Does income lose its nature over time?

The s.21 exemption

Under s.21 Inheritance Tax Act 1984 , it is possible for certain gifts to be exempt from inheritance tax (IHT) where they are “normal expenditure out of income”. To qualify for the exemption, three conditions must be met:

• the gift must be made as part of the normal expenditure of the transferor
• the gift must be made out of the transferor’s income, taking one year with another
• after the gift, the transferor should be left with sufficient income to maintain their usual standard of living.

It is possible for only part of a gift to qualify for exemption under s.21 .

What is “normal”?

Subsection 21(1)(a) requires that the gift must be made as part of the normal expenditure of the transferor. For these purposes, “normal” takes its ordinary dictionary definition, and so relates to expenditure that is standard, regular, typical, habitual or usual. In other words, not a one-off gift.

What’s “normal” expenditure for one person, however, can differ significantly to what’s “normal” for another. Deciding whether a gift is made as part of normal expenditure therefore requires a multi-factorial analysis, taking into account the amount of each gift and whether those amounts are similar, as well as other factors such as the reason why they were given.

The frequency of gifts is also relevant, with those made on a regular basis more likely to be part of a transferor’s normal pattern of expenditure. While there is no set time span over which a person must show their pattern of giving, HMRC’s position is that a reasonable timeframe is typically three to four years (see Follow up ).

One-off gifts?

While the exemption is intended for regular gifts out of income, it is also possible for a single gift to benefit, e.g. where the transferor died a short while after an initial gift. This was considered in Bennett v IRC, in which the judge noted that a pattern of expenditure may be established by “proof of the existence of a prior commitment or resolution…” . HMRC’s position is that there must be strong evidence in such cases that the gift was genuinely intended to be the first in a pattern, and that there was a realistic expectation that further payments would be made.

In your mother’s case, as her gift is intended to be single and non-recurring, the exemption would not be available. The gift would need to form a regular pattern of giving to be eligible.

Capital versus income

Assuming that your mother is instead willing to make regular gifts to her grandchild, another issue arises when it comes to the savings that they would like to gift. This is because under s.21 the gift must be made out of income.

Income is not specifically defined within the IHT legislation. However, HMRC’s view per IHTM 14250 is that it should be determined for each year in accordance with normal accountancy rules, with income being the net income after payment of income tax. Common sources of income include employment or self-employment, rental properties, pensions, interest and dividends.There are certain exclusions from what is considered income, see ss. 21(2)-(5) .

 Outright gifts of capital assets, such as shares in a company, do not qualify for the s.21 exemption as the gift is not made from income. However, where a capital asset is purchased from the transferor’s own income with the intention of making the gift, the exemption may still be claimed, provided all other conditions are met.

Fluctuations and accumulating income

Even if a transferor has fluctuating income levels and does not have enough income to make their gift(s) in the year they were made, s.21 may still be available if sufficient income can be shown in earlier years, as s.21(1)(b) allows income to be taken one year with another.

However, if a gift consists of money that has accumulated over several years, the question arises as to whether that gift is still made out of income. HMRC’s view is that income from earlier years does not retain its character as income indefinitely - at some point it becomes capital.

Generally, the longer the period of accumulation, the more likely that the income has become capital. If there is no evidence to the contrary, HMRC’s position is that this happens after a period of two years. However, this is a general position only. There could be evidence that either shortens or lengthens this assumption.

In McDowall v CIR the money out of which gifts were made had accumulated in the deceased’s deposit account for around three years prior to transfer. However, the gifts were still determined to have been made out of income on the basis that it was “identifiably money which was essentially unspent income and not invested in any more formal sense.”

 HMRC’s position is that the outcome in McDowall does not mean that all income that is not formally invested retains its character as income indefinitely.

For your mother, it will be important to establish how long the savings have been held and whether any amounts intended for gifting have been invested into capital products, as this will help determine whether the savings could still be considered income.

Robust record keeping

If your mother wishes to make use of s.21 , it will be important to collect robust documentation to show that all three conditions have been met, i.e. that the gift was made out of the transferor’s normal expenditure; that the gift was made out of her income; and that the transferor was left with sufficient income after making the gifts to maintain her usual standard of living. What counts as a “usual standard of living” will vary from person to person. Where the transferor sees a drop in their standard of living, e.g. due to redundancy, the exemption may still be available, provided they had a regular commitment to make the gifts at a time when they had enough surplus income.

 Even if a gift is made out of income, s.21 will not be available where the transferor has drawn on capital to fund their usual living expenses.

Broadly, evidence should achieve the following:

• document the transferor’s intention to make the gifts
• record what gifts were given, when, and to whom (this helps establish a pattern of giving);
• outline the transferor’s level of income and expenses
• detail the reason for the gift, e.g. whether it was charitable giving, a regular gift to a family member, to a trust etc.

Form IHT403 contains a table that captures most types of income and expenditure to evidence that a gift has been made as part of a person’s normal expenditure out of income.

In cases where gifts have been made by an individual who has since died, it might prove harder to gather all relevant documentation. However, it is still important to find evidence that can prove the deceased’s intention to make regular gifts of their income, and that they had the means to do so. This is especially important where only one gift was made prior to death.