April 2012 – HMRC Revised approach to normal expenditure exemption

Author: Mitchells Roberton
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  • If you make lifetime gifts then, in the event of your death, they may be added back when it comes to working out any inheritance tax (“IHT”) payable on your estate. But some gifts are “exempt” from IHT so they are not added back and would not increase the amount of tax payable on your estate on death.
  • An important exemption which can sometimes be overlooked is the “normal expenditure out of income” exemption. So, if you are thinking of making any lifetime gifts but want to try to make sure they will not be added back to your estate for IHT, this is an exemption well worth considering.
  • It should be emphasised at the start however that this exemption requires that your income exceeds your expenditure; and by a greater margin than the sixpence envisaged by Mr Micawber in David Copperfield (“Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness…”). To make use of the “normal expenditure out of income” in a worthwhile way your income has to exceed your expenditure by a comfortable margin.
  • In essence, there are three conditions each of which must be satisfied for the exemption to apply:
    • the gifts must be part of your “normal expenditure”;
    • the gifts must be made out of income, and
    • taking the gifts into account you must be able to maintain your usual standard of living.
  • The Revenue (“HMRC”) have recently adapted their approach as far as the second of those conditions is concerned. But before turning to look at HMRC’s change of approach It is worth expanding a little on each of the requirements.

–          “Normal expenditure”

What counts as “normal expenditure” can be established in two ways. First there can be a pattern of gifts over a period of time (most likely a few years). Secondly, the individual may be shown to have assumed a commitment to future expenditure and then complied with it.

–          Gift must be made out of income

“Income” is not defined in the legislation but it must mean net income after payment of income tax. And, subject to what is said below, “income” is considered to refer to current income: not income earned in the past which has been saved over a period.

–          Maintaining your usual standard of living

The standard of living is your own individual standard: it is not that of the proverbial man on the Clapham omnibus.

  • As mentioned, HMRC have changed their stance a little as far as the second requirement is concerned i.e. the requirement that the gifts be made out of “income”.
  • It was generally the case that if you had retained surplus income over a period of years without investing it then HMRC might accept that gifts out of that retained income were nevertheless gifts out of income for the purposes of the exemption. So, one large gift out of those savings could still qualify for the exemption.
  • HMRC’s updated views on this aspect of the matter are these:

“…If there is no evidence to the contrary, we consider that income becomes capital after a period of two years…each case will depend on its own facts but, in general, the longer the period of accumulation, the more likely it is that the income has become capital…”

  • This is not a fundamental change. It could simply be described as a change of emphasis. But it does indicate that HMRC will take a stricter line than before. That in turn points to its being important, where this exemption is being relied on, to keep detailed records including your intentions with regard to retained income i.e. records which can function as “evidence to the contrary”.
  • HMRC have a form being the one which would need to be completed in the event of your death where the “normal expenditure out of income exemption” is claimed. This includes a table for claiming the “normal expenditure out of income” exemption which is set out quite helpfully and could well be used in life as a record of such gifts. The form is known as “Form IHT403” http://www.hmrc.gov.uk/inheritancetax/iht403.pdf and we can supply a paper copy of the table included in the form if you wish.

Note: This material is for information purposes only and does not constitute any form of advice or recommendation by us. You should not rely upon it in making any decisions or taking or refraining from taking any action. If you would like us to advise you on any of the matters covered in this material, please contact Neil Mackenzie: njm@mitchells-roberton.co.uk

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