Recent research carried out by Standard Life showed only 38% of the British public is aware of this valuable IHT exemption. This represents a great opportunity for financial planners to guide clients through this area.
Minimise the impact
With careful planning, a client can end up with a pot set aside for relatives in a way that minimises the IHT impact. A trust that holds an offshore bond could be of use here, as it is a way to hold regular gifts, while making use of a regular premium facility.
There are several client benefits here. Firstly, provided it meets the criteria, the gift is effectively a non-event for IHT purposes for the donor, since the exemption means no seven-year clock is running for IHT. Secondly, a discretionary trust could be used with no 20% IHT entry charge, with careful planning, which gives maximum flexibility over who benefits and when. Thirdly, there is the possibility of no ten-year IHT charges in the trust, if the values are kept within certain limits.
This article will look at some scenarios to show how this IHT exemption can work, as well as high-lighting a few pitfalls. The paperwork that supports the exemption is the key to success. Financial planners involved in annual reviews to make the most of UK tax year-end planning are well placed to support clients.
Exemption criteria
Section 21 of the Inheritance Tax Act 1984 sets out the three criteria to be satisfied. These are:
- the gift is from income;
- the gift forms part of a pattern of gifting;
- making the gift does not undermine the client’s standard of living, which can still be funded from remaining income (ie. dipping into capital to top-up does not help with this exemption).
Perhaps the best aspect of this exemption is that the test is personal to the client. Unlike other IHT exemptions, which are for fixed amounts, this exemption all depends on the income and expenditure of the individual. This means the client who lives quietly with smaller overheads will not be judged against the client who has higher expenditure.
The figures in each case have to stack up, looking at the income, expenditure and then demonstrating there is a surplus available to make gifts.
The best way to see the level of evidence HMRC requires is to look at form IHT403, found at www. hmrc.gov.uk/inheritancetax/iht403.pdf. Often, this exemption is only scrutinised after a client’s death, when the lifetime gifts are reported by the executors as part of winding-up the estate. This IHT form is used for that purpose.
Detailed approach
The last page of the form shows a spreadsheet that gives the best indication of how detailed an approach HMRC will take. There is no reason why this form should not be used as a lifetime record, to capture the evidence in each tax year.
Using the form also helps in another way – it says something about the client’s intention in making the gift(s). Evidence of this intention could prove to be vital if the client dies unexpectedly after only one or two gifts had been made. It would also be sensible for clients to write a letter at the time of making the first gift, setting out their intention to make future income gifts. This all helps to point to a pattern of gifting.
The pattern of gifting
There is no fixed test as to how many years must pass before a pattern is established. It is a mixture of evidence of the client’s intention together with the number of payments made. The more there is in the way of written evidence, the less is required in terms of number of years of gifts. Equally, without written evidence of intention, it will take more time for a pattern to be “read into” the gifts made. The leading case in this area looks at what constitutes a regular pattern – the case of Bennett v IRC in 1995.
Mrs Bennett was a widow and received income payments from her late husband’s Will Trust (she was the life tenant). For a while, these payments were quite small – around £300 a year – arising from dividends in the family company. When the family firm was sold, however, the trust income rose significantly. Mrs Bennett gave a direction to the trustees that the excess trust income should be gifted to her sons, as she did not need it. Each of her three sons received £9,000 in one year, and £60,000 the following year. Mrs Bennett died, and the question arose over the status of these gifts.
Exemption qualifying
HMRC argued the gifts were PETS (potentially exempt transfers) since there was not a regular pattern to them, so they did not qualify for the exemption as they were not “normal expenditure”.
Mrs Bennett’s executors disagreed, and the judge held that the exemption did apply here. Mrs Bennett’s direction to the trustees was an important factor, as evidence of her intention. The fact her death was unexpected was also a relevant factor: “deathbed gifts” would not satisfy the exemption where someone made an initial gift and knew they were unlikely to live.
It is possible that, in some cases, a single income gift could satisfy the exemption. This could occur where someone documented their intention to make regular gifts, made the first, and died unexpectedly.
Key factors
The two key factors in proving the case with HMRC would be the written intention and also that the gift was made when the client was in good health. Gifts when in serious ill health can affect how inheritance tax applies to a client’s estate in a number of ways, and it would probably rule out the availability of this exemption.
Surplus income
Another scenario involving regular gifting relates to those with surplus retirement income. This was the situation in the Scottish case of McDowall v IRC in 2003.
The pension income of the late Mr McDowall was paid into his bank account. When he moved into residential care, it was relatively straightforward to show his standard of living was being supported through the expenditure involved in paying the care home fees – the surplus in the bank account was clear to see.
Ultimately, this case was not successful for the family, due to an important point about powers of attorney. While all the ingredients were in place for the IHT exemption, unfortunately the power of attorney document did not contain the specific word¬ing needed to authorise the attorney to make gifts, when Mr McDowall lost capacity.
There is an important distinction between Scottish law and English law here. In Scottish law, an attorney could have power to make gifts, if that wording is in the Continuing Power of Attorney document.
Under English law, an attorney can only make gifts in more limited circumstances, and would need Court of Protection authority for this sort of gifting. If your client does not have capacity, proceed with care when it comes to advice on gifts.
Good solution
In relation to investment bonds, there has been some discussion about the status of the 5% withdrawals and whether they count as either income or capital. The safer viewpoint is the 5% withdrawal is counted as a return of capital, which means it cannot be gifted using this IHT exemption.
The role of an investment bond here is more likely to be as the receiving vehicle for the gift, rather than the source of what funds the gift.
As usual when making gifts, if family members are young, it may not be desirable to place more significant sums in their hands. Holding the funds in a trust could be a good solution in larger cases.
Julie Hutchison is head of international technical insight at Standard Life International
