Introduction
Over the years, there have been many complex and contrived schemes put in place to avoid inheritance tax (IHT). However, in many cases, significant savings can be made by simply taking advantage of one of the statutory exemptions from IHT - gifts made out of income. No convoluted structuring or complex documentation is required to benefit from this exemption, simply some care in ensuring that the statutory conditions are met. Accordingly, this is a cheap and simple way to reduce IHT liabilities, and is one which is frequently overlooked.
How does it work?
A gift will be exempt from IHT if:
- it is made as part of the normal expenditure of the person making the gift (the donor);
- it is made out of the donor’s income; and
- the donor is left with sufficient income to maintain his usual standard of living after making the gift (or all such gifts).
There is no specific limit on the amount which can benefit from this exemption, nor any restrictions as to whom the recipient may be, nor any requirement that the donor survives for any minimum period after the gift.
Normal expenditure
For expenditure to be treated as “normal” it must conform to an established pattern of expenditure by the individual concerned. It is a subjective test – it is necessary only to be “normal” for the donor, not for people generally. The payments can vary in amount and be to different people. However, there must be an established pattern – so a gift of a car from a grandparent to each of their grandchildren on the occasion of their 17th birthday would qualify, even though each recipient receives only one gift, the amounts would vary (albeit perhaps not by much, in the interests of fairness!) and the timing of the gifts would not be regular.
The critical element though for the IHT exemption to be available is to establish the pattern. In circumstances like the above, it may be sufficient merely to show that the sequence of payments took place. However, it would be prudent to provide some documentary evidence, such as a letter to each grandchild accompanying each gift. Evidence of entry into a commitment (which may, but need not be legally binding) to make regular payments should also be sufficient. Taking out a life policy with regular premiums (linked to the donor’s life) in favour of the recipient is a good example of what would constitute normal expenditure.
Payment must be out of income
Essentially what the exemption is aimed at are payments made out of the donor’s excess income. Usually, it will be clear whether this is the case – where the income concerned is salary, dividends from shares, interest from deposit accounts etc. However, it is not sufficient that the amounts concerned are taxable as income in the hands of the donor. Some receipts satisfy that requirement but still have the nature of capital, and hence payments from that source would not qualify for the exemption. Examples of this are payments out of the maturity proceeds of an endowment and some income from annuities.
It should be noted that the fact that the income concerned has been accumulated over a number of years would not prevent a claim for exemption – as long as such income has not been reinvested in a capital asset, it should retain its character as income.
Lastly, it is not necessary that the income concerned should be taxable as such – it may be exempt from income tax (e.g. income from ISAs).
Maintenance of donor’s standard of living
As mentioned above, the payments must be made out of the donor’s excess income, i.e. income of the donor which is surplus to what he or she needs to maintain his or her standard of living. The payments must not be of such a level as to require the donor to dip into capital savings to maintain their lifestyle.
This is another matter where it is prudent to ensure that there is sufficient documentary evidence available at the time the claim for exemption is made (which will be after the donor’s death). Any donor intending to rely on the exemption should ensure that they keep all relevant bank statements etc. Ideally, the donor could demonstrate in this way that the payments were being made out of that part of their income which they normally put into savings.
Conclusion
Where an individual has more income than he or she needs to maintain their current lifestyle, they may be in a position to make gifts out of the excess income during their lifetime in a way which will be exempt from IHT. While this exemption has historically been underused, the tax authorities will still need to see clear evidence that the statutory conditions for the exemption are met before allowing a claim. The claim itself is made after the donor’s death (by his personal representatives) but it is essential that steps are taken by the donor at the time the relevant payments are made to facilitate that claim. While these arrangements do not require complex structuring, advice should be taken to ensure that all the relevant steps are taken to ensure that the exemption is available.
For more information on this article contact Claire Sharp
