I wish to present out of surplus revenue, how do I show the cash is not from my capital?

I’m planning to use gifting out of surplus income to mitigate inheritance tax, but I have some concerns.

Is it possible to get an interim review of the records being kept to demonstrate gifts are from income and not capital? Once one is dead there is little that can be done to correct mistakes…

To this end is there a definitive list of what HMRC consider as genuinely capital spend as opposed to living expenses. 

For example, it is understandable that IT purchases would be considered a ‘living expense’ as they quickly become redundant, while purchases of expensive jewellery remain in the estate and can thus be regarded as capital expenditure.

Would this logic place such items as home extensions, replacement windows/doors/shutters and replacement central heating systems etc as reasonable capital spend, the value remaining in the estate, or as maintenance in the same group as decorating required to maintain one’s standard of living?

An excellent tax consultant put us on the right track two year ago, but he has since moved on and they are not that easy to find. G.A, via email

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Harvey Dorset, of This is Money, replies: The exemption you are looking to use, officially known as ‘normal expenditure out of income’, is a useful way of passing on wealth to your children without incurring inheritance tax on the money you give to them.

Gifting rules stipulate that you can only pass on £3,000 per year in total without being liable for inheritance tax if you die within seven years. 

You can also make multiple gifts of £250 or less to recipients who weren’t among those benefiting from the £3,000. 

In each tax year, you are also allowed to give a child £5,000 as a wedding gift.

In order for your gifts to qualify as gifting out of income, the money must form part of your normal expenditure, be made out of your income rather than your capital, and leave you with enough income to maintain your normal standard of living.

Forming part of your normal expenditure is usually considered to mean the transfer is a regular gift that forms a ‘pattern of giving’.

Your worry is that the Government could deem your gifts as having been made out of capital spending rather than income. 

As a result, it is essential that you keep a record of your expenses and income, as well as tracking the gifts that you make. The onus to track these figures falls largely on you.

Because of this, it is wise to get expert help. We spoke to two financial advisers to find out what you need to know in order to ensure that the money you are gifting comes out of your income, rather than your capital.

Sam Gibson, senior wealth planner at Canaccord Wealth, said: Trying to mitigate inheritance tax can be a minefield. 

Along with ever-changing legislation, budgets, cost of living increases, long term care rule changes and the fact that life expectancy is increasing, it is nigh-on impossible to predict how much money an individual will need for the rest of their life. 

One thing is for certain: most people would rather not pay further tax on any inheritance they leave to their loved ones, especially as they have most likely already paid tax on the accumulation of this money in the first place.

Trying to plan how much to gift and the timing of gifts can be daunting and usually people prefer to delay these decisions, often leaving them unnecessarily wealthy in their later years when options become more limited. 

The reverse of this is that decisions are made that create problems down the line, for example gifting money they may need for long term care costs, or gifting property that they may retain a benefit from, ultimately causing the gift to fail. So planning is key.

What is a ‘gift’?

HMRC defines a gift as:

• Anything that has a value, such as money, property, or possessions

• A loss in value when something is transferred. For example, if your house is worth £300,000 and you sell it to your child for £200,000, the £100,000 shortfall counts as a gift.

What gifts are exempt from IHT?

Each individual has an annual exemption allowance of up to £3,000 which they can gift and this will become exempt from inheritance tax. 

You can carry forward any unused amount for one year only, therefore a total of £6,000 split across two tax years could be available.

In addition to this, any number of gifts worth up to £250 to a sole recipient can be made. However, there is a caveat to this in that these gifts must be made to people who have not already benefited from the annual exemption (£3,000).

As well as the above, the following can be given away in each tax year:

• Wedding or civil ceremony gifts (up to £5,000 for a child, £2,500 for a grandchild or great-grandchild, or £1,000 for anyone else)

• Money to help with another person’s living costs – usually to children under 18 or people who are dependent on you because of old age or infirmity

• Gifts to charity or political parties

• Gifts out of surplus income.

What is deemed a gift out of surplus income?

There are three specific conditions that need to be met to count as a gift from surplus income:

1. There is clear evidence of an intention to make regular gifts outside of normal expenditure.

2. The gift was made from net income and not a transfer of capital assets; common sources are employment, rent from property, pension income, interest, and dividends.

3. The donor has enough income to maintain their current standard of living and not have to resort to capital to meet their needs.

However, it’s important to note that the gifts must form part of a pattern. 

HMRC is likely to go back previous years to find evidence that the gift is habitual. Ideally, you would not leave gifting to the last minute each year and instead distribute income throughout on a monthly or quarterly basis where possible.

Gifts from income should be for around the same amount, but it is expected these could fluctuate if the income is known to vary. HMRC can also consider single gifts made, if there’s evidence this gift was intended to be the first of many.

Answers to reader’s specific questions:

1. Is it possible to get an interim review of the records being kept to demonstrate gifts are from income and not capital? 

A financial adviser should be able to review these records and provide a comprehensive analysis of what they deem to be qualifying and non-qualifying, however, HMRC form IHT403 provides useful guidance in establishing what surplus income there is net of tax and expenditure.

2. Would this logic place such items as home extensions, replacement widows/doors/shutters and replacement central heating systems, etc. as reasonable capital spend, the value remaining in the estate, or as maintenance in the same group as decorating required to maintain one’s standard of living?

In general large one-off purchases such as these would not fall under normal expenditure as HMRC could argue these have been the result of general savings to fund a purchase. 

These would likely fall under capital spending from the estate and subsequently these improvements would likely increase the value of the property which could – in time – increase the estate value for IHT purposes.

Remember IHT only applies if your estate is valued over £325,000 (£650,000 for married couples and £1,000,000 for married couples with direct descendants who own property valued at £350,000 or more) at the time of death. 

Any gifts above these allowances made within the previous seven years at time of death will be brought back into the estate for the purpose of the inheritance tax calculation. 

The rate of IHT reduces three years after the date of the gift at a rate of 20 per cent per annum to 0 per cent after year seven.

By starting to plan early, it can be easier than you think to reduce the overall value of your estate without impacting your quality of life in retirement. 

A good financial planner will be able to discuss these options with you and put a long-term strategy in place.

Zoe Davies, private client tax partner at Forvis Mazars, replies: While it is not possible to ask HMRC to review the documentation kept for gifts made as part of normal expenditure out of income (‘NEOOI’) on a contemporaneous basis, this is something you could ask a tax adviser to do for you and ideally, this would be done annually or at least every two years. 

A good adviser should be able to help you identify whether the gifts meet the necessary conditions for the transfers to be exempt from IHT and to adequately document this. Specifically, it will need to be considered whether:

• The gifts were made out of income, as determined each year in accordance with normal accountancy rules; and after the gifts were made, was the donor left with sufficient income to maintain their usual standard of living and,

• The gifts were made as part of normal expenditure, with a clear pattern of making the gifts and there is a ‘realistic expectation that further payments would be made’.

What counts as ‘income’ under normal expenditure out of income?

‘Income’ is not specifically defined in the IHT legislation, but HMRC state that ‘income should be determined each year in accordance with normal accountancy rules’. 

Examples could include, employment income, pension income, self employment profits, rental profits, interest income and dividend income.

HMRC do contend that at some point income will become capital for these purposes and, although there is no set ‘cut-off’ for this, two years is usually the relevant timeframe. 

There is therefore scope to use the previous tax year’s income to make gifts, but HMRC will consider the current tax year income in the first instance to determine if there is sufficient surplus income for making gifts.

What is ‘normal’ income and expenditure?

HMRC guidance defines ‘normal’ income for gifting out of income purposes as ‘standard, regular, typical, habitual or usual’. 

It must also be ‘normal for the transferor and not for the average person’. Income and expenses should be reviewed against any gifts on a regular basis. 

Practically, I would suggest reviewing this after your Self-Assessment Tax Return is completed each year and expenses will include anything needed to maintain your usual standard of living which would include standard maintenance of your home such as replacement windows and decorating.

Factors that HMRC will consider when determining whether a gift is ‘normal’ include:

• Frequency – the more regular the gifts are, the easier it is to identify a pattern. For example, a gift of cash every birthday. A one-off gift is unlikely to qualify, it would need to be part of an intended pattern of gifts.

• Amount of the gifts – irregular amounts may be subject to more scrutiny from HMRC to determine how they fall into a pattern. For example, a gift of £1,000 in cash every birthday is much less likely to be scrutinised by HMRC than a one-off payment of £20,000.

• Nature – gifts of cash would be expected to qualify, whereas a gift of existing assets (e.g. existing jewellery) would indicate a capital gift. However, a gift of an asset purchased with surplus income could qualify as NEOOI but evidence of the source of funds used to purchase the gift should be documented. 

For example, it may be possible for a gift of cash used to purchase replacement windows/doors/shutters to qualify however there must be sufficient surplus income in the year in question and a regular pattern of gifting a similar amount of cash each year.

• Recipients – some gifts may fall within categories such as ‘nephews and nieces’ rather than being made to specific individuals. For example, you may habitually gift £1,000 to your nephews and nieces each year, but which nephew or niece may alternate.

• Reasons – circumstances should help determine whether the gifts form part of a pattern. Gifts ‘clearly made for some special purpose’ will be disregarded by HMRC and not counted as gifts out of income. 

For example, a one-off gift of cash to build a kitchen extension would be difficult to argue as forming a pattern of gifting compared to a habitual gift of cash every birthday.