Chapter: 2 - Inheritance Tax Mitigation: The Basics

Normal expenditure out of income

2.2.6

A transfer will be exempt only if (taking one year with another) it was made out of income leaving the transferor with sufficient net income to maintain his usual standard of living, ie without resort to capital (IHTA 1984 s21). HMRC used to argue that a pattern of expenditure of at least three years must be shown, though the Bennett decision in 1994 (see below) roundly disapproved this. A pattern of giving should be started as early as possible. Records should be kept to back up any claim if necessary. The gifts must be made out of income (which, not surprisingly, does not include the proceeds of sale of shares: see Nadin v CIR [1997] SSCD 107 (SpC 102)).

Expenditure will of course include Income Tax and all regular expenditure of an income nature – as opposed to capital, eg extending the house.  This exemption is quite extraordinarily useful and is generally underused.  It is important to keep careful records, in the event that death falls within seven years after a gift in a series, in order to convince HMRC that that gift was exempt.  Where the exemption is used over a number of years, it does not matter if in one of those years there was a deficit (out of which of course no gift can be made), so long as ‘taking one year with another’ there was a surplus and gifts were made out of that surplus.

Note the helpful principles set out in the leading case (by Lightman J in Bennett & Others v CIR [1995] STC 54).

• ‘normal expenditure’ means expenditure which, when it took place,  accorded with the settled pattern of expenditure adopted by the donor;
• a settled pattern can be established either by examining the donor’s  expenditure over a period of time, or by showing that the donor has  assumed a commitment, or adopted a firm resolution, regarding future  expenditure and has thereafter complied with it;
• there is no fixed minimum period during which expenditure has to be  incurred; a single payment implementing the commitment or resolution  may be sufficient;
• where there is no commitment or resolution, a series of payments may be required;
• a pattern need not be immutable, but it must be intended to remain for a sufficient period (barring unforeseen circumstances); thus, ‘death bed’ resolutions would be excluded;
• the expenditure need not be fixed nor need the recipient be the same on each occasion. The amount of the gift may be fixed by a formula, eg a percentage of earnings, or by reference to an ascertainable liability, eg the cost of nursing home fees, and the donees may be a general class,  eg family members or needy friends; and
• tax planning does not disqualify the expenditure.

In Bennett, the deceased was the life tenant of her late husband’s Will Trust. The trustees had on her instructions paid to her three sons total income of some £28,000 in February 1989 and then £180,000 in February 1990, a few days before the deceased’s death. Nevertheless, applying the above criteria, Lightman J was satisfied that ‘normality of expenditure’ had been achieved. He said that the donor had had a single and continuing intention regarding the surplus trust income and that that intention was put into effect. The decision in this case is likely to prove helpful in situations where a life assurance policy has been written in trust and where the grantee of the policy has died unexpectedly having paid only one or a very limited number of the regular premiums which would have been due had he survived.

TAX TIP:  As with the annual exemption, it is axiomatic that where the taxpayer does have post-tax income surplus to normal living requirements this extraordinarily valuable exemption is used. Clear records should be prepared each tax year to provide the necessary evidence in case of death within the following seven years, ideally in the form provided in Schedule 403 to the Inheritance Tax account form IHT400.