Ten Steps To Securing The IHT Income Exemption
It can be difficult to obtain acceptance by HMRC that a gift from a taxpayer’s income is covered by the IHT gift out of income exemption (s21 IHTA 1984). Problems usually appear after the taxpayer’s death when it is too late to take any meaningful action to improve the position and with personal representatives being left to look for more evidence that often is not available.
To comply with s21, the three conditions to be observed when making the gift are-
- that it was made as part of the normal expenditure of the transferor; and
- that (taking one year with another) it was made out of his income; and
- that after allowing for all transfers of value forming part of his normal expenditure, the transferor was left with sufficient income to maintain his usual standard of living.
Documenting the outcome of regular reviews by advisers with taxpayers can provide evidence: but taking the following steps will increase considerably the prospect of agreement with HMRC that the exemption applies.
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Step 1 – Identify what is “normal expenditure”
The main difficulty centres usually on what can be regarded as “normal expenditure.” The only High Court decision on the use of this exemption remains Bennett & others v IRC (1995). This case determined that for expenditure to be “normal” the taxpayer must show a settled pattern evidenced-
- EITHER by a sequence of payments out of past expenditure
- OR by proof of a prior commitment or resolution adopted by the taxpayer regarding his future expenditure AND to have thereafter complied with it.
These are two different requirements. The ideal is to have a settled pattern that complies with both tests, but that is not a legal necessity.
“You must test whether a gift is “normal” by considering all the relevant factors. These include the frequency and amount, the nature of the gifts, the identity of those who received them and the reasons for the gifts” (HMRC’s IHT Manual at paragraph 14243).
Step 2 – Sequence of payments or resolution?
An adviser’s aim should be to retain flexibility for the taxpayer and try to ensure that all gifts of surplus income secure the s21 exemption, whatever the amount, frequency or purpose of the gift. By its definition, relying on a sequence of payments is going to be limiting, both because it looks backwards – “out of past expenditure” – and retains a link to conservative regularity – “an examination of the transferor’s expenditure over a period of time may reveal a pattern, for example a payment each year of 10% of all income to charity or members of the individual’s family…” (the Bennett case).
“A proven habit of making gifts of one sort has no apparent bearing on whether gifts of the other kind were normal” (IHTM p14243).
The adoption of a firm resolution gives greater flexibility, as providing the taxpayer –at the time the resolution is made and documented – is likely to survive to make payments, “a single payment implementing the commitment or resolution may be sufficient (for the exemption to apply)”. A written resolution can document the taxpayer’s resolve to gift all surplus income and set out the ways in which this will be done.
Additionally with a resolution in place, if subsequently a terminal illness was to develop unexpectedly, the deathbed gift of surplus income say in a “sweeping up” exercise anticipated and documented in the resolution can be acceptable, providing the resolution was put in place when the taxpayer had a “sufficient period (barring unforeseen circumstances)” for payments “fairly to be regarded as a regular feature of the transferor’s annual expenditure.” There must also have been compliance with the resolution.
This should not be confused with the comment in the Bennett case judgment that a “death bed” resolution to make periodic payments “for life” and a payment made in accordance with such a resolution will not suffice. Here the judge has in mind a resolution first made when the taxpayer is dying.
In case HMRC successfully challenges whether a resolution exists, it is also worth having and documenting a proposed sequence of payments and ensuring that sequence is put in place.
Step 3 – Secure the future
So put in place a written resolution (see Step 7). Agree with the taxpayer how to comply with that determination. The simplest way is to resolve to and then set up a standing order with payments directly to a recipient’s bank account: work out the anticipated annual surplus income, divide that figure by twelve and set up the monthly standing order for that amount. A gift of income is not necessarily a gift covered by the s21 exemption. Setting up a simple regular payment system is the best approach to comply with the requirements of s21.
Record an intention to rebalance to the actual surplus income figure every three or six months and indeed more frequently if circumstances change e.g. if more surplus income arises (say a windfall dividend) or a change occurs in the taxpayer’s health. An alternative could be a commitment to an insurance based savings scheme. It is important to keep to the plan as recorded: doing so will minimise the likelihood of a successful challenge by HMRC after the taxpayer’s death.
“There is no set time span over which the taxpayer must show the pattern of giving. A reasonable span would normally be three to four years” (IHTM p14242).
Step 4 – Secure the past
It is likely that the taxpayer will have a history of past gifts, some of which will be from surplus income. But if the taxpayer died unexpectedly early –say next year – would the s. 21 exemption be available for those past gifts? Cover the past in the resolution.
Take for example a taxpayer who for many years had an irregular pattern of transferring surplus income to a joint account with his late wife and an equally irregular pattern of gifting from that joint account. When the couple saw a need within the family, gifts were made from this joint and then (after the death of his wife) sole account. Some of these gifts were substantial but infrequent e.g. for house deposits.
Strikingly when this procedure was first started twenty years previously the reason given was that the couple thought it would be “decadent” to accumulate income when there was need within the family. Full details of the history and motivation were incorporated in a draft statement with the taxpayer signing and dating the bottom of each page. The taxpayer died a few days later before agreeing and signing the final form of the resolution. HMRC accepted the draft statement as evidence of the settled pattern that had arisen and a significant amount of IHT was saved.
Step 5 – Identify what is income
“Income is not defined in the IHTA 1984 but should be determined for each year in accordance with normal accountancy rules. It is not necessarily the same as income for income tax purposes…. It is usually clear whether payments received are income in nature” (IHTM p14250).
The receipt by a taxpayer from a discounted gift bond is considered as a capital, not income, receipt. If the 5% pa from the original capital investment is taken from an investment bond, whether this is capital or income is an area of uncertainty. In the past there have been letters to practitioners from HMRC putting both views, the income perspective qualified with the comment “so long as the capital of the bond is maintained.” The current guidance in the IHTM at p14250 is “to obtain all the relevant documents and refer the case to Technical,” which suggests the matter is still open for discussion.
Many taxpayers are wealthy because they have saved throughout their lifetimes. Making gifts of income to reduce an anticipated IHT liability cuts across the concept of saving and may be difficult for some taxpayers to implement fully. In particular it is surprising how often income from investments within an ISA and some of the tax free NS&I products is allowed to accumulate. This is income that can be available for distribution using the s21 exemption and can be overlooked by both the taxpayer and his investment adviser.
Step 6 – Deal with accumulated income
Section 21 states that for the exemption to apply, gifts must be made out of income, taking one year with another. If the taxpayer has not been in the habit of gifting all his surplus income, there are likely to be income accumulations from earlier years. To what extent can these accumulations be given away too using the s 21 exemption? The tribunal case of McDowall & ors v IRC (2004) –where the taxpayer lost – contains the only judicial analysis with some focus on what had been done with the accumulations – placed on deposit “but not invested in any more formal sense.” HMRC’s IHT manual has a recently added page on the McDowall case (p14251).
HMRC’s current view is that income is deemed to have been capitalised after two years – based on the phrase “taking one year with another” in s 21 OR “longer if evidence of a specific purpose can be shown.” So again documenting evidence -if it is the case- of a desire to save and then making payment for, say a house deposit to gift to children/grandchildren would be helpful.
“Often the taxpayer will try and claim that the exemption applies on gifts made out of several years of accumulated income, which you should deny. But this is a contentious area and you should seek the advice of Technical before becoming entrenched.” (IHTM p14250)
It seems very likely that a test case will emerge soon on this issue.
Step 7 – The resolution
This should be personal to the taxpayer, as detailed as possible and document the gifts made in the past and intended to be made in the future with the reasons for making those gifts. The aim will be to show both a pattern and a resolve to gift surplus income and how the payments will be made. A major objective should be to unite and illustrate the settled pattern of the past and propose a pattern as regular as possible for what is to be the future use of the exemption. The bottom of each page of the statement should be signed and dated by the taxpayer.
Reasons to make gifts can be very varied, but some do seem to arise regularly; a desire for the taxpayer’s estate not to pay unnecessary IHT, perhaps because a deceased parent paid a large sum in death duties; a wish to help struggling grandchildren who have student debt when the taxpayer had a free University education; a worry that the need to make mortgage interest payments will put unnecessary pressure on a child’s marriage and a grandchild’s upbringing: a general desire to act as the insurer or safety net (that the taxpayer never had) for grandchildren and adult children.
The taxpayer’s reasons for making the gifts usually show common themes, which combined with the gifts and background circumstances can change what appear to be irregular (i.e. not “normal”) gifts into part of the “settled pattern” needed. For example it may be necessary to go back twenty or thirty years to record a taxpayer’s intention always to try to give a significant cash deposit towards an adult child’s house purchase: a gift of £3,000 for this purpose in the early 1970s could need £50,000 now when the child starts afresh following a divorce. It is often worth exploring and then recording what had happened in the period before lifetime gifts become taxable: and record why it was important for the taxpayer to make a gift for this purpose and how those reasons support the taxpayer’s “settled pattern.”
“For the purpose of this exemption, “normal” means normal for the transferor and not for the average person. In most cases it will be clear whether or not there is a pattern of giving, but it is not always that simple.” (IHTM p14241)
“You must leave out of consideration any gift clearly made for some special purpose.” (IHTM p14242)
“The amount of the gift is an important factor. The gift must be comparable in size…. If a particular gift is in a different category from those which are normal because of its size, further evidence will be needed to see if and how it fits in with the normal pattern.” (IHTM p14243)
So use the resolution to make clear what is normal for the transferor and the transferor’s motivation for making the gift(s). This is an important document that needs care and thought in its preparation, particularly for the section dealing with existing lifetime gifts that could be caught for IHT if the taxpayer died immediately after signing the resolution.
Step 8 – Back up the settled pattern with records
Remember the need to show a “settled pattern” by either a sequence of payments and/or a resolution that is followed through. As mentioned above the best way to do this is with a banker’s standing order. The standing order does not have to be directly into the proposed recipient’s bank account. Instead or in addition payments could be to an ISA or personal pension account opened by and in the recipient’s name, to the recipient’s mortgage provider or to a Junior ISA for an infant grandchild.
There are also likely to be comparatively infrequent gifts that initially appear to be outside the settled pattern –for example money to help with the purchase of a car if an adult child’s car was suddenly written off. Many taxpayers will want to keep some “gifting” funds in reserve – an “as the need arises” fund. If this reserve is to be from income and not capital those monies and the proposed use of them should be identified within the resolution and ideally separately earmarked, possibly in a different account but still in the taxpayer’s name.
There are risks with this strategy – on the taxpayer’s death this money still can be in his estate and gifts from this source could open the debate with HMRC as to whether any income has been capitalised or was a one off gift and therefore not “normal” and thus in either case is not available for the s21 exemption.
An alternative would be to use the s21 exemption to make gifts into a discretionary trust, where each gift would become immediately exempt and not remain part of the taxpayer’s estate. The cost of setting up and administering such a trust would need to be considered. The use of the exemption for gifts into a trust is also likely to start enquiries –“In rare cases, the exemption may need to be discussed during the transferor’s lifetime, for example where a gift is made into trust and would be an immediately chargeable lifetime transfer if the exemption was not available” (IHTM p14242).
On death the s21 exemption has to be claimed by the taxpayer’s personal representatives: unlike the immediate annual exemption of £3,000 it is not automatically allowed. (”It is up to the taxpayer or agent to provide you with enough evidence to show that on the balance of probabilities the conditions are satisfied” – IHTM p14234.) The starting point of any claim is completing page 6 of HMRC’s form 403 – gifts and other transfers of value. This is supplemental to the main IHT400 form- Inheritance Tax Account. Page 6 is headed “Gifts made as part of normal expenditure out of income” and contains a list of income and expenditure sources to be completed: that list is not exhaustive.
It is worthwhile printing off this form 403 and discussing the list with the taxpayer with a view to completing the list on a regular basis, partly because it will help the personal representatives when the taxpayer dies and more importantly because the adviser needs to monitor the figures to see how much can be gifted using the exemption. Supplemental form 403 can be obtained by searching for “Form 400-Inheritance Tax Account” on HMRC’s website.
Step 9 – Keep up to date
There are three areas where change can occur: the principal legislation in s21 could change; case law, either a High Court or tribunal decision can arise; or HMRC may change its practice or view of the application of the law.
For example the guidance within HMRC’s IHT Manual does change and that Manual should be checked on a regular basis. HMRC’s Litigation and Settlement Strategy was updated in July 2011 from the issue in 2007. A significant development in that update is the moving away from the all or nothing approach and the embracement of the concept of a fair settlement, including the use of alternative dispute resolution. The s21 exemption is severable i.e. a gift may not be fully covered by s21 – “a transfer of value is an exempt transfer if, or to the extent that, it is shown…” So expect more probing by and negotiation with HMRC when the exemption comes to be claimed.
Also check regularly as to whether the actual gifts made fit in with the documented plan. If there are discrepancies, record the reasons and show how the overall objectives are still being fulfilled: it can be beneficial to use this review as an opportunity for the taxpayer to update and republish his resolution. A sequence of resolutions over the years is stronger evidence than just one resolution made some years before the taxpayer’s death. The existence of several resolutions will reduce the possibility of HMRC arguing that a taxpayer’s mindset or resolve changed after a resolution was signed.
Step 10 – Three final tips
The taxpayer should be warned that a claim for this exemption is tested by HMRC and should be advised to tell his executors to expect this to happen. As the documented plan for the future use of the exemption plays out into reality the evidence in support will strengthen.
In the McDowall case, the taxpayer’s mental illness meant that the gifts by his attorney failed due to the taxpayer’s lack of mental capacity to complete them: the solution is an application to the Court of Protection by the attorney/Deputy for permission to make gifts on behalf of the taxpayer. A knowledge of the Mental Capacity Act 2005 is necessary, but be aware that Act does not apply to powers set up under an Enduring Power of Attorney, as opposed to a Lasting Power of Attorney. The Law Society issued a helpful updated practice note on 8th December 2011 – Lasting Powers of Attorney.
The taxpayer’s sudden death will give HMRC a stronger hand to challenge whether there was a sufficient period “for any payment fairly to be regarded as a regular feature of the transferor’s annual expenditure” (the Bennett case). In those circumstances an adviser may need to obtain evidence from the taxpayer’s medical practitioner to confirm the taxpayer’s death was indeed unexpected.
COPYRIGHT PETER NELLIST 2012
Acknowledgement: With thanks to Money Management, an FT publication, and Trusts & Estates Tax and Law Journal where this article was first published.
If you found this article interesting, please see this article – Saving IHT by gifting excess income – by Amy Berry
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