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What does HMRC mean by gifts from 'surplus income'?

A reader seeks guidance on how to avoid falling foul of HMRC rules
What does HMRC mean by gifts from 'surplus income'?

My wife and I would like to make gifts to family from what we deem to be our excess income that at the same time secure an exemption with regard to inheritance tax. However we are rather in the dark about what counts as excess income as far as HMRC is concerned, and there is not enough detail on Form 403 for me to understand if our plans fall within the rules. Could you shed some light on what is permitted in terms of the gifting rules and also how “excess expenditure” is defined? Will we need to keep detailed records and evidence of the gifts that we make?

DS 

Stephanie Court, private client tax director at RSM UK

A valuable exemption from IHT applies to gifts out of excess income. Gifts which meet the qualifying conditions are immediately exempt from IHT, and there is no monetary limit on the exempt amount, provided the gift does not exceed surplus income.

A gift is exempt from IHT if it can be evidenced as follows:

  • 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 income, and
  • that, after allowing for all gifts forming part of their normal expenditure, the transferor was left with sufficient income to maintain their standard of living.

A gift must meet all these conditions to qualify for the exemption, and by the very nature of the conditions, each individual’s claim will be unique. Taking these conditions in order, it is helpful to understand how the terms contained are defined.

The first condition calls for the gift to be part of the normal expenditure of the transferor. For the purpose of this exemption, HMRC accepts that ‘normal’ means normal for the transferor itself, not for the average person. The term ‘normal’ takes its usual meaning, that is standard, regular, typical, habitual or usual. HMRC’s guidance states the factors it will consider in looking at any pattern of gifts including the frequency, amounts, nature and reason for the gifts, as well as the identity of the recipient.

There is no set time span over which the pattern of gifting is measured, but HMRC states three to four years would be reasonable. A pattern of gifting could be established from a single gift with sufficient evidence of intention, or over a longer timespan if it helps a taxpayer illustrate that the gifts were normal. In many cases, a pattern of gifting will be clear, but if you are intending to establish a pattern of gifting, it is generally recommended that you show a commitment to make regular gifts, for example by writing a letter stating your intention to the recipient.

The second condition for exemption is that the transferor should have made the gift out of their income. Capital assets therefore do not usually qualify, and as income is usually received in the form of cash, cash gifts tend to be the most obvious format for this exemption. ‘Income’ is not defined so is taken by HMRC as determined by normal accountancy rules and arising each year to 5 April.

It is important to note that ‘income’ for this exemption is not necessarily the same as a person’s income for income tax purposes. For example, income from individual savings accounts (Isas) is tax-free, but is considered income for this purpose, while payments from investment bonds are usually considered capital, even though subject to income tax. In any case, income is the net income after payment of income tax.

The intention of including ‘taking one year with another’ in the exemption is to provide for the case where a person’s income and expenditure fluctuates year to year, but overall they have enough income to make normal gifts and meet their standard of living on an ongoing basis. Initially, HMRC will look at the income of the year in which the gifts were made to see if there was enough income available to make the gift, before considering earlier years. It is possible, however, for income to be accumulated and carried forward, though HMRC’s guidance goes on to state that the longer the income has been accumulated, the more likely that the income has become capital. It is generally recommended to keep a record of your income and expenditure for the two tax years prior to your first gift, as HMRC will usually accept that accumulated surplus income will only become capital after two years, and the brought forward surplus may therefore be utilised in a later tax year.

The third condition is that, after allowing for the gifts, the transferor must have been left with enough income to maintain their usual standard of living. Gifts, even if made out of income, will not qualify for exemption if the transferor had to resort to capital to meet their normal living expenses. However, provided the gifts leave the transferor with sufficient income, they do not need to have actually used the income to meet their living expenses.

The usual standard of living will generally be what was usual for that person at the time the transfer was made, so if a person has to lower their standard of living for some other reason after the gift is made, the exemption should not be lost. Living expenses in this context not only include the deceased’s share of household bills and basic costs of living, but all the costs associated with maintaining their lifestyle, including leisure activities.

HMRC’s guidance suggests that to decide whether the exemption applies, you need to establish whether the transferor could meet their normal living expenses from their income after reducing it by the gifts in that year, and if not, could they do so by taking one year with another.

The exemption must be claimed by completing the schedule in form IHT403. It is not necessary to provide copies of bank statements or bills with the claim, which is made by the executors of the deceased, but they should be prepared to provide documentary evidence of the deceased’s income and expenditure should HMRC request it in order to satisfy HMRC that the gifts meet the exemption.