As a quick reminder the exemption applies where a gift meets all three of the following conditions:
- It formed part of the donor’s normal expenditure
- It was made out of income
- It left the donor with enough income to maintain their normal standard of living
- What is normal expenditure?
This needs a common sense approach, and is based on some degree of regularity, year by year, although the amounts do not have to be exactly the same – school fees can increase dramatically if a child moves from day school to boarding and you are asked to pay! Furthermore a single payment could qualify if it had been established with the intention of regularity. For example the first premium on a life policy written in trust, if the life assured died in an accident within the first year.
- What is income?
This is the tricky one. Income means income subject to income tax, ie what may go into your annual tax return by way of salary, pension, dividends, or bank interest. But this will not include the capital element of an annuity even though you regard it as part of the income which you live on. The same applies to the 5% tax free withdrawals from an insurance bond, or perhaps a “gift and loan trust” or “discounted gift plan”. These withdrawals are regarded by HMRC as capital.
- Maintaining standard of living
This can be problematical but HMRC allow you to “take one year with another” to establish an overall pattern of income, accepting that it can fluctuate. However if you have a good year with a big bonus, HMRC do not accept that the surplus to your normal living standards can be rolled forward for more than two years, when your normal income relapses to a more standard pattern.
- The retrospective view
It is important to understand that whatever you plan year by year, a claim for IHT exemption will only arise on a lifetime gift into trust where the nil rate band (£325,000 currently) has been exceeded, or (most commonly) on death.
Then, the claim to have used exemptions will be judged retrospectively, looking back over the previous seven years. By then the payments may indeed have been regular for many years, but what if available “income” has reduced because of investment changes, or increased taxation, or if the cost of maintaining your standard of living has dramatically changed because of the need to fund nursing home fees?
While definitive answers may only be established on death, you should take particular care to review your lifetime IHT strategy if investing in insurance bonds to receive that convenient 5%pa “tax free income”, or are thinking of buying a lifetime care plan, or an annuity.
One thing which can make a big difference is keeping accurate records of your gifts, which can be found by your Executors following your death. The normal expenditure exemption is one for which HMRC demand detailed evidence, which non-family Executors in particular may have difficulty in finding.
If you have not reviewed your IHT strategy for several years, why not contact us now? There are other approaches.