Lifetime Giving – Potentially Exempt Transfers & Normal Expediture Out of Income

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Gifts to your family or friends may be Potentially Exempt Transfers for Inheritance Tax purposes provided you survive for 7 years after the transfer, explains Jarlath Devlin.

Inheritance Tax (IHT) is arguably the UK’s most unpopular tax.  Over the years, Labour and Conservative party manifestos have promised to abolish it, however, as we all know, this has not happened, nor is it likely to happen in the foreseeable future. Yet, despite annual tax receipts of over £5 billion, fewer than 5% of estates pay Inheritance Tax. This article explains how lifetime transfers, specifically Potentially Exempt Transfers can help minimise your family’s exposure to IHT.

Lifetime Giving and Transfers of Value

While people talk about ‘lifetime giving’, the law doesn’t use this expression. Instead, it refers to a “transfer of value.” This is because something can be a gift but have no monetary or tangible value. More importantly, the value of a gift to a recipient can be much less than the value to the person making the gift.

As an example, let’s say someone has a pair of 18th-century dueling pistols worth £3million as a pair, but only worth £1million each. He gifts one of them to his son (worth £1million), but by doing so the donor loses £2million from the value of his estate. Structuring the law to tax the loss to the estate aims to stop someone transferring large parts of their estate and reducing the value out of all proportion to what they actually give away.

A more common example is where a person has gifted a half share of a house. The entirety of the property is worth £300,000 but the half share is worth £135,000. The loss to the estate of the donor is, therefore, £165,000 (£300k-£135k).

How do I make an effective gift?

For many items, simply handing them over to a family member and telling them the asset is now theirs is sufficient to make the transfer effective. Giving a son or daughter the keys of a car and the registration book and telling them the car is theirs is generally accepted as making the transfer.

Land however, is different. Under s.2 law of Property act 1989, “a contract for the sale or other disposition of an interest in land can only be made in writing….”  The transfer must be undertaken by Deed, which legally transfers the property into the name of the new owner.

Gifts by Cheque

A person in the last few days of their life, may decide to make death bed gifts to family by cheque. However, a cheque is a revokable mandate that can be stopped at any time prior to encashment. So, if the donor dies before the cheque clears, the value of the gift will be added back into the estate at the date of death. This gift will not be classed as a Potentially Exempt Transfer and the annual exemption of £3000 will not apply. While the writing of cheques has declined, many people still use cheques to pay bills and make gifts. Indeed, recent statistics indicate that in 2018/19 over 405 million cheques were written in the UK.

Gifts — Annual Exemptions

An annual exemption allows you to gift a person up to £3,000 each year without it being added to the value of your estate. If you have not used the annual exemption in the previous tax year, up to £6,000 can be gifted tax-free.

Small Gift Exemption

You can make a small gift of up to £250 to as many people as you wish tax-free. This is called the ‘small gift exemption’. If the amount given to any one person exceeds £250, the £3,000 annual exemption applies instead.

Wedding gifts

Wedding gifts up to a certain value are also tax-free. The limits for these gifts are:

• Up to £5,000 for a child
• Up to £2,500 for a grandchild or great-grandchild
• Up to £1,000 for a more distant relative or friend.

Gifts to pay for Living Costs

Gifts to help pay for the living costs of a former spouse, an elderly dependent relative or a child under 18 or in full-time education may also be exempt from IHT.

Transfers between Spouses/Civil Partners

Transfers between spouses and civil partners are exempt from IHT as are gifts to charities and political parties.

What is a Potentially Exempt Transfer (PET)?

Outside of the limits described above, it is also possible to make further potentially tax-free gifts to family or friends. These are classed as Potentially Exempt Transfers.

The problem with PETs is that you must survive for 7 years after making the gifts before they fall outside of your estate for IHT purposes. So, it is important to transfer capital wealth to your family while there is a reasonable expectation that you will see out the 7 years.

If the maker of the gift dies within 7 years and the value of the gifts exceed the exemptions outlined above, they will in effect be added back into the overall value of the estate and taxed at 40%.

IHT Nil Rate Band

Currently, the Inheritance Tax Nil Rate Band (the tax-free limit for every estate) is £325,000. Once this is exceeded, inheritance tax is charged at 40%. Lifetime gifts generally use up the IHT Nil Rate Band before any other assets. If gifts made within 7 years of death exceed the IHT threshold, the recipient is taxed at 40% on the excess. A reduced charge can apply if more than 3 years have passed from the date of the gift, as per the table below.

Years between gift and death	Tax paid
Less than 3	40%
3-4	32%
4-5	24%
5-6	16%

Business and Farming Assets

Certain assets, such as business and agricultural property, qualify for special relief from Inheritance tax.

• Business Property Relief: Certain business transfers are eligible for up to 100% Business Property Relief. To qualify, the business must have been trading as a potentially profit-making venture for two years or more and must not be an investment-based business. While the 7-year rule still applies, if the person making the transfer does not survive for 7 years, the recipient may still be eligible for Business Property Relief provided they are still running the business as a trade.
• Agricultural Property Relief: Farmers also receive very generous IHT breaks on agricultural land used for agricultural purposes for a minimum of 2 years. Where a person is farming their own land and the farmhouse is attached to the land, it also may qualify for Agricultural Property Relief. Any value over and above the agricultural value (development value) may attract Business Relief where the owner is farming the land him or herself. Where agricultural land is transferred during the lifetime of the farmer, the 7-year survival rule applies. However, if the farmer fails to survive 7 years, the recipient can still benefit from Agricultural Property Relief provided they are still farming the land.

Note that professional advice should always be sought when planning to avail of Business or Agricultural Property Relief as there can be potential pitfalls depending on the circumstances.

Exemptions on Expenditure Out of Income

Up to now, this article has focused primarily on Capital Assets where, provided transferors survive for 7 years, anything they transfer during their lifetime is not included in their estate on death.

It’s now time to focus on income. Rarely can HMRC be described as generous, but there is one exception to that rule—namely, normal expenditure out of income. Under section 21 of the Inheritance Tax Act 1984, a gift is exempt from IHT if it meets the following three conditions:

1. It is part of the transferor’s normal expenditure
2. It is made out of income (taking one year with another), and
3. It leaves the transferor with enough income to maintain his/her normal standard of living.

The first condition focuses on the word ‘normal’. Essentially, the gifting process should be habitual; there must be a settled pattern or a commitment to a settled pattern. For example, this could be achieved by making regular payments towards a family member’s pension pot. Not only would such a payment qualify as exempt, if made from income, the pension contributions will also receive tax relief from the Government for the recipient. HMRC generally insist upon a period of 3 years or more to cover this condition, although this time scale is not included in the legislation. For anyone wishing to have a look at a court ruling where one significant gift qualified for the exemption, see the Inheritance Tax Manual at IHTM14244 and read about Bennett and Others v IRC.

Secondly, the gifts must be ‘income’ and not capital assets. The likes of gifting quoted shares, jewellery, or a car for instance, will not qualify. They are Potentially Exempt Transfers. HMRC forensically examine the income levels for each relevant year to ensure there was sufficient income available to cover the gift. In a year showing an income shortfall, any surplus from the previous year may be carried forward to compensate. HMRC will resist any attempt to carry forward unused surplus income from more than two years previous, contending that after that period, income turns into capital, especially when it is invested in a savings account. Providing there is sufficient surplus income, there is no limit to the amount that can be given away. As an aside and for clarity, HMRC will accept that section 21 applies should a parent actually spend income to purchase a capital asset for a child, such as a car. It does not apply if the gifted car is already in the ownership of the parent.

Finally, gifts out of income will not qualify if the transferor had to reach into savings to meet normal living costs. HMRC will then treat the gifts as PETs and the 7-year survival rule will apply.

IHT Form 403

In death estates, the form IHT403 must be completed when declaring lifetime gifts including Potentially Exempt Transfers. The last page of this form contains a template that must be completed when claiming normal expenditure out of income. This is a useful tool when contemplating making gifts out of income. It helps to break down income from various sources and itemise expenses and outgoings when arriving at your surplus income level.

Gifts with Reservation (GWR)

Taxes became a bit of a political football in the 1970s and 1980s. The then Chancellor, Denis Healy famously declared that he was going to “tax the rich until the pips squeaked.” Labour then introduced Capital Transfer Tax which had some stiff rates of tax and included the taxing of all lifetime gifts when made.

The Conservatives came to power in 1979 with a different philosophical approach: they believed that wealth should be allowed to “cascade down the generations.” Accordingly, in 1986 Nigel Lawson abolished tax on gifts and replaced them with Potentially Exempt Transfers (PETs). Unfortunately, if you were going to keep the Tax but allow gifts there was always going to be a problem.

People started making gifts of their homes, cars and other valuables but continuing to enjoy benefit of these assets, so Gifts with Reservation (GWR) legislation was introduced as an anti-avoidance measure.

GWR Examples

The GWR legislation can be extremely complex, but an example that will resonate with many people is where an elderly relative transfers the legal title of their home into the name of child or grandchild while continuing to live in the property until they die. Irrespective of whether the child or grandchild could have evicted them, the very fact that they continue to reside in the property unhindered is enough to trigger the GWR legislation. On death, the date of death value will be included in the estate.

But what about Residence Nil Rate Band exemption? While in all probability this will apply, RNRB only came into force in 2017.

Where the person transferring the property is not a parent or a grandparent of the beneficiary, the full value will be chargeable, even though the legal title may have been transferred more than 7 years previous.

Could GWR be avoided in this scenario?

The transferor could pay the beneficiary an open market rent, or alternatively, move out of the property, leaving the beneficiary to take up possession and enjoyment of the gifted house.

Provided the transferor is excluded or virtually excluded from benefitting from a gifted asset and the beneficiary takes up possession and enjoyment of the asset, there will be no reservation of benefit.

Joint Bank Accounts and Inheritance Tax

A question that can arise is, “If I place the name of a child on my bank accounts will they become a joint account holder?” While the answer is usually “Yes” as it is assumed that on death of the parent, the investment will belong to the child, the test for Inheritance Tax is somewhat different. If one person provided all the funds within the account prior to it becoming jointly held, the entire value must be declared on form IHT404 on that person’s death. There is no gift in this situation as the parent remains able to withdraw all the funds, at any time, unhindered. If the child withdraws any money from the account for his/her personal use, then this is classed as a Potentially Exempt Transfer. Further information on Joint Property can be accessed in the Inheritance Tax Manual IHTM15000.

Here to Help

What appears in principle to be a very straightforward subject, is in practice anything but. Lifetime giving can become a minefield where IHT is concerned.

More often than not, parents and other relatives make gifts to family members blissfully unaware of the IHT implications should they not survive the requisite period.

There are also issues where personal representatives are tasked with uncovering lifetime gifts through extensive investigation of bank statements and questioning of family members, many of whom do not want to disclose what they received. It can all get very messy, especially where there is a GWR.

Where people are considering transferring property that has a significant value, they should always seek professional advice. Ignorance of the law is not accepted as an excuse by HMRC and can turn out to be expensive for the next generation.

AAB’s Private Client Team is made up of Tax Specialists who are based both in UK and Ireland, North and South of the Irish border. This means our Tax Team are experts on the intricacies and complex reporting requirements of both tax jurisdictions, ensuring we provide the best possible advice to our clients.

Talk to us today for advice on making the most of the opportunities available to you and your business.