Mrs Bennett was in her late 80s when a trust set up by her deceased husband, of which she was the only income beneficiary, suddenly enjoyed a significant increase in both capital and income. This followed the sale by the trustees of some private company shares to a public limited company. The elderly lady found herself in receipt of wads of income far beyond what she needed to finance her modest lifestyle. She wanted her three sons to benefit from this remarkable upturn in her circumstances.
So old Mrs Bennett went to see her solicitor and explained her predicament. Fortunately this solicitor had his head screwed on. Without referring to section 21 of the Inheritance Tax Act 1984 directly he explained to Mrs Bennett that gifts out of surplus income were exempt from inheritance tax if it could be shown that:
- they represented part of the transferor’s normal expenditure;
- taking one year with another, they were made out of income; and
- the transferor was left with adequate income to maintain his or her usual standard of living.
He also went on to say that HMRC interpreted the word “normal” to mean habitual or regular and that they were prepared to accept that expenditure was normal when it had occurred over three years.
With commendable foresight the lawyer drew up a simple document confirming Mrs Bennett’s decision to make an initial and ongoing gifts to her sons out of surplus income. This is what he wrote:
I Kathleen Bennett, life tenant of the Frederick Cecil Bennett Will Trust, hereby authorise and request you as Trustees to distribute equally between my three sons… all or any of the income arising in each accounting year as is surplus to my financial requirements of which you are already aware.
Mrs Bennett signed the document on 30 January 1989. A month later she made gifts of £9000 to each of her three sons and nearly a year later she made further gifts of £60,000 to each son. Sadly, before she could make a third set of gifts, the old lady died.
In the process of time HMRC reviewed the estate and sought to disallow the claim for gifts out of surplus income on the basis that only two gifts had been made. Mrs Bennett’s executors appealed and the case was heard by Mr Justice Lightman in the High Court.
Mr Justice Lightman went into considerable detail in his judgement and effectively broadened the scope of the relief. Here are some of the things he said:
1. The expression “normal expenditure” could be established in two ways:
a) an examination of the individual’s expenditure over a period of time may reveal such a pattern; or
b) the individual may be shown to have assumed a commitment or adopted a firm resolution and then complied with it.
Mr Justice Lightman went on to amplify point b) by saying the commitment or resolution may be legal, religious or moral - in fact it may be none of these things but still be effective to establish a pattern.
For expenditure to be “normal” there was no fixed minimum period during which the expenditure (gifts) shall have occurred. In other words there was no requirement that they had to be made over three years to be classed as gifts out of income.
2. If there was a commitment then a single payment implementing the commitment may be sufficient.
3. The amount of the expenditure need not be fixed nor need the individual recipient be the same. Mrs Bennett might have made gifts to her daughters in law and/or grandchildren, for example, without prejudicing her claim.
4. Large gifts do not disqualify relief provided all the conditions are met.
5. The fact that gifts of surplus income are made as part of a tax planning exercise e.g. to prevent an accumulation of income that would be liable to inheritance tax on death “is no impediment” - these judges come up with interesting expressions!
Interestingly HMRC did not attempt to appeal this decision and have never brought forward legislation to counter it.
Mrs Bennett has done her bit. Her name (or the name of the tax case, to be precise) features in the HMRC Inheritance Tax Manual and no doubt appears in many IHT planning publications. It’s all about an invaluable inheritance tax exemption which is little known and little used - gifts out of surplus income.
C&H Stedman will be glad to advise on this and other inheritance tax planning matters.