Gifts out of surplus income - S.21 IHTA 1984

Trusts Discussion
1

Most discussions about this exemption have concentrated on identifying ‘income’. I think most have accepted that the 5% p.a withdrawals from life policies don’t count. I expect few would regard premium bond wins as income, but I can see an argument that they constitute the fruit; as the ‘tree’, the premium bond holding, survives.

However, what interests me is whether capital expenditure can ever count as ‘normal expenditure’. Installing a new kitchen, bathroom or chair-lift are clearly not done every year. Would re-decoration - done perhaps every five years - also be excluded? I suggest a more detailed analysis of expenditure should be carried out when completing HMRC’s form.

What is practioners’ experience?

Ray Magill

2

S.21(1)(a) IHTA requires expenditure to be “normal”. Page 8 of IHT 403 would surely say something about capital expenditure if HMRC thought it should be taken into account. But perhaps they don’t want to give taxpayers and their advisers fancy ideas!

IHTM14242 starts off with promise as to the meaning of “normal” but in fact only the heading refers to expenditure. IHTM14244 does quote Lightman J in Bennett referring to a “settled pattern of expenditure” but without elaborating on the nature of it.

Ray highlights an intriguing point as regards capital expenditure, e.g. on a significant home improvement, that is discharged either by agreed annual instalments or by a loan repayable by annual repayments, whether credit is provided by the supplier or a third party.

The commercial incentive of such arrangements is often precisely to allow regular payments to be met out of future net of tax income by those who might otherwise be unable to fund the upfront one-off cost. Where there is no additional charge for credit a term loan can put greater pressure on the supplier to provide obligatory contractual after-sales service than would payment in full on completion, depending on the precise contractual terms if the credit provider is not the supplier. Even so if that lender is a regular provider of credit to customers of the supplier a threat to pause repayments until remedial work is done under the supply contract can provide extra-contractual business reputational leverage. In these cases the GAAR should not be an issue as regards passing the double reasonableness test.

There is nothing in the statute nor in case law that ordains that expenditure must be revenue in nature as long as it is met out of income. Regular capital payments may surely be capable of being “normal”.

Tactically I would suggest that it is more prudent to argue the point when the facts happen to present the opportunity, rather than advise a client that it will be within s21, at least without a warning that HMRC may challenge it and with an indication of the consequent downside if defeat has to be conceded before an appeal or after losing one.

Jack Harper

3

Wise advice as usual from Jack. But I would hang my hat on the phrase ‘normal expenditure out of income’ if the capital expenditure I mentioned is met from capital, without need for a loan. I agree that if such costs are met by payment in instalments, the position differs.

Returning to the nature of income, arguably the ‘5%s’ from non-qualifying insurance policies should not be totally ignored. Any growth in value will include re-invested income. For example, suppose the initial premium is £100k, 5% is drawn for each of the next five years, the fund grows to £180k on final surrender, wholly by retention of income. There are no changes in the securities within the policy so the overall growth is £105k and on total surrender that will be taxed as income. In retrospect the intervening £25k should have been recognised as income, as well as the final £80k. Of course, in practice that calculation will not be possible for the investor.

Questions also arise regarding offshore income gains (largely dealt with by the Offshore Funds (Tax) Regulations 2009/3001) and income subject to adjustments under the accrued income scheme. An investor in a non-reporting offshore fund can be subject income tax on income that he doesn’t receive or on what he thinks of a capital gain. An investor selling a gilt can be subject to income tax on part of his sales proceeds. Presumably the investor’s income for the purposes of S.21 should be the amount subject to income tax, yet he might have no actual receipts from which he can meet his normal expenditure.

This is an exercise that deserves closer scrutiny.

Ray Magill

| jack jack harper
6 July |

  • | - |

S.21(1)(a) IHTA requires expenditure to be “normal”. Page 8 of IHT 403 would surely say something about capital expenditure if HMRC thought it should be taken into account. But perhaps they don’t want to give taxpayers and their advisers fancy ideas!

IHTM14242 starts off with promise as to the meaning of “normal” but in fact only the heading refers to expenditure. IHTM14244 does quote Lightman J in Bennett referring to a “settled pattern of expenditure” but without elaborating on the nature of it.

Ray highlights an intriguing point as regards capital expenditure, e.g. on a significant home improvement, that is discharged either by agreed annual instalments or by a loan repayable by annual repayments, whether credit is provided by the supplier or a third party.

The commercial incentive of such arrangements is often precisely to allow regular payments to be met out of future net of tax income by those who might otherwise be unable to fund the upfront one-off cost. Where there is no additional charge for credit a term loan can put greater pressure on the supplier to provide obligatory contractual after-sales service than would payment in full on completion, depending on the precise contractual terms if the credit provider is not the supplier. Even so if that lender is a regular provider of credit to customers of the supplier a threat to pause repayments until remedial work is done under the supply contract can provide extra-contractual business reputational leverage. In these cases the GAAR should not be an issue as regards passing the double reasonableness test.

There is nothing in the statute nor in case law that ordains that expenditure must be revenue in nature as long as it is met out of income. Regular capital payments may surely be capable of being “normal”.

Tactically I would suggest that it is more prudent to argue the point when the facts happen to present the opportunity, rather than advise a client that it will be within s21, at least without a warning that HMRC may challenge it and with an indication of the consequent downside if defeat has to be conceded before an appeal or after losing one.

Jack Harper

4

It occurs to me that regular life assurance premiums, which HMRC accept not just as normal expenditure but as exempt from the first payment, may result in the acquisition by the payer or a donee of a capital asset as no differentiation between term and savings policies is made in IHTM14242.

The entire Manual commentary on this exemption is riddled with obscure comments (such as the gift of a capital asset purchased out of income in 14231-really?) and equivocations setting out acceptance of a general principle immediately qualified vaguely by reference to unstated possibilities denying exemption.

The most curious comment, to be fair based on a strange statutory provision namely s29(4) IHTA, is how a loan can be exempt:14236. If anyone can describe to me how this adaptation of s21 could allow a loan itself to be exempt, as opposed to regular waivers of amounts repayable, I would be much obliged. Even if a loan is made out of income how does a once-off TOV become normal? Although s.29(4) does not disapply the section heading that surely cannot govern the interpretation of the substantive provisions as adapted. The word “normal” still applies under the subsection so recurrent loan TOVs may be needed and the sufficient remaining income condition stands. A loan TOV calculation depends on its terms but it does not need s3(3) and charging below market interest or none at all are not omissions but intrinsic terms; so is the length of the term, not an omission to make it either shorter or on demand (which would eliminate a TOV). A s3(3) omission is one to exercise a subsisting right so it does not apply to a failure either to make a gift or to make it on any given terms.

Note that s21 does not prevent a GROB arising. The right of repayment is one not given away and it remains in the donor’s estate. Its value may be initially discounted, hence the TOV, but that in itself does not cause a GROB to arise. Despite HMRC’s warning it is hard to see how outright gifts of cash, the most typical, could be caught.

Jack Harper

5

I suspect that the inconsistencies, idiosyncrasies and indeed idiocies in this exemption and in HMRC’s interpretation of it are as Ray indicates there waiting to be challenged. Case law is limited and in McDowall obiter. The onus of proof is on the claimant and it is apparent that HMRC have developed their practice over decades largely by internal reflection behind the scenes and with outcomes which as usual are slanted towards refusal of exemption but tempered to a degree by their hoping to avoid adverse precedents in contested court cases.

This exemption first appeared under ED in s59(2) of the FA 1910 when gifts had to be “reasonable having regard to [the donor’s] income” and limited to £100. S.37 FA 1968 replaced it with what we have now, more or less. What Parliament meant by “income” in 1910 as an undefined ordinary word was plainly different to what it might have meant in 1968 and 1975 when CTT replaced ED and now. In particular the way individuals organise their spending and saving and the savings products on offer do not rigidly recognise the income-capital distinction as might have been prevalent in the era of Soames Forsyth and his Consols or undated War Loan issued in both world wars.

In recent years we have had to come to terms with all kinds of capital receipts taxable as income mainly to counter avoidance by means of alchemy. They have cropped up in relation to s479 ITA which imposed the special trust rate on the income for trust purposes of DTs. HMRC are opposed to policy gains for s21 but appear to accept that the income portion of a PLA is income.

The tactics here as often elsewhere is to note what HMRC say about anything, then apply salt in varying quantities, and do a cost/benefit analysis of taking contradictory action during lifetime, realising that it will almost certainly be for the donor’s PRs to ultimately decide how far to take the likely battle.

The exemption is still valuable as a planning tool if not quite as much as under ED where there was no special exemption for a lifetime gift to a spouse donee. HMRC show no sign of wishing to clarify the statute itself and so must be content strategically with the status quo of highly ambivalent quasi-legislation by IHTM proclamation and confidential settlement of individual fact-dependent cases.

Jack Harper

6

Not my area (sorry Jack) but in relation to:

The entire Manual commentary on this exemption is riddled with obscure comments (such as the gift of a capital asset purchased out of income in 14231-really?)

I always assumed that this comment was made to take ensure that the present of a Hornby trainset (bought for £100 on Christmas Eve) and given to a niece on Christmas Day, was treated the same as a £100 cash gift that the niece’s mum then used to buy a Scalxtric set in the sales.

In relation to, it’s not my area (sorry Jack) but:

The most curious comment, to be fair based on a strange statutory provision namely s29(4) IHTA, is how a loan can be exempt:14236. If anyone can describe to me how this adaptation of s21 could allow a loan itself to be exempt, as opposed to regular waivers of amounts repayable, I would be much obliged.

I had always assumed that it was a weird provision where the people who drafted it were not quite sure what they were instructed to draft and, well, it was nearly 4pm on a Friday afternoon, the Two Chairmen was calling and there was a bet about getting the word “borrower” somewhere where it did not belong.

On the other hand, it might be that the history of s29(4) is a bit like the history of changing from a cash basis to an accruals basis and not bothering to do a proper job, with some bits of the original tax legislation required squinting, hand waiving or a trip to the Supreme Court.

In the old fashioned times, when you let someone use some money or some other property of yours on the cheap, there was a deemed amount that was transferred based on the difference between (i) the consideration you could have got, and (ii) the consideration you actually got for that period. So every chargeable period you lent something, you got a deemed transfer for CTT purposes and that transfer was treated as being made out of your income. With that in mind, s29(4) is really handy in that it says you can ignore any CTT being due if these deemed transfers (that are deemed to be coming out of income when of course they are not) are normal (and that’s not a deemed normal, just a normal normal). Unfortunately, the equivalent deeming legislation is not in place any more and so, unless you are in the habit of lending money regularly (not on demand, less than market rate of interest), s29(4) has become a bit like a chocolate teapot in a world where everyone drinks lattes.

7

I believe the Two Chairmen just off Trafalgar Square of blessed personal memory has now gone the way of perdition into flats. Though there is another hostelry of the same name across St James’s Park which (amazingly) has never received a visitation by me, given that (a) it sells real ale and (b) is in London.An appalling oversight on my part.

Jack Harper

8

I can do all those mornings,

9

Surely S 29 refers only to a TOV represented by the interest foregone on a loan made on ‘soft’ terms.

The treatment of regular life assurance (or insurance) premiums is only relevant to S.21 if the beneficiary of the policy is someone other than the payer.

The more difficult question is whether a donor’s income includes amounts on which he is deemed to be subject to income tax even if not received.

As you say, Jack, there are now many occasions when capital receipts are treated as income for tax purposes. Liquidation distributions can be subject to income tax, in part. Other transactions in securities can result in income subject to income tax. Those investing in non-reporting and reporting offshore funds may receive nothing until disposal yet be subject to income tax on deemed income. Incidentally, what does PLA stand for, other than Port of London Authority? I must be having a senior moment.

Conversely the accrued income scheme can transform interest into capital proceeds.

Rolled-up income can result in a single dividend being received that represents many years’ income.

HMRC speak of looking to see if there is enough income to make a gift. But what if there is deemed income not actually received, but capital cash available to do so?

In conclusion, the simple heading to S.21 - normal expenditure out of income’ requires a more careful analyis of ‘normal’, ‘expenditure’ and ‘income’ than in HMRC’s IHTM 14241 to 14255.

Ray Magill

10

PLA= purchased life annuity.

S.29(4) is a solution looking for a problem. A soft loan not repayable on demand will be a TOV and a “gift”. It may or may not carry interest. Any interest will be income for s.21 (unless as you say rolled up, and so capitalized, or only payable on redemption and so income for that one year).

If some income is payable annually or at shorter intervals how does s.29(4) actually apply? The actual income surely already falls within s21. How does s29(4) operate? What gift does it purport to exempt and out of what income?

If income is forgone by a legally effective method the right to it never arises, so there is no omission to exercise it under s3(3);just as not to charge it in the first place is not such an omission but a factor in the loan itself being a TOV (unless repayable on demand).

If s29(4) functions and a TOV is made, by the soft loan itself or indeed otherwise, what is the elusive income that the s21 exempt transfer can apply to which is not already within s.21? Any interest from the loan and any other relevant income all fall to be taken into account under s.21.

If s.29(4) is somehow to be regarded as converting a once-off loan into normal expenditure by reference to the length of its term the wording is in my view too inscrutable to achieve such a radical counterfactual outcome. Surely the absence of any relevant commentary in IHTM is significant.

Even if its purpose is to make a loan normal expenditure what is the matching income within s.21? Even if the loan monies stem from an unmixed source of income it will be past income.It would be an extraordinary proposition that the wording could justify some backwards reckoning of the “taking one year with another” test. HMRC do express a wishy washy opinion about whether gifts can be made out of past income but even that is for the purpose of linking it to future conventional normal expenditure, which a once-off loan is not without a clear statutory deeming provision.

Jack Harper

11

Thanks for reminding me what a PLA is.

S.29 serves a useful purpose. Of course, there is a TOV when a loan is made for a stated period on soft terms. S.29 says that that TOV is treated as made by a normal outright gift by the lender. After that, there is the usual discussion about available income to meet the lender’s normal expenditure.

With respect, I don’t think S.29 is inscrutable, it is tackling an issue which needed an answer.

Returning to the question of identifying income, a realistic example occurs to me.

Warren Buffett is an extremely successful investor; his Berkshire Hathaway is famous for its success (compound growth at 20% a year), but also for not paying dividends, as Buffett decided that they just reduced the capital he could invest. So anyone who wants an “income” from their holding has to sell stock.

Someone fortunate enough to have invested only in Berkshire Hathaway might talk of getting his ‘spending money’ from such part disposals; to meet any gap between his income per se and his ordinary expenditure

Why shouldn’t this be regarded as income in the same way as dividends that are immediately invested in further shares, or (if prizes on premium bonds are accepted as income), such prizes are applied to buy more premium bonds?

Ray Magill

| jack jack harper
9 July |

  • | - |

PLA= purchased life annuity.

S.29(4) is a solution looking for a problem. A soft loan not repayable on demand will be a TOV and a “gift”. It may or may not carry interest. Any interest will be income for s.21 (unless as you say rolled up, and so capitalized, or only payable on redemption and so income for that one year).

If some income is payable annually or at shorter intervals how does s.29(4) actually apply? The actual income surely already falls within s21. How does s29(4) operate? What gift does it purport to exempt and out of what income?

If income is forgone by a legally effective method the right to it never arises, so there is no omission to exercise it under s3(3);just as not to charge it in the first place is not such an omission but a factor in the loan itself being a TOV (unless repayable on demand).

If s29(4) functions and a TOV is made, by the soft loan itself or indeed otherwise, what is the elusive income that the s21 exempt transfer can apply to which is not already within s.21? Any interest from the loan and any other relevant income all fall to be taken into account under s.21.

If s.29(4) is somehow to be regarded as converting a once-off loan into normal expenditure by reference to the length of its term the wording is in my view too inscrutable to achieve such a radical counterfactual outcome. Surely the absence of any relevant commentary in IHTM is significant.

Even if its purpose is to make a loan normal expenditure what is the matching income within s.21? Even if the loan monies stem from an unmixed source of income it will be past income.It would be an extraordinary proposition that the wording could justify some backwards reckoning of the “taking one year with another” test. HMRC do express a wishy washy opinion about whether gifts can be made out of past income but even that is for the purpose of linking it to future conventional normal expenditure, which a once-off loan is not without a clear statutory deeming provision.

Jack Harper

12

My non-exhaustive survey of learned tomes reveals that authors merely paraphrase what s29(4) says and in the case of 2 eminent books on IHT planning do not mention it at all in their coverage of s21!

If the only condition of a soft loan is the sufficient income test, and there is no specific insistence on an income source of the loan monies in either provision, what is the expenditure that is exempted?

The soft loan if it does so at all results in a single TOV at the time of making the advance.There is no requirement even that the sufficient income test must be met for the duration of the term. So can it really be the case that a soft loan creating an immediate TOV and only such can be exempted by meeting the sufficient income test at that time and only then? Are the planning authors just being coy by their silence?

The TOV calculation is distinctive to IHT. It does not charge the value of the benefit to the borrower. That is the position under CGT and NR trusts and benefits, soft loans, use of chattels and occupation of land by beneficiaries. Before statute intervened to provide a statutory valuation basis, the question arose: when is the benefit of a free loan etc. provided. Was it only when the loan was made or annually while it subsisted? IHT avoids this dilemma and I can see no justification for the sufficient income test for a once-off soft loan being applied, either forward or backwards, to any other point than the date of the TOV.

Jack Harper

13

If an interest-free loan is made for a fixed term, there is an immediate transfer of value. The value of the transferor’s estate will fluctuate throughout the term, increasing if only by the passage of time; but such changes have no IHT significance. There are no subsequent TOVs,so no need to have sufficient income at any subsequent date during the life of the loan.

The initial TOV is deemed by S.247 to be an outright gift forming part of the lender’s normal expenditure. In reality it is the exchange of a sum of money for the loan. No income need be involved; the transferor’s income is available to meet his normal expenditure, including other TOVs.

The transferor’s capital is lent to the borrower. This is clearer if the loan is of a chattel or land on ‘soft’ terms.

But can the amount lent be income?

Ray Magill

14

For some reason I referred to S.247 rather than S.29 in my previous email.

Ray Magill

If an interest-free loan is made for a fixed term, there is an immediate transfer of value. The value of the transferor’s estate will fluctuate throughout the term, increasing if only by the passage of time; but such changes have no IHT significance. There are no subsequent TOVs,so no need to have sufficient income at any subsequent date during the life of the loan.

The initial TOV is deemed by S.247 to be an outright gift forming part of the lender’s normal expenditure. In reality it is the exchange of a sum of money for the loan. No income need be involved; the transferor’s income is available to meet his normal expenditure, including other TOVs.

The transferor’s capital is lent to the borrower. This is clearer if the loan is of a chattel or land on ‘soft’ terms.

But can the amount lent be income?

Ray Magill

15

In relation to:

But can the amount lent be income?

No. But as I mentioned earlier, in old fashioned times (the FA 1975 position) there was a transfer of value each tax year that was deemed to be out of the transferor’s income.