Steve Berridge, Technical Services Manager at IFGL says that the normal expenditure out of income exemption is often a misunderstood secret weapon in reducing liability to IHT.
We are now less than seven months away from the new tax year and the arrival of arguably the most significant piece of pension legislation since the 2015 pension reforms.
The April 2027 reforms will bring most unused pension funds within scope of Inheritance Tax (IHT) for the first time and move the goalposts significantly in the area of IHT planning and mitigation.
Much has been written in the financial press about the potentially horrific marginal tax rates that might apply to beneficiaries once IHT and income tax are combined.
This leaves financial planners the unenviable task of trying to navigate an area of taxation that can be a minefield.
Most people are aware of the Nil Rate Band (NRB), which at £325,000 has been frozen now since April 2009. Perhaps slightly less well known is the Residential Nil Rate Band (RNRB) which can be up to £175,000 and also the £3,000 annual exemption which is available for gifting.
There are also other exemptions available for gifts on marriage and single £250 gifts.
What is perhaps less well understood and often neglected is the normal expenditure out of income exemption. This is a pity because after April 2027 it could become a useful tool for reducing liability to IHT.
The expenditure out of normal income exemption is contained in Section 21 of the Inheritance Tax Act 1984. This confirms that a transfer of value is an exempt transfer if, or to the extent that, it is shown –
- 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 their regular income, and
- That, after allowing for all transfers of value forming part of their normal expenditure, the transferor was left with sufficient income to maintain their usual standard of living.
In their first technical note issued on 12 May, hidden right down the bottom in section 11.2.5, HMRC confirmed that the changes being made to the taxation of pension benefits for Inheritance Tax purposes do not alter the existing position for lifetime transfers (including the normal expenditure out of income exemption).
This is really good news for pension policyholders.
Essentially it enables policyholders to transfer regular sums from their pension to beneficiaries, reducing the size of their pension fund, whilst not eating into their NRB of £325,000.
As with all legislation care is required to ensure that the three conditions are complied with. Firstly, what is meant by income? Well essentially monies received which are in nature income, rather than capital.
So, regular in nature, for example income from employment or self-employment, rents from property, pensions, interest and dividends. This is all confirmed in the Inheritance Tax Manual (Section IHTM14250).
Secondly the “taking one year with another” condition is to provide for the case where a person’s income fluctuates from year to year but overall they have enough income to meet gifts that meet their standard of living on an ongoing basis.
Thirdly, what is meant with being left with sufficient income to maintain your usual standard of living?
This condition is perhaps the one most open to interpretation (and abuse), but broadly speaking, if someone is still able to feed and clothe themselves, pay all their bills and continue their normal lifestyle, then their gift can be considered to be made from “normal expenditure”.
For those pensioners then who find their regular income exceeds their regular living expenses, there is real scope to give away money from that income.
With IHT receipts increasing year on year, HMRC are certainly keeping a careful eye on the area of inheritance tax.
It would therefore be prudent to ensure that all gifts using this exemption are recorded somewhere for possible future inspection and are timed in such fashion that their regular nature cannot be questioned. Use of a direct debit or standing order for example, might be sensible.
At the start of my article, I suggested that this area of IHT planning can be misunderstood and this comment is made from a real-world example involving a family member.
My mother-in law visited her accountant recently with my wife and they were both told (incorrectly) that she (or rather her beneficiaries) would probably pay IHT on the regular gifts she had in the past year set up for three beneficiaries.
She is someone who receives widow’s scheme pension and state pension income which far exceeds her modest daily needs, so much so that she is finding the level of her savings increasing each month.
The comment by the accountant was therefore incorrect and served to worry an 86-year-old lady who is very switched on about financial matters compared with most of her peers.
To conclude then, the new IHT rules are creating concern and stress but as with any tax change, careful financial planning and the use of the existing exemption regime can be used to mitigate the worst-case scenario.
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