When it comes to making lifetime gifts, many people are familiar with the “seven-year rule” in that if the donor making the gift survives seven years from the date of the gift and does not reserve a benefit in the asset given away, the value of the gift will not be taken into account on the donor’s death for inheritance tax (IHT) purposes.
Perhaps not so well known is that the seven-year rule does not apply to gifts that have been made from the donor’s surplus income, provided that certain conditions are met. The rationale behind this potentially significant exemption is that the inheritance tax regime should not apply to funds which have just been taxed to income tax. Gifts (including gifts into trusts) which meet the qualifying conditions are immediately exempt from IHT and there is no limit on the amount that can be given away, provided that the gift does not exceed the donor's surplus income.
The requirements for this relief to apply are as follows:
1. The gifts must be made as part of the normal expenditure of the donor;
2. They must be made from the donor's income (taking one year with another);
3. The gifts must leave the donor with sufficient income to maintain his or her normal standard of living.
HM Revenue & Customs (HMRC) regards “Normal” as meaning typical, habitual or usual of the donor, according to a settled pattern of expenditure adopted by them. This can be established by reference to a sequence of payments by the donor over a period of time or by proof of a prior commitment or resolution adopted by the donor regarding future expenditure.
The gifts need not all be to the same person, or of the same amount, and may fluctuate where the source of income is variable or if the gifts are for a particular purpose, for example payment of grandchildren's school fees. This flexibility and the ability to stop making the payments at any time, or change the amounts as interest rates fluctuate, is an advantage of the relief during uncertain times. The gifts do not have to be made on a regular or annual basis, although gifts made on a regular basis are more likely to meet the “Normal expenditure” test. A single payment may be sufficient to establish that the gift is normal expenditure for the donor if it can be shown that the donor formed a prior commitment or resolution to make a series of payments. For this reason, it is advisable that a letter or document is created, setting out an intention to make regular payments of surplus income, so that if the payments are cut short due to unforeseen circumstances, there is proof of a prior commitment.
Made from income
The exemption only applies where the gifts are made from surplus income after tax. There is no definition of income for the purposes of the exemption and income need not have the same meaning as for income tax purposes. Examples of income include pension income, interest from savings (including ISAs), dividend income, rental income or income payments received from a trust.
It is possible to carry forward income from an earlier year to set against gifts made in the following year. HMRC considers that, if there is no evidence to the contrary, income becomes capital after two years. Families who wish to rely on this exemption should be careful not to leave scope for HMRC to argue that any retained income has lost its character as income. HMRC accept that income may retain its character for longer if it is retained for a specific purpose, so it could be useful to document why income is being retained if necessary.
As only income is being given away, the donor's capital is preserved and available for use if required.
Maintaining the donor’s standard of living
After making the gifts, the donor must be left with sufficient income to maintain their usual standard of living and this will depend on the individual donor. If the income that remains after making the gifts is not sufficient for the purposes of maintaining the donor’s standard of living, then part of the gift may still qualify for the exemption.
Gifts that a deceased made before death have to be reported to HMRC and if the exemption from surplus income is being claimed, the burden is on the personal representatives (PRs) of the estate to prove the conditions have been satisfied. PRs are required to submit details of the deceased’s income and expenses for each year that the exemption is being claimed. It will therefore greatly assist PRs if there are annual records of a donor’s income and expenditure, demonstrating a clear surplus income that covers the gifts made. It is a lot more difficult to put together evidence of intention retrospectively, which is why it is advisable to write a letter setting out an intention to make regular payments from surplus income.
A donor should seek legal advice during their lifetime as to how best to organise their affairs, and structure their gifts, especially if they think they could take advantage of this valuable IHT exemption.