Clients should be aware of the significant tax saving benefit available under Section 21 of the Inheritance Tax Act 1984 which sets out the so-called normal expenditure out of income exemption.
Section 21 provides that if a gift (called "disposition" in the legislation) is exempt, then, for tax purposes, it is irrelevant whether or not the person making the gift survives for seven years. Such gifts can therefore be taken out of your estate for IHT purposes immediately.
For the exemption to apply, it must be evidenced that three conditions are met:
- You must show that it formed part of the normal expenditure of the person making the gift;
- that it was made out of income;
- and that it left the person making the gift with enough income to maintain his or her normal standard of living.
This would seem an entirely fair and logical exemption to the divisive 40pc death duty. Because if a person does not spend all of their income, that income becomes capital and if you are likely to be subject to the tax, more capital equates to more tax.
The first hurdle to get over is what counts as "normal expenditure". For HMRC to be convinced, expenditure must be in line with genuine usual disposal of wealth. It is also desirable for the gifts to be regular.
To make life easier a sensible approach is to look at it annually, perhaps at the same time your tax return is submitted, because then you should know what your income has been, and you can look at what your expenses have been as well. Any excess of income over this regular expenditure can potentially be gifted without triggering the Potentially Exempt Transfer (PET) seven year rule.
The second hurdle is having evidence of what income is available. Income is not defined as such in the legislation, but a common sense understanding what it means for accounting purposes should apply – such as income from employment, pensions, rent, dividends and interest. It should of course be income net of tax, which is used for the calculation of what is available to gift.
Typically, the final hurdle is proving that it is genuine income being gifted. For instance, using cash from a maturing fixed-term bond to buy a new car or pay for a new kitchen is using capital towards expenditure that you would otherwise apply income towards, thereby skewing the amount of income available to make gifts.
This means a year of high expenditure may mean some years’ regular gifts-out-of-income are not possible.
You can suppose that HMRC will be expecting less generous gifts out of income at the moment as food, petrol and home energy bills have rocketed and dividend income has faltered. Recent higher interest rates for savers may of course offset some of that.
Once you have done the maths and can see there is surplus income available to give in accordance with Section 21, then it would be good practice to document the gift and the computations behind it. A simple Deed can be drafted to formally notify beneficiaries of your intentions to start gifting before regular payments are made annually at around the same time of year.
There may be a problem where beneficiaries are acting on behalf of a relative with reduced mental capacity in law. Unless they can understand and make the gifts themselves, attorneys may not make the gifts for them under the authority of the Lasting Power of Attorney.
If they can genuinely understand the proposed transaction that is fine. But if there is no certainty in that regard, it would be exceeding the legal power attorneys have to make a gift of this kind. Attorneys have only limited power to make gifts, particularly to themselves.
As an attorney you may make small gifts to family members at Christmas and on birthdays, in accordance with any pattern of such gifts made when they had capacity, but beyond that the permission of the Court of Protection is required. And that is a long winded and expensive road to go down.
In these cases, there is the possibility of a spouse making regular gifts out of their own surplus income. If they agree, then the value of their joint estates can be reduced in a tax-cutting and perfectly legitimate manner.
"IHT is a complex but largely avoidable tax on post-tax wealth. If you are interested in the planning opportunities available in this area please get in touch. As ever, we are keeping our clients informed and are very happy to discuss any concerns or questions they might have. If you would like to have a discussion about your tax situation please call 01727 730550 to book a consultation."