Inheritance Tax: Normal Expenditure Out of Income Exemption

Understanding the Exemption

Inheritance Tax (IHT) is a key concern for individuals looking to pass on wealth without unnecessary tax burdens. One often-overlooked exemption is the Normal Expenditure Out of Income Exemption, which allows tax-free gifting, provided certain conditions are met.

Unlike other exemptions, there is no financial cap on this relief. Instead, gifts qualify if:

• They form part of the donor’s normal expenditure (i.e. regular, habitual payments).
• They are made entirely from income, not capital.
• The donor retains sufficient income to maintain their usual standard of living.

If these conditions are satisfied, the gifts are exempt from IHT and do not form part of the donor’s taxable estate.

Determining what counts as normal expenditure

HMRC looks for evidence that the gifts form part of a pattern rather than being isolated, one-off transfers. Examples of how this can be demonstrated are duration of gifting, normality of payments value of payments and the recipients of the payments.

Sometimes a single gift may still be considered ‘normal expenditure’ if it is made in accordance with a prior commitment. An example of this would be regular payments made to maintain a life insurance policy.

What does “Out of Income” mean?

The second key condition requires that the gift be made from your income, not from capital. HMRC’s view is that:

• Income refers to any net income received after payment of income tax which includes salaries, bonuses, pensions, dividends, rental income, and interest from savings.
• Capital refers to your accumulated savings or assets. HMRC generally treats income as turning into capital after about two years unless there is clear evidence to the contrary.

Exclusions from Income

There are specific types of funds that do not qualify as income for this exemption, including:

• Insurance policy withdrawals
  Regular withdrawals, such as an annual 5% capital withdrawal from an insurance policy.
• Purchased annuities
  Only the income element qualifies, not the capital element.
• Lifetime care plans
  Payments that return part of the capital used to purchase the plan are excluded.

Gifts of personal chattels (like jewellery or art) usually do not count unless there is evidence that they were purchased with income with the intention of gifting them as a replacement to the income itself.

Maintaining your standard of living

Even if your gifts form part of a regular pattern and are made from income, the exemption will not apply if you are unable to maintain your usual standard of living following the gifts. HMRC considers:

• Everyday expenses
  These include mortgage or rent, household bills, council tax, food, travel, and entertainment.
• Lifestyle costs
  Regular expenses that reflect your habitual lifestyle, such as holidays and leisure activities.

In cases where the remaining income is deemed insufficient, HMRC may allow only a portion of the gift to qualify for the exemption.

It is worth noting that income from previous years may be “carried forward” if the current year’s income is insufficient, a particularly useful provision for those with fluctuating incomes.

Practical steps to support your claim

Any gift that could potentially lead to an IHT charge must be reported within one year of death. The exemption is not automatically applied, and must be claimed by Executors at the time of your death.

This means they will need to provide HMRC with a full statement of facts that includes all details of the gifts, income and outgoings. The burden of proof is on the taxpayer to demonstrate that all conditions have been met. To support your claim, consider the following best practices:

Detailed record-keeping

• Document your gifting intentions
  Before making any gifts, write down your intentions. A simple letter signed by both you and the recipient can serve as evidence of a commitment to make regular gifts.
• Maintain financial records
  Keep a detailed record of all income, including payslips, tax returns, dividend statements, and any other sources. Record all deductions and payments of income tax.
• Record your expenditure
  List all your regular outgoings—household bills, mortgage or rent, council tax, and everyday expenses. This will help demonstrate that you have sufficient income left to maintain your standard of living after making gifts.
• Log every gift
  For each gift, record the date, the recipient’s name and relationship, a description of the asset or cash given, and its value. This detailed log will be invaluable if HMRC requests evidence.

Key takeaways

• Unlimited gift amount
  There is no fixed limit on the amount that can be gifted under this exemption, if the gifts are consistent, made from income, and do not compromise your standard of living.
• HMRC scrutiny
  HMRC will examine the duration, regularity, value, and recipients of your gifts. Clear documentation can greatly assist in demonstrating compliance with the exemption’s requirements.
• Planning ahead
  Careful financial planning and record keeping are essential. Not only does this support the IHT exemption claim, but it also ensures that your estate is managed efficiently after your death.

For a more detailed explanation of any of the issues covered above, please contact Ann or call the offices on 01206 574431.