Most forms of tax relief or exemption have an upper limit, such as the income tax personal allowance, or the annual exemption for capital gains tax purposes.
However, there is an inheritance tax (IHT) exemption which has no upper monetary limit. The exemption is only limited broadly by the individual’s personal resources, and the amount of spare income available to give away. It is available for lifetime gifts (but not transfers on death), and can apply to all or part of the gifts. For such a generous exemption, it is perhaps surprising that more people do not make use of it.
How does it work?
The IHT exemption is for ‘normal expenditure out of income’ (IHTA 1984, S 21). A gift will benefit from the exemption to the extent that certain conditions are satisfied. These are broadly as follows:
- The gift was part of the normal expenditure of the person making it;
- It was made out of his or her income (taking one year with another); and
- The person making the gift was left with sufficient income to maintain his or her usual living standards.
Everyone’s personal circumstances will vary, and in practice it can sometimes be difficult to establish that the exemption is due. In addition, the brevity of the legislation has allowed HM Revenue & Customs (HMRC) to place its own interpretation on the exemption conditions. However, where all the conditions are satisfied, the exemption can shelter significant gifts for IHT purposes.
Satisfying the conditions
The exemption for normal expenditure out of income is clearly very useful and generous, so HMRC can be expected to apply the above conditions quite rigidly. For example, HMRC may seek proof that the gifts satisfied the ‘normal expenditure’ condition. HMRC’s approach is that a regular pattern of giving needs to be demonstrated, normally over a period of three or four years. However, there has been some helpful case law on the ‘normality’ test.
Aside from the ‘normal expenditure’ condition, the other two exemption conditions must be satisfied as well. For example, the ‘out of income’ condition means that the gift of a capital asset (e.g. jewellery or shares) does not qualify, unless it was a ‘gift-in-kind’ bought out of income specifically with the intention of making the gift. Care is also needed if income fluctuates from one year to another.
The third condition (i.e. that the person making the gift should be capable of maintaining his or her usual standard of living from remaining income after making the gift) is applied at the time of making a gift. Thus a change in usual living standards due to reasons outside a donor’s control (eg redundancy) will not necessarily be fatal for exemption purposes, if an earlier commitment had been made when the surplus income was available.
HMRC has published detailed guidance on the normal expenditure out of income exemption in its Inheritance Tax manual (at IHTM14231 and subsequent paragraphs), which can be accessed via HMRC’s website. This guidance does not carry the force of law, but it is helpful in terms of being aware of how HMRC defines the exemption conditions and seeks to apply them in practice.
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