennett and others v CIR in 1995 gave the court the opportunity to identify several points that need to be considered in relation to this exemption:

• “Normal expenditure” means that which, when it took place, 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 firm resolution, in relation to future expenditure and then made gifts in accordance with that commitment;
• There is no fixed minimum period to establish the exemption;
• Where there is no formal commitment or resolution, it may be necessary to show a series of payments (three will usually suffice, possibly two);
• There can be some variation in the pattern but, to claim the exemption, it must be shown that the donor intended a pattern to exist and for it to remain for a period of time (barring unforeseen circumstances);
• The amount of the transfer does not have to be fixed; nor does the amount have to be to the same person(s) each time; the amount may be fixed by a formula such as a percentage of earnings or a figure such as “what is left over after paying nursing home fees”;
• Tax planning does not disqualify the expenditure: almost the reverse; if the taxpayer can show that he or she entered into a series of gifts having taken advice, and intending to make use of the normal expenditure exemption, it will help in claiming the exemption that he or she took the advice.

HMRC interprets income as meaning income net of tax and normal outgoings. It is irrelevant whether the income is earned or unearned, as long as it is income. However, the distinction between income and capital may become rather blurred.

For example, the “income” from a purchased life annuity has two elements; an interest content which is subject to income tax, and a capital content which is free of income tax. As the name suggests, the capital content is not income.

Consequently, gifts made out of it cannot qualify for the normal expenditure exemption.

Annuities and life policies under trust

While referring to annuities, it is important to remember one set of circumstances when the normal expenditure exemption cannot be used at all. A client might choose to take out an annuity simultaneously with a whole of life policy under trust, for example, with the intention of using the annuity payments to fund the premiums on the whole of life. However, such an arrangement could be used for effective deathbed tax planning if both the annuity and the whole of life policy are taken out with the same product provider.