6th April 2016

Canada Life: The art of regular gifting to reduce your tax bill

For our second instalment in this new series looking at how you can cut your family’s inheritance tax (IHT) bills, we look at a solution ideal for those finding their feet in estate planning. 

The inheritance tax (IHT) exemption for Normal Expenditure Out of Income (NEOI) may not flow off the tongue or be well-known, but nevertheless it’s an exemption that has been around for many years which can be very helpful. In short, it means that any qualifying gifts are immediately exempt from IHT. Unlike gifts of capital, there is no need for the person making the gift to survive for the seven year period.

If you or your family want to pass on wealth from your income without having to worry about the seven year rule or the £3,000 annual exemption on gifts, this handy exemption is a must.

It always surprises me how often this truly valuable unlimited tax exemption is overlooked. But, why? Perhaps because most people focus on more common one-off gifts. Although that route has merits in simplicity, the £3,000 annual limit is too low for many. 

Using the rules on normal expenditure out of income may not be well understood, but it should be because it is such a powerful way of reducing an IHT bill.

A closer inspection highlights its many attractive facets and features:

• Simplicity

The criteria are brief and easy – there are only three requirements. In essence a transfer of value is an exempt transfer if:

a)   it was made as part of the your normal expenditure

b)   taking one year with another, it was made out of your net income

c)    after making the transfer, your standard of living was maintained

In other words, gifts out of surplus net income are made regularly.

• Generosity

As long as you meet the above criteria, there is no limit to the amount that can be gifted. As there is no restriction on the level of gifting the limitation of the available nil rate band just falls completely away.

This is what characterises this form of exemption and sets it apart from others. Fundamentally it must be remembered that it is an exemption and not a relief. 

If you have a cushion, which for some may be extensive, between after tax income and expenditure you have the ability to gift (large) amounts of surplus income. As long as the exemption criteria are met the gifted surplus income immediately leaves your estate and so does not fall within the IHT net.

• Flexibility

This is another great attribute. If your circumstances change, in a particular year or indeed over a number of years, it is possible not to take up the use of the exemption. Where there has been a call on the cushion between net income and expenditure, the gap could narrow or completely disappear. The outcome is IHT neutral, as the surplus will have been spent and no longer sits in your estate.

The true point of flexibility is that when your circumstances are restored, with a disposable income existing again then it will permit the exemption to be picked up once again.

Another point on flexibility is this planning mechanism offers a great alternative to lump sum gifting. In estate planning terms it is a great complement to capital solutions that are thought of as the primary IHT mitigation tools. When combined with capital solutions, and in the right circumstances of high income and lower expenditure, a very powerful and effective estate planning strategy can unfold.

• Focus

Here the focal point must be directly on gifting surplus net income. So this translates to mean that no form of capital can be used to fund the exemption.

This includes tax-deferred withdrawals from life assurance bonds because they do not qualify as income. It is a regular payment of capital. 

The capital content of a Purchased Life Annuity cannot be used in connection with NEOI. However, the interest element can be factored in as net income because this element is income and is subject to 20% tax at source. 

As a whole these features and facets provide a compelling argument for those who are getting to grips with the marketplace, to create methods of mitigation that operate as combinations that are complementary to each other. 

Patrick Kennedy

Tax and Estate Planning Consultant

Canada Life Limited

01707 422999

ican@canadalife.co.uk

Tax, Trust & ISA