Mark McLaughlin highlights a useful exemption which can allow funds to be transferred into trust without triggering an inheritance tax charge.
The inheritance tax (IHT) exemption for normal expenditure out of income is very generous. There is no upper limit on an individual’s gifts (or ‘transfers of value’) in monetary terms; the only cap is the amount of ‘spare’ income eligible to be given away!
Perhaps unsurprisingly, there are strings attached. A gift will only benefit from the normal expenditure out of income exemption if three conditions are all satisfied (in IHTA 1984, s 21), broadly as follows:
- the gift was part of the normal expenditure of the person making it;
- it was (taking one year with another) made out of his or her income; and
- the person making the gift was left with sufficient income to maintain his or her usual standard of living.
These conditions appear straightforward. However, HM Revenue and Customs (HMRC) apply them strictly, and according to their own interpretation of the rules (see HMRC’s Inheritance Tax manual at IHTM14231-IHTM14255). An analysis of the conditions is outside the scope of this article.
Cash gifts into trust
The normal expenditure out of income exemption can be useful in a number of ways, such as when making lifetime gifts of cash into a discretionary trust for family members.
A difficulty with such transfers is that an individual is generally limited in the amount of cash that can be gifted in a seven-year period without incurring an IHT liability (i.e. to the available ‘nil rate band’ (£325,000 for 2016/17), subject to any reliefs and exemptions).
By contrast, gifts within the normal expenditure out of income exemption do not use the donor’s IHT nil rate band. Furthermore, unlike potentially exempt transfers (e.g. a cash gift between individuals) it is not necessary for the donor to survive at least seven years before the gift becomes exempt for IHT purposes (although see HMRC’s view below).
However, care is needed. For example, HMRC considers that it has the right to decide whether a gift satisfies the exemption conditions. This is because the legislation states that the gift is exempt 'if, or to the extent that, it is shown’ that all the conditions are satisfied. HMRC interprets ‘shown’ as meaning ‘shown to the satisfaction of HMRC’ and considers that the gift therefore remains a chargeable transfer unless and until the normal expenditure out of income exemption is shown to apply (IHTM06106).
There is a general requirement to report chargeable transfers to HMRC within statutory time limits, such as cash gifts into a discretionary trust (IHTA 1984, s 216(1)(a)). However, this requirement is subject to an exception in certain circumstances. For example, the cash gift will qualify as an ‘excepted transfer’ (i.e. not reportable) broadly if the cumulative total of all chargeable transfers made by the donor in the seven years before the transfer, together with the value of the current chargeable transfer, does not exceed the IHT nil rate band (SI 2008/605, reg 4(2)).
This article was first printed in Tax Insider in October 2016.