Showing resolved intent
Whenever an adviser meets a new client there are three matters that should always be on the agenda: does the client have in place an up to date will, a Lasting Power of Attorney and, for inheritance tax purposes, a letter documenting an intention to gift surplus income?
There was an article in the Saturday edition of a national newspaper a while ago suggesting that readers should encourage their elderly parents to put in place a Lasting Power of Attorney. The incentive mentioned was that an LPA would save about £5,000 in the costs that would be paid if a parent became mentally incapacitated and an application had to be made to the Court of Protection to appoint the adult child as a Deputy to be able to administer the financial affairs of the parent.
But as well as the initial application for the appointment of a Deputy, there are the costs of seeking advice about and complying with the ongoing obligations imposed e.g. filing annual accounts, which Senior Judge Lush in a recent case estimated roughly at £2,000-£3,000 per annum for a panel Deputy until the death of the patient. Mental incapacity can strike suddenly and unexpectedly. There is a good argument that almost every adult, whatever the age, should have an LPA in place.
The immediate IHT income exemption
Similarly, where the client is expected to pay IHT on death and is making or is prepared to make gifts, obtaining the immediate IHT income exemption for (or for some of) those gifts should be considered by the adviser. The law is set out in section 21 IHTA 1984 – see below:
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s.21(1) A transfer of value is an exempt transfer if, or to the extent that, it is shown –
(a) that it was made as part of the normal expenditure of the transferor, and
(b) that (taking one year with another) it was made out of his income, and
(c) 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.
(Subsections 2 to 5 of section 21 are not shown here)
this provision is now well known. Not so well known is that there are two ways in which making a gift as “part of the normal expenditure” of the taxpayer can be shown. These alternatives were set out in the case of Bennett & others v IRC in 1994: there is a very brief summary in the IHT Manual at paragraph 14244. Highlighted below is part of the judgment of Mr Justice Lightman in this important case, highlighting the alternatives for showing a pattern: either by “reference only to a series of payments” or by “proof of the existence of a prior commitment or resolution.”
(Quote from the judgment in the Bennett case)
“The existence of a settled pattern may be established in two ways. First, an examination of the expenditure by the transferor over a period of time may throw into relief a pattern, eg a payment each year of 10% of all income to charity or members of the individual’s family or a payment of a fixed sum or a sum rising with inflation as a pension to a former employee. Second, the individual may be shown to have assumed a commitment, or adopted a firm resolution, regarding his future expenditure and thereafter complied with it. The commitment may be legal (eg a deed of covenant), religious (eg a vow to give all earnings beyond the sum needed for subsistence to those in need) or moral (eg to support aged parents or invalid relatives).”
After a client’s death there is a minefield of difficulty to cross before HMRC will accept that the s 21 exemption can apply. It is the lack of appreciation of how technically complex it is to use the exemption successfully that creates the biggest hurdle. Particularly difficult are single gifts that are irregular eg house deposits to adult children, even if made from income, whether that income is accumulated to some extent from earlier years – or not.
HMRC’s IHT Manual at paragraph 14242 in considering “pattern of gifts” states that HMRC staff “must leave out of consideration any gift clearly made for some special purpose.” In the same paragraph HMRC goes on to instruct that – “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. However you can consider a longer period if this helps the taxpayer to show that the gifts were normal.”
The advantages of a resolution
The proper use of a resolution, as opposed to relying on a pattern building up from past gifts, can make it possible for the s21 exemption to apply to what otherwise HMRC would argue was a “single” gift. The resolution enables the taxpayer to state what he/she regards as “normal” and the pattern he/she intends to create. Box 3 contains an example of a detailed statement of resolve from a taxpayer addressed to his two children as his executors. It is phrased on behalf of the taxpayer and his wife and should be signed and dated by both husband and wife at the bottom of each page and at the end of the statement. Always keep in mind the importance of complying with the resolution and regularly updating it, so the resolution records what is happening and why any changes have occurred from what was initially envisaged. Box 4 shows five of the more important factors an adviser should consider when helping a client use this exemption.
Technical points to consider
Finally some of the technical points to keep in mind are –
- It is possible for a gift to be made from surplus income and not to qualify for the s21 exemption.
- The burden of proving (on a balance of probability basis) that the section 21 exemption applies is on the taxpayer’s personal representatives.
- Turning up adequate proof after the death of a taxpayer of an intention to gift surplus income – beyond the existence of the gifts themselves – is often not possible.
- Detailed documentation of a resolve to use the s21 exemption creates flexibility, primarily because it sets out the pattern of giving the taxpayer intends to follow and should put beyond doubt that a regular commitment to gift has been made.
- At the time of documenting the resolve the client should be in reasonable health. Unlike a will that can be made at any time prior to death, the resolve to commit to gift must be made with a reasonable prospect of building up the envisaged pattern of gifting BUT
- Once a resolution is in place, if a client’s health suddenly deteriorated and there was a wish to gift accrued surplus income, that can be done and be effective to achieve the s21 exemption. (But ensure the gift is part of the intended and stated pattern and is completed before death.)
- Importantly as with any proposed gift, discuss the problems that will come with the death, divorce or debt (“the three Ds”) or mental incapacity of the intended recipient and the alternative of using trusts.
- If mental incapacity of a donor does occur, then advisers need a Court order to continue to make any gift which is “not of a reasonable amount on customary occasions.” Interpret this conservatively and keep in mind if not observed the gifts are ineffective for IHT. In a recent case (Re PC, heard on 30th October 2014) Senior Judge Lush described proceeding without such an order as “unprofessional conduct” and for this breach and other reasons revoked a LPA a patient had given to her two sons.
An example letter
Dear Sue & Penny,
On the advice of both our solicitors and our financial adviser, Tom Smith, your mother & I are writing this formal letter to you as our executors to be kept with our wills which are held by our solicitors. Periodically we intend to update this letter so there may be a series of letters in a similar vein.
As you know we have both just retired. With Tom’s help we have more than sufficient income for us to maintain our normal standard of living. Tom calculates that my gross income is just over £40,000 pa and your mother’s income is about £30,000 pa gross. We regard our combined income as belonging to us jointly. Our income tax liability is about £10,000 pa: as some of our income comes from dividends on the investment trusts in our ISAs that is tax free in our hands. Additionally I withdrew only part of my private pension fund when I retired and placed the Pension Commencement Lump Sum of £150,000 on deposit with the intention of spending £15,000 pa as though it were income.
I have been granted Fixed Protection 2012 on my private pension fund so what remains undrawn will be left to accumulate. It can grow up to £1.2 million without any excess tax charge (I have used £600,000 of my private pension: £150,000 as a PCLS, £150,000 to buy an annuity and leaving £300,000 in drawdown, which has now grown to £340,000 despite the withdrawals I have made from it.)
Your mother, Tom & I review our financial arrangements every six months. I hope over the next nine years or so, ie before I reach the age of 75 years, that the retained pension fund will have grown sufficiently to provide both another significant (tax free) PCLS to replenish the first Sum we are spending at about £15,000 pa. and to increase my drawdown fund. (Incidentally there is now the prospect of that drawdown fund passing to you free of death tax and from which you could draw a taxable income. Mum and I have agreed this will not happen until after the death of the survivor of us.)
Presently Mum & I are spending about £38,000-£40,000 pa on ourselves, so we have surplus income of about £35,000 pa: this includes the drawdown of the PCLS. Additionally we have accumulated income of another £35,000 from last year which is presently part of the deposit in Mum’s name with our bank. We both feel it would be immoral and almost decadent of us to retain this money for ourselves for no particular purpose, while you are both having to be careful with money yourselves and have the expense of bringing up your children.
From this accumulated and accruing income, we have just given you £20,000 each to be used by Sue towards reducing her mortgage and by Penny to buy out her former husband’s share of their home as part of their divorce settlement. As you also know we want to build up a source of income for you when you stop working and have arranged for you to set up ISAs in your names with an initial payment of £10,000 each. We have put in place a standing order with our bank to pay £500 a month to each of your ISA providers to increase your ISAs with the purchase of more equity investments as advised by Tom. We have cash savings earmarked to buy impaired life annuities if ill health strikes either of us, but even in those circumstances we intend this basic provision of at least £500 a month to each of you to remain in place until the death of the survivor of us.
When your mother & I got married in the early 1970s we had to save up for about two years for the deposit for our first home, with the amount you could borrow on a mortgage being, as now, restricted. We found it difficult and were about £300 short of the amount needed. My parents felt unable to lend that money to us, but Mum’s parents did do so. We were able to repay that loan after 3 months’ of saving. What we own now is as a result of hard work and saving, helped by a free University education which I know will not be available for your own children.
When my mother died last year I found a receipt for just under £300 for a carpet she had purchased a month or so after we bought our first house. We greatly appreciated the £300 Mum’s parents lent us to bridge the gap to enable us to buy our first home: we are determined not to be selfish and buy carpets when the money could help you. As you know, whilst I passed my share of that inheritance from Grandma onto you both by a deed of variation there was still a significant amount of inheritance tax to be paid. Mum remembers that when her grandfather died almost 70% of his estate was paid out in estate duty.
Mum & I are determined not to repeat the pattern of hanging onto money for no real reason and just thereby increasing what you both will have to pay in inheritance tax when the survivor of us dies. From our own experience we are both very aware that money is most needed when you are young. We are also very firmly resolved to help you and your families as much as possible financially and to ensure that at least ALL of our surplus income is passed to you to be used in any way possible to secure your and our grandchildren’s futures.
As you will have realised when we gave you each house deposits ten years ago by Mum passing over her share of her mother’s estate to you, we interpret “help” in a broad context including payments to help with the business Penny is just setting up, to help with moving house and, of course, building up your savings and reducing your mortgage debt. If we are unable to help to the degree needed you can always access your ISA savings, for example to pay for your own children’s university education: but we hope we will still be alive then and able to help there too. If we are not alive then, then you will have received an inheritance from the survivor of us, albeit reduced by inheritance tax.
As you also know Mum worked in the 1970s at a London auction house running the jewellery department. We have continued using some of our income to buy at auction select items of jewellery with the intention of gifting these purchases, usually spending in the region of £1,000-£2,000 a piece: some of these items are given to you and some are placed in the safes in your homes gifted as shown to your daughters. We enjoy and will carry on doing this, but probably less frequently and more selectively.
Mum & Dad (C & RA Jones)
- Expect to complete the very detailed form IHT 403 and to be prepared to show bank statements to HMRC if requested.
- If there have been gifts from surplus income in the seven years prior to signing this resolution, document those gifts too in the resolution.
- The final paragraph picks up that a capital asset –jewellery – was purchased by the donor from income with the intention of making a gift. With this intention documented the s21 exemption can apply (see the IHT Manual at paragraph 14250).
- Using the PCLS in this way as “income” will be contested by HMRC – again see paragraph 14250 of the IHTM. Whether this use of the PCLS falls within the definition of “out of income” is unresolved and contentious. The case of MacDowell v IRC 2004 might give some support to this strategy if properly documented (for a summary of the MacDowell case see IHTM at paragraph 14251).
- Seek assurance that any payment to a divorcing child will not affect the final financial settlement between the divorcing parties.
- Remember that the section of HMRC dealing with IHT will have access to and will check HMRC’s income tax records for the taxpayer.
Five points for an adviser to remember
- Warn the client to tell his executors that HMRC will challenge the use of the exemption BUT
- HMRC is less likely to challenge proper use of the exemption if that use is supported by contemporaneous documentation signed and dated by the taxpayer.
- A standing order or direct debit from the client’s bank account supported by a signed statement is unlikely to be challenged by HMRC, although evidence will still have to show payments were from income and did not affect the taxpayer’s usual standard of living.
- A five or six line perfunctory statement is unlikely to be acceptable to HMRC. Personalise the statement, giving as much detail as possible.
- Every client will have a different history. Take the time to understand the client’s motivation and to document it.
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