This is probably the most obscure of the various IHT lifetime exemptions and certainly the easiest one to trip up on if you are not fully conversant with the rules. However, used properly it can save the eventual beneficiaries of your estate a lot more tax than the other lifetime exemptions. It is not an exemption that is allowed automatically and must be claimed by a deceaseds personal representatives. For this reason, it is prudent to keep a record of all your income and expenditure if you make regular large gifts as the claim will be based on information that may be up to 7 years old.
The best thing about this exemption is that it is theoretically unlimited. If a person has sufficient surplus income, it is perfectly legitimate to make gifts out of it without limit, provided that the donor has sufficient income after making the gifts to enjoy his/her normal standard of living. There are 3 tests that a gift must pass in order to qualify for the exemption:
1) it must form part of the donors normal expenditure
2) it must be made out of the donors income; and
3) it must leave the donor with sufficient income to maintain their normal standard of living
Note that the gift must be unconditional; ie unrestricted with no strings attached and not in lieu of goods or services of any kind. There should also be no reservation of benefit to the donor otherwise the gift will be treated as a GROB and potentially subject to IHT when the donor dies. Dealing with each of these 3 conditions in turn, the following notes show how they operate in practice and illustrate some potential tax planning opportunities.
1) Normal Expenditure
Firstly the gift must be normal expenditure. This does not mean normal in the usual sense of the word. It means typical of the donor. In the view of Justice Lightman J in Bennett v IRC it must accord with the settled pattern of expenditure adopted by the transferor. He considered that this can be established in 2 ways:
a) by finding a pattern from examination of the donors expenditure over a period of time; or
b) by the donor having made a commitment, or adopted a firm resolution, and thereafter complied with it.
It should be noted that normal does not have to mean regular or annual such as birthday or Christmas presents. It could include occasional gifts on a type of occasion which is not expected to occur frequently (unless you are the old woman who lived in a shoe) such as children graduating from university, starting university, leaving home or getting married. A man could make large gifts to each of his children on such occasions, even if they are many years apart, and provided he is consistent and it is the same type of occasion each time they would form a settled pattern. Problems claiming this exemption could arise if only one or two such gifts had been made by the time the donor died. Therefore, it is prudent to put your intentions in writing before the first gift is made and have it witnessed by a notary. Then, so long as you stick to the arrangement, there can be no argument about it.
However, it is very important to ensure that such gifts are habitual rather than special. One-off gifts will always be special if there is no intention to repeat them on future such occasions. For example, if a man makes a large marriage gift to one of his children but does not do the same for his other children (or has no stated intention of doing so), it would not qualify for the exemption even if he makes habitual gifts to them on other occasions. As this example illustrates, there can be a very thin dividing line between special and habitual. Usually this type of situation will only manifest itself after the donor has died and gifts made within the previous 7 years are being reviewed for potential IHT liabilities.
Gifts must be comparable in size in order to qualify under the exemption, although this would normally only be queried if some of the gifts were abnormally high compared to the others. They must also be comparable in nature. For example, a car may be regarded as comparable with jewellery, but assets like chattels, cash, shares or business interests may well not be comparable with each other. This applies even if the original gift took the form of cash which was then used to buy the asset in question.
The most common form of expenditure claimed under this exemption is premiums paid on a life policy which benefits another person (unless they are your spouse or civil partner in which case they are usually exempt anyway). Watch out for annuities though as these can be disallowed if they are deemed to be linked with a life policy in a back-to-back transaction. A commitment to pay school fees for children on an ongoing basis is another way you could use this exemption. No need if you are a parent of course as you would be responsible for their education anyway. Not even Gordon Brown would lumber your kids with an inheritance tax bill when you are dead on the grounds that you paid for their schooling (or at least youd hope he wouldnt, but who knows what the next stealth tax might be!)
Normal expenditure is usually considered over a 3-4 year period, but there is no set time span and longer (or shorter) periods can be used to illustrate normality, depending on the circumstances. However, it is unlikely that gifts can be claimed under this exemption if the donors life expectancy at that time was very short, as it would be difficult to prove that they were habitual.
Lastly, the gift must be purchased out of your own income specifically for that reason. You cannot make a gift by foregoing rights which you are legally entitled to and then claim the subsequent fall in the value of your estate under this exemption. This would include repeatedly waiving bonus shares in a company controlled by a person you wish to benefit from this action, as that would be a gift out of capital rather than income. However, you may get away with purchasing shares under a rights issue in the name of your intended beneficiaries.
2) Made out of Income
The second test concerns the means by which you paid for the gift. Basically it must come out of income, not capital. You must be able to show that you had sufficient income over the period in question to afford the gift, without liquidating savings or investments. This can be problematic for retired people with no earned income. Just as you come to the time of your life when you would consider making large gifts, you have little income with which to do it. For that reason, the exemption is normally only useful to wealthy individuals with a substantial private income, not all of which they need to maintain their own standard of living.
The period between acquiring income and making gifts out of it must not be too long. Unspent income may become capital over a period of time if it is invested in long-term savings. However, if it was merely saved on a temporary basis whilst accumulating enough to make a planned gift, this will normally qualify for the exemption provided that it is not made out of income saved over several years. This is a grey area that one should always seek advice on, as each case would be decided according to its particular circumstances.
Gifts made from a current account will normally be regarded as having been financed by income, even if the account contains capital receipts. It is sufficient that the gift could have been made out of income, having regard to the normal income of the donor. However, it is still important to prove that you had sufficient income over a couple of years to afford the gift. It should also be noted that your income must be net of tax. If income tends to fluctuate from one year to the next it is permissible to carry any surplus forward for a year, although longer periods would be open to dispute.
3) Standard of Living
The third test is that donors must leave themselves with sufficient income after making the gift to maintain their usual standard of living. How this is measured will vary from one individual to another. Some people have a more extravagant or decadent lifestyle than others, notwithstanding their income, so surplus income is dependent on normal living expenses at the time the gift was made.
There is a schedule on Form IHT 403 which is used for analysing income and expenditure to prove surplus income. This contains headings such as travelling, entertainment and holidays, which can be very difficult to complete unless the deceased kept detailed records. Therefore, if you are planning on making habitual gifts out of income, it would be wise to keep such records whilst you are still alive so that your personal representatives will have a fighting chance of reducing IHT on your estate as much as possible.
Even if a gift is made out of income, it will cease to qualify for the exemption if the donor then reduces their capital in order to afford their living expenses. It will also cease to qualify if living expenses are substantially reduced in order to afford the gift. Special gifts are ignored for this purpose as they do not qualify for the exemption anyway. If capital is reduced after making both special and habitual gifts, you can assume that it was for the purpose of making the special gifts first, and if they account for the whole capital reduction then your income can be considered sufficient to live on provided you have not reduced your standard of living too.
You are also allowed to use your capital to pay for living expenses without losing the exemption if you have chosen to do this rather than spending your income. The important thing is to have sufficient income to maintain your standard of living, and it is irrelevant if you choose not to actually spend it on living expenses. The exemption will also apply if you had to reduce your standard of living due to lower income, caused by unemployment or retirement for example. It is the standard of living that prevailed at the time the gift was made that counts, and provided this was not reduced as a direct result of making the gift, the exemption will still apply.
There is a limited exemption to the above rules when it is necessary for you use capital to finance living expenses after making a gift. This can apply when unforeseen expenses arise, such as nursing home fees, when a commitment already exists to make gifts out of normal expenditure, such as premiums under a life policy. The important thing to prove here is that the gifts were not regarded as excessive at the time the commitment was made.
Claiming the Exemption
Any gifts made by a deceased person during the last 7 years of their life will normally be assessed as part of their estate unless they were exempt transfers or if the lifetime exemptions applied. Whilst there is usually little dispute about the annual exemption, the small gifts exemption or the marriage gifts exemption (these are normally granted automatically unless there is evidence to the contrary) gifts made as part of normal expenditure must be proved. The only way to do this is to analyse both the income and the expenditure of the deceased for the years in question.
The personal representatives of the deceased must report any lifetime gifts within the last 7 years that were in excess of £3,000 in any tax year (or £6,000 if the annual exemption was carried forward) that were not made to a spouse, civil partner or charity on Form IHT 403 (Gifts and other transfers of value). Page 6 of this form is an analysis of income and expenditure for those years and must be completed in order to claim the exemption. It is therefore vital for the deceased to have kept a proper record of lifetime gifts and also of their income and expenditure for those years in order for those gifts to qualify for this valuable exemption.
Come and speak to us at Acumen Tax Solutions if you would like any help with the estate of a deceased person.