Unlock the Value of the Normal Expenditure Out of Income Exemption to mitigate Inheritance Tax

In the complex world of estate planning and inheritance tax is a valuable, yet often overlooked, exemption known as “Normal expenditure out of income”.

This provision is included in the UK's Inheritance Tax Act of 1984 and offers a significant opportunity for individuals with surplus income to mitigate their inheritance tax liabilities. However, despite its potential benefits, many remain unaware of its implications and requirements.

To whom does this exemption apply?

Normal expenditure out of income exemption could assist individuals within the scope of UK IHT , whose taxable estates exceed their transferable nil rate bands and have surplus income that could be within the scope of UK IHT also.”

Essentially, it allows individuals with surplus income to make gifts that are immediately exempt from inheritance tax, provided the requisite conditions detailed in s21 of the Inheritance Tax Act 1984 are met.

Benefits of the exemption

This exemption offers a multitude of benefits that can profoundly impact estate planning strategies. Notably, gifts made under this exemption immediately fall outside the donor's estate, reducing the potential inheritance tax burden, in contrast to other gifts which can remain potentially chargeable for seven years or be immediately chargeable.

One of the key advantages of this exemption is its flexibility. Provided the relevant criteria is met there is no upper limit on the value of gifts made.

Furthermore, this exemption can apply to lifetime gifts made to individuals or trustees, offering a wide scope for tax planning.

Understanding the conditions

The crux of this exemption lies in demonstrating that the gifts were made as part of the transferor's normal expenditure out of income.

This requires the donor to maintain their usual standard of living after making the gifts, without dipping into capital reserves. The legislation does not define what constitutes "normal" expenditure and "usual" standard of living. Instead, this is measured against what is “standard” or “typical” for the individual concerned.

Key factors considered by HMRC

To assess if gifts made qualify for this exemption, HMRC scrutinises several factors including the frequency, amounts, nature, recipients and the reasons for the gifts. While there is no prescribed timeframe for making gifts, a regular pattern over three to four years is often considered indicative of normal expenditure. A single gift can qualify too, if it is intended to be the first gift in a pattern of gifts.

Documentation of intentions and records of income and expenses are crucial for substantiating claims for this exemption.

Potential savings and opportunities

For individuals with surplus income, leveraging this exemption can lead to substantial tax savings, potentially up to 40% of the value of the gifts. Moreover, this exemption is not exclusive to the ultra-wealthy; even regular taxpayers can benefit from strategic gift-giving strategies.

By maintaining meticulous records and seeking professional advice, individuals can navigate the complexities of inheritance tax planning more effectively. Failure to maintain such records can lead to cumbersome and expensive endeavors, as seen in retrospective attempts to recreate records for estate settlements.