The gift of exemption

This month, Technical Connection examine the normal expenditure exemption for inheritance tax

Under Section 21 IHT Act 1984, lifetime gifts, other than gifts with a reservation of benefit, are exempt to the extent that they are made out of the donor’s income. To qualify for this exemption, the donor must 
show that:

• The transfer was part of their normal expenditure;
• Taking one year with another it was made out of income; and
• After the gift the donor was left with sufficient income to maintain his or her usual standard of living.

A gift is regarded as part of the donor’s ‘normal’ expenditure if the amount and type are consistent with their usual pattern of gifts. ‘Normal’ is regarded as broadly equivalent to typical or habitual. The first gift in a series can qualify as ‘normal’, provided that there is clear evidence that further gifts are intended (even if they are not subsequently made), so, for example, the exemption could cover the first of a series of premiums on a life assurance policy written subject to trust. If there is no such evidence, but further similar gifts are in fact made, the first gift of the series can qualify retrospectively for exemption.

‘Income’, for the purposes of the exemption, means net income after income tax and is determined in accordance with normal accountancy rules (rather than income tax rules). Income is measured ‘taking one year with another’ and, accordingly, the exemption is not lost merely because of fluctuations in income from one year to another. Nor would it be lost if the donor used income to make a gift and, having met some exceptional expense, was temporarily obliged to resort to capital to meet ordinary living expenses, the depletion of capital later being made good.

‘Income’, for the purposes of the exemption, means net income after income tax and is determined in accordance with normal accountancy rules (rather than income tax rules)

Out of income

In practice, the ‘out of income’ test is regarded as satisfied if the donor can show that they could have made the gift out of income after meeting living expenses. But gifts of property other than cash do not qualify for the exemption, unless the donor can show that the property was purchased out of income in order to make 
the gift.

It should be noted that the capital element of a purchased life annuity bought after 12 November 1974 is not regarded as part of the donor’s income for this purpose. Also, if a person buys an annuity and pays premiums on a life assurance policy for the benefit of someone else, the exemption is not available if the taking out of the policy and the purchase of the annuity were associated operations that would have given rise to a charge under Section 
263 IHT Act 1984.

Furthermore, HMRC has confirmed that it treats withdrawals from single premium investment bonds as capital for the purposes of the exemption. 

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