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30th January 2012

Inheritance Tax Exemption - Regular Gifts Out Of Income

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For those who are in the fortunate position of having more income than they can spend there is a little known but valuable inheritance tax exemption.

The exemption applies to gifts made regularly out of income. It must be claimed by your executors after your death which means that they must prove to HM Revenue and Customs’ satisfaction that all the conditions for the exemption have been met. The best way is for you to keep accurate and detailed records of your income and expenditure. We can help with this by explaining the records that will be required. Another area we can help with is identifying income. Not all receipts will be recognised as income for these purposes.

This exemption applies where you can show that a gift meets all three of the following conditions:

  • It formed part of your normal expenditure,
  • It was made out of income (taking one year with another), and
  • It left you with enough income to maintain your normal standard of living

1. Normal expenditure

This is expenditure which at the time it took place accorded with your settled pattern of expenditure. This pattern can be established in two ways:

1.1 By examining your expenditure over a period of years which may highlight a pattern to the expenditure

1.2 You may be shown to have assumed a commitment or adopted a firm resolution about future expenditure which you have thereafter complied with.

Because the pattern can be established by showing the commitment to follow it, it is possible for a single gift to qualify for the exemption. But in this case some evidence, perhaps in the form a letter, of your resolution to make the payments regularly would be required. It is not possible to claim the exemption on a single payment if the resolution is adopted at a time when you know you may not live for long.

2. Made out of income

There is no definition of “income” in the inheritance tax legislation. It is assumed that income would be ascertained on normal accountancy principles on an annual basis. It does not necessarily have the same meaning as for income tax purposes. HM Revenue and Customs take the view that after 2 years income becomes capital. This means that although you can carry forward some surplus income from one year to the next they will resist any carry forward for more than two years.

HM Revenue and Customs take the view that it is not fatal if you have to lower your standard of living for some reason, such as losing a job or a drop in income on retirement. The exemption may not be completely lost if you had made a regular commitment at an earlier date when surplus income was available. But, a commitment made at a time when the fall in income could be foreseen would not qualify.

3. Maintain normal standard of living

This means that the gifts must not force you to resort to capital to meet your normal living expenses. What is normal in this situation is what is normal for you. It is not what would be normal for the average person.

HM Revenue and Customs take the view that to decide whether the exemption applies, you need to establish:

3.1 Whether the you could meet your normal living expenses from your income after reducing it by the gifts in question, in that year, and

3.2 If not, if you could do so by taking one year with another

You should consider what is current income and expenditure on an annual basis using the accounting year to 5 April.

If you are in the fortunate situation of having surplus income, this is a very valuable exemption. If the surplus income were not given away it would be increasing your capital wealth which would be subject to inheritance tax on your death. The income would therefore be subject to an income tax and to an inheritance tax charge. By giving away the surplus income it will suffer only income tax in your hands.

It does not suffer tax in the recipient’s hands.

For more information please contact Emma Satterly on or on 01223 532725.