Chapter: 2 - Inheritance Tax Mitigation: The Basics

Normal expenditure out of income

2.2.6

A transfer will be exempt only if (taking one year with another) it was made out of income leaving the transferor with sufficient net income to maintain his usual standard of living, ie without resort to capital (IHTA 1984 s21). HMRC used to argue that a pattern of expenditure of at least three years must be shown, though the Bennett decision in 1994 (see below) roundly disapproved this. A pattern of giving should be started as early as possible. Records should be kept to back up any claim if necessary. The gifts must be made out of income (which, not surprisingly, does not include the proceeds of sale of shares: see Nadin v CIR [1997] SSCD 107 (SpC 102)).

Expenditure will of course include Income Tax and all regular expenditure of an income nature – as opposed to capital, eg extending the house.  This exemption is quite extraordinarily useful and has been generally underused (though the advent of the 50% Income Tax band from 2010/11 has reduced the quantum of post-tax ‘spare’ income which can be the subject of s21 gifts).  It is important to keep careful records, in the event that death falls within seven years after a gift in a series, in order to convince HMRC that that gift was exempt.  Where the exemption is used over a number of years, it does not matter if in one of those years there was a deficit (out of which of course no gift can be made), so long as ‘taking one year with another’ there was a surplus and gifts were made out of that surplus.

Note the helpful principles set out in the leading case (by Lightman J in Bennett & Others v CIR [1995] STC 54):

• 'normal expenditure’ means expenditure which, when it took place,  accorded with the settled pattern of expenditure adopted by the donor;
• a settled pattern can be established either by examining the donor’s  expenditure over a period of time, or by showing that the donor has  assumed a commitment, or adopted a firm resolution, regarding future  expenditure and has thereafter complied with it;
• there is no fixed minimum period during which expenditure has to be  incurred; a single payment implementing the commitment or resolution  may be sufficient;
• where there is no commitment or resolution, a series of payments may be required;
• a pattern need not be immutable, but it must be intended to remain for a sufficient period (barring unforeseen circumstances); thus, ‘death bed’ resolutions would be excluded;
• the expenditure need not be fixed nor need the recipient be the same on each occasion.   The amount of the gift may be fixed by a formula, eg a percentage of earnings, or by reference to an ascertainable liability, eg the cost of nursing home fees, and the donees may be a general class,  eg family members or needy friends; and
• tax planning does not disqualify the expenditure.

In Bennett, the deceased was the life tenant of her late husband’s Will Trust. The trustees had on her instructions paid to her three sons total income of some £28,000 in February 1989 and then £180,000 in February 1990, a few days before the deceased’s death. Nevertheless, applying the above criteria, Lightman J was satisfied that ‘normality of expenditure’ had been achieved. He said that the donor had had a single and continuing intention regarding the surplus trust income and that that intention was put into effect. The decision in this case is likely to prove helpful in situations where a life assurance policy has been written in trust and where the grantee of the policy has died unexpectedly having paid only one or a very limited number of the regular premiums which would have been due had he survived.

The status of regular withdrawals from investment bonds for the purposes of the normal expenditure exemption was the subject of a series of postings on the Trusts Discussion Forum in November 2010. The better view is that they are not income either under ‘normal accountancy rules’ or for Income Tax purposes (see HMRC’s Inheritance Tax Manual at IHTM 14250).  While it appears that at a CIOT presentation in 2005, shortly before he retired from the then Capital Taxes Office (CTO), the late Peter Twiddy expressed the CTO view that withdrawals from single premium insurance bonds are regarded as income for the purposes of IHTA 1984 s21 provided that the capital of the bond is maintained, this is not now the HMRC view.  So the point cannot be raised as something of a ‘last ditch’ argument to try and save a gift made within seven years before death being converted from PET to a chargeable transfer.  The supplemental form IHT 403 (lifetime transfers) to Inheritance Tax account form 400 does refer to income for Income Tax purposes.

John Woolley of Technical Connection reports that HMRC have replied to him in their letter as follows:  'It is our view that the regular withdrawals of 5% of the premium from a single premium insurance bond are payments of capital and, as such, they do not fall within the description of income for the purpose of the IHTA 1984 s21 exemption.

'We are aware that contrary opinions have been expressed in the insurance industry and we intend to make our position clearer in an update to the guidance in the Inheritance Tax Manual in due course.'

(Taxation 18.08.11 article by John Woolley of Technical Connection Ltd, p16)  [22 September 2011]

TAX TIP: As with the annual exemption, it is axiomatic that where the taxpayer does have post-tax income surplus to normal living requirements this extraordinarily valuable exemption is used. Clear records should be prepared each tax year to provide the necessary evidence in case of death within the following seven years, ideally in the format provided in Schedule 403 to the Inheritance Tax account form IHT 400.

HMRC change their guidance
HMRC have substantially rewritten the sections of their IHT guidance manual dealing with gifts claimed to be ‘normal expenditure out of income’, in particular the distinction between income and capital.

The redraft of sections IHTM14231 to IHTM14255 is intended to ‘reflect HMRC's current practice’ on granting or withholding the exemption, as set out in IHTA 1984 s21.

An important part of the new guidance relates to what HMRC regard as income rather than capital. It is not defined in IHTA 1984 and is not the same as income for Income Tax purposes.

HMRC advise their staff to deny taxpayers' claims that the exemption applies on gifts made out of several years of accumulated income. But they admit that in some cases there is room for dispute. Contentious cases cited by HMRC in the new guidance are annuities and insurance policy payouts (which HMRC say are not counted as income for IHTA 1984 s21 purposes even when they charge Income Tax on them).

The guidance goes into some detail on the status of lifetime care plans, which have become increasingly popular for the elderly in recent years. The idea is that the individual makes a single advance payment to the plan provider, who then pays the fees for future nursing or residential care.

HMRC assert that these fee payments by the plan provider are not income for s21 purposes; instead they represent a return of part of the capital originally provided by the purchaser. However, there may still be a way for taxpayers to include them in their income for a s21 claim, by noting that part of the payment represents income produced by the unused part of the premium while it is held by the plan provider. In that case, the tax inspector has to refer the claim to HMRC's technical department, along with specifics of the care plan (STEP UK News Digest 22.09.11).

Further observations
It seems that a lifetime care plan has the character of an insurance contract, rather like an annuity under which if you die soon after taking out the policy then (subject to a guarantee period) the capital is lost.  It appears that under at least some lifetime care plans a death benefit may be payable.  It is presumably the analogy with an annuity which might lead HMRC to accept that part of the sum provided each year represents income in the hands of the individual.  Any such argument has been firmly kicked into touch by HMRC in relation to the 5% annual withdrawals from a non-qualifying insurance policy (see above).  This would have been on the basis (apparently accepted by the late Peter Twiddy in 2005) that insofar as the capital of the bond was maintained, that is with annual growth at more than 5%, the withdrawals could be accepted as income.  Does it seem a bit tough to deny the possibility of a s21 claim on the latter case, while granting it on the former?  [18 October 2011]