Creating a Settled Pattern: Key to Qualifying for Normal Expenditure Out of Income IHT Exemption?

I was engaged by a client, David, to ascertain his unrealised inheritance tax (“IHT) liability and plan how best to reduce his anticipated IHT exposure.

During a review of the gifts he had made over the previous seven years, I sensed some resistance, as if he wasn’t telling me everything, so I probed a little further. He explained that he had recently made some gifts out of income and that his adviser had confirmed these gifts were exempt from inheritance tax. As such, he believed they needn’t be considered as part of my review.

To provide some context, a gift from one individual to another will be exempt from IHT if the transferor survives seven years after making the gift. Therefore, the “normal expenditure out of income” (gifts out of income) inheritance tax exemption becomes valuable only if the transferor does not survive the seven years, because the gift then becomes chargeable, or if the transferor chooses to settle the income into a trust, which is an immediately chargeable transfer.

The “normal expenditure out of income” legislation provides for an immediate IHT exemption for a transfer of value if it can be shown that:

• it was made as part of the normal expenditure of the transferor;

• it was made out of income (taking one year with another); and,

• 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.

Where these conditions are satisfied, the IHT exemption is immediate and absolute.

Knowing that the “normal expenditure out of income” legislation is so deceptively simple it misleads some into assuming any gift out of income will qualify for the relief, I asked David whether the gifts were made in accordance with HMRC guidance. Understandably, he had no idea what I was referring to and deferred to his adviser’s pronouncement.

The issue is that while the legislation is brief, the published guidance by HMRC is comprehensive. Although the guidance represents HMRC’s interpretation and is not strictly enforceable, where parts of the statute have been considered by the courts, the case law typically validates their position. 

I told David that given HMRC’s power to challenge the validity of an exemption claim, it is prudent that all gifts be made in accordance with their guidance.

I insisted on reviewing the details of these gifts and asked him for a schedule; he didn’t have one.  He resorted to compiling a list of dates and amounts using his bank statements and added the names from memory although he ‘couldn’t be certain’.

There were no details on his list about who the donee was to David, nor the reason for the gift. There was also no record of income or living expenses during those years.

I may sound pedantic, but I was only asking for information that HMRC might ask for. David struggled with the list and resented my intrusion, so I asked him to consider how much more stressful it would be for his grieving family to find the same information if an enquiry arose following his death.

A quick comparison of David’s list with his self-assessment tax returns showed that he didn’t have sufficient income in those years to make the gifts he had out of income. He advised me that the income had been accumulated over several years.

Another concern was that there appeared to be no pattern to the gifts made. Establishing a pattern is necessary to satisfy the ‘normal expenditure’ condition (see below).

I doubted whether the gifts David had made, if subjected to assessment by HMRC, would satisfy the conditions to qualify for the inheritance tax relief.

Rather than recount what I explained to David, I will provide a summary of the HMRC guidance.

Normal expenditure condition

To safeguard against failure to satisfy this condition, all relevant factors must be considered to ensure a settled pattern is established and that all gifts out of income form part of it.  The relevant factors are:

• frequency;

• amount;

• nature of the gifts;

• identity of the donees; and,

• reasons for the gifts.

Frequency

“Normal” does not necessarily mean regular or annual; however, gifts made on a regular basis are more likely to meet the normality test.

A gift of all dividend income as it arises from a modest stocks and shares portfolio could result in irregular payment frequency.

Amount

The gifts must be comparable in size unless they are made by reference to a source of income that is variable, such as a stocks and shares portfolio, or a specific cost, such as annual school fees.

If a settled pattern is established but a particular gift does not form part of the pattern because the size of the gift is more than the others, the gift may be treated as including an amount that is ‘normal’ and an amount that is not. The normal part would be exempt, and the balance would be potentially exempt (or immediately chargeable if settled into a trust).

An example of such a situation would be where a transferor makes regular, annual gifts of, say, £100,000, but one year the amount of the gift is £150,000. HMRC may assert that the additional £50,000 should be excluded from the IHT exemption claim.

If the pattern is broken by a gift that is less than the regular, annual gifts, it may be excluded altogether.

Nature of the gifts

A gift out of income will ordinarily take the form of a cash gift; however, it is possible for the transferor to use the income to purchase a capital asset for the transferee.

The capital asset must be purchased out of income, not capital, and the other relevant factors should still be complied with to maintain the settled pattern.

Identity of donees

There will be occasions where a transferor wishes to benefit multiple individuals with one-off gifts only. On the face of it, no pattern would be established, but by broadening the objects of the pattern to groups of beneficiaries, such as family or friends, instead of individuals, it might be possible to successfully contend that a pattern has been established.

Reasons for the gifts

The reason for the gift can also mean that it falls outside the “normal expenditure out of income” exemption. For example, if a settled pattern is established by making regular payments towards school fees, and a gift is made to acquire a property, this gift to help acquire a property may not be covered by the exemption.

Made out of income condition

To satisfy the conditions for the inheritance tax exemption, the gifts should be made out of income, not capital. HMRC’s opinion is that income doesn’t retain its character indefinitely and maintains that it becomes capital if accumulated for two years or more. It also argues that the longer the period of accumulation, the more likely it is that income has been capitalised.

Any gift out of income will be regarded as having been made out of current-year income in priority to earlier-year income.

There has been only one case - McDowall and others v commissioners of Inland Revenue - that has considered the made out of income condition, but it did not discuss the duration of accumulations. HMRC are keen to stress that the case does not endorse the position of income retaining its character indefinitely.

Maintain usual standard of living condition

Gifts out of income will not qualify for the exemption if the transferor was left with insufficient income to maintain their usual standard of living or was required to resort to capital to do so.

There is some leeway with this rule. Should net income in any one year not be sufficient to make the relevant gift and continue to maintain the usual standard of living without resorting to capital, income and expenses over more than one year may be considered.

It is also important to note that although the gifts must have left the transferor with sufficient income to maintain their usual standard of living, they may choose to use capital to meet their living expenses and use the excess income for some other purpose.

Conclusion

Although the HMRC normal expenditure out of income guidelines are intended to be prescriptive, a looser pattern of gifting may be acceptable to them. Unfortunately, there isn’t the facility to apply for advance clearance, which is why, where possible, it is important to make gifts in accordance with their guidance.

Having discussed the guidance with David, he was concerned that there was no discernible pattern to the gifts he’d made and also that some or all the gifted amounts would likely be regarded as capital payments.

I suggested he first update his schedule to include all his income and his living expenses. I sent him a copy of IHT403 to use a guide. A detailed schedule not only assists the personal representatives of an estate but would also help David see if he has, or can, establish a pattern when considering the relevant factors of the ‘normal expenditure’ condition.

We discovered that his net income was higher than anticipated because he received a sizeable amount of ISA dividend income that didn’t show on his self-assessment tax returns, as it’s exempt from income tax.

David decided to resume making annual gifts to the beneficiaries of his previous gifts, but for lower amounts in line with his excess income. He wrote a memo to document his intention for the gifts to be made out of excess income. His expectation was that if the earlier gifts become chargeable, a large proportion of the gifted amounts would be exempt.

I would like to end this case study by acknowledging that not all gifts will satisfy the “normal expenditure out of income” inheritance tax exemption. But, if you’re making gifts in anticipation of the relief being available, it is necessary for the gifts to be made in accordance with legislation and the HMRC guidance, and for the transferor to maintain a detailed schedule of their income, expenses and the gifts.

If you're worried that your past gifts might not meet the inheritance tax exemption criteria, don't wait until it's too late. Contact me for an expert review of your lifetime gifts and a tailored strategy to protect your estate from unexpected tax liabilities.

Please note that the information contained in this blog post is provided for general informational purposes only. It does not constitute any form of legal or tax advice, and you should not use it as a substitute for advice tailored for your specific circumstances. I disclaim all and any liability for any actions you take (or omit to take) in reliance upon the contents of this post.