Double Taxation on Lifetime Gifts?

Christopher McNeill says there is no need to pay income tax AND Inheritance Tax

Income is subject to income tax, reams of legislation being devoted to making sure this is so. Taxed income then finds its way into the taxpayer’s estate, either by purchasing appreciating assets or by reducing debt or simply by adding to cash on hand. The whole estate, after any available reliefs, is then subject to Inheritance Tax at 40%. The surplus income, already taxed at 40% in many cases, is taxed again at the same rate on death. Again, much case and statute law is required to make sure this is so.

The taxpayer can of course avoid IHT altogether by making outright lifetime gifts and outliving them by seven years but there has always been a quicker and simpler way to start benefiting the family – Section 21 Inheritance Act 1984.

This Section remains as useful today as when it was first enacted, especially when – unlike the rest of the IHT legislation – it still applies virtually on its original terms.

Once the taxpayer has paid all income tax due and provided for their own standard of living, Section 21 allows the taxpayer to give away as much of their surplus income as they choose. The only real limitation is that this must be part of their “normal expenditure” in the same way as their spending on their own standard of living. HMRC will take “one year with another”  to see what is normal in terms of that year’s income and expenditure but otherwise the taxpayer just has to show an intention at the outset to make such gifts of income and then start to make gifts that demonstrate that continued intention.

Beyond that, the only limitation in terms of size is the amount of the surplus income itself. By keeping within these limitations, the transfer is “an exempt transfer”, in terms of the IHT legislation. Because there is no “transfer of value” for IHT purposes, the taxpayer’s estate is not regarded as being reduced in value by these income gifts and no IHT arises.

As always in dealing with HMRC, it is only sensible to keep complete records of all payments and also to put in writing before the first gift the intention to make such gifts.  As the section itself says, the gift is an exempt transfer if “it is shown” that it is made as “normal expenditure out of income”, hence the advisability of having the evidence to demonstrate this is the case.

Originally, HMRC argued that “normal” expenditure out of income required recurrent gifts but in Bennett v IRC [1995] STC 54 the court decided this was not necessary. As long as the intention was there to continue such gifts – and the gift was actually of surplus income – then section 21 applied to the first and all later gifts; no tax was due because there was no transfer of value.

The advantages of section 21 go far beyond the legitimate avoidance of IHT:

1. The donee (the recipient) has no tax liability of any kind; the receipt may have come from the taxpayer’s income but it is not income in their own hands nor does it affect their own tax position
2. There is nothing to report to HMRC – by either party
3. Relatively small sums can be of great benefit to the donee in support of their own living standards
4. The payments can be varied in amount from year to year, as can the dates of payment –the payments need not even go to the same donee, in fact, should the taxpayer wish to spread the payments around the family in varying proportions. As long as the taxpayer is making payments out of surplus income as part of his “normal expenditure”, all these factors are simply variables in how the taxpayer chooses to distribute that income
5. The payments can be stopped if the taxpayer’s income drops away or their own expenditure increases, or perhaps the donee’s needs are reduced, or the taxpayer feels the donee has stopped making good use of the money. Ceasing to make further income gifts will not of itself make the previous gifts retrospectively taxable
6. The flexibility to stop, reduce or vary the gifts avoids the taxpayer having to face difficult decisions about how much they are committing to at the outset – including whether a particular donee might be receiving too much!
7. There is no “seven year rule”. In fact, as long as the limitations of section 21 itself are followed, none of the other IHT rules and regulations will apply nor any of the complexities of such anti-avoidance provisions as the Gift With Reservation rules or the Pre-Owned Asset Regime that have been added since 1984 to make IHT workable as a gift tax and an estate duty.
8. There is no interaction with other tax reliefs. Capital gifts can still be made using any available IHT reliefs such as the £3,000 Annual Exemption and these will be completely separate from section 21 gifts.

A final bonus is that, once the taxpayer starts to take advantage of section 21, the use of even the minor IHT exemptions becomes much more meaningful. With an income gift of, say, £3,000 and an annual exempt gift to match, the taxpayer can easily and safely give away £60,000 over a ten year period without incurring any tax, or over committing themselves for the future or endangering their own lifestyle. In particular, this sidesteps the problem of over benefiting any one family member in a way the taxpayer might later have come to regret with a much larger capital gift.