Investment bond withdrawals and regular expenditure out of surplus income

Afternoon all,

I have an estate where the IFA had advised the deceased to put two rather small discounted gift trusts in place (that is a side issue) and then use the annual 5% returns of capital to make regular gifts out of surplus income, relying on these payments back from the DGTs to have enough income for there to be a surplus.

My understanding has been that these 5% payments are capital in nature but have their own tax rules to bring the gains into the charge for income tax as a means to get around their unique nature of them. That being the case, these returns of capital could not be treated as ‘income’ for the purpose of this IHT gifting relief. The IFA views this differently but hasn’t backed this up with any authority.

Your thoughts on whether the payments can be treated as income for the purposes of this relief would be much appreciated.

Payments from a life assurance bond are capital in nature.

See IHTM 14250 for the HMRC view of payments from a life assurance bond in the context of the normal expenditure from income exemption.

A ‘discounted gift trust’ usually specifies that the payments to the settlor are payments of capital.

Ordinarily the ‘perceived wisdom’ is that the Settlor of the DGT’s should have been seen to have spent his/her 5% receipts per annum on himself/herself. It does seem a tad strange that the IFA has ‘muddied the waters’ by having had his/her client making use of the 5% p.a. to then make regular gifts out of surplus income. But if in fact the regular gifts were not directly related to the 5 per cents then what has happened should well ‘stand up’. The tax rules do not bring the gains into a charge for income tax. These are free from tax for 20years as HMRC view the 5% p.a as return of capital.

If the IFA was looking at additional gifting AFTER all other gifting allowances have been used up each tax year, then perhaps the adviser was considering that the 5% withdrawals could help to meet the client’s support needs, thereby freeing up some actual ‘income’ that is generated elsewhere, possibly from pension income?

However, the way the adviser seems to have presented the opportunity is incorrect.

Without knowing the complete picture it is difficult to know if the suggestion was correct, but I would hope that additional opinions were sought from other IFA’s before any commitment was made.

I suggest you ask the IFA to confirm his advice in writing; this would at least cause them to review and clarify it. I agree with the earlier points raised regarding the tax treatment of withdrawals.

It should also be borne in mind that the IFA may be taking a fee from the bond, and unless it is a preexisting bond, they will be taking the fee from the five per cent allowance.

The normal expenditure out of income exemption simply requires that a lifetime gift qualifies if it paid out as part of the normal expenditure of the donor.

Unfortunately, the legislation does not define what constitutes “income” for this purpose but HMRC’s IHT manual sets out HMRC’s views.

In their view the 5% withdrawals from a bond represent a return of capital which are treated in principle as “tax free” for 20 years.

Accordingly, the 5% withdrawals do not constitute income for the normal expenditure out of income exemption.

Malcolm Finney

As everyone has confirmed, the 5% withdrawals are deemed as capital, and so must be completely ignored when calculating surplus income.
The donor could not give away any surplus income and then rely on the 5% withdrawals in any way to meet their normal expenditure.

I do not agree with Francesca but rather with SeniorSam80. The calculation of income certainly excludes the 5% withdrawals but there is no tracing mechanism. What is given away can come from any source of funds. Without the withdrawals a donor might not feel able to give away money that includes his annual net disposable income; but if he also receives capital equal to the annual withdrawals he might then feel able to give away an amount of cash that, surprise surprise, is equal to the amount of that net disposable income.

Jack Harper

As the claim for the normal expenditure out of income exemption is made on death it is important to keep records. Clear evidence should be kept to support a claim for this exemption.
To determine whether a report is required, the donor needs to add together any gifts made under this exemption in the preceding seven years with any chargeable lifetime transfers made in the same seven year period. If the total exceeds the donor’s nil rate band, they will need to report all the gifts to HMRC using form IHT100.
HMRC will review the exemption at this time to confirm it meets the requirements and confirm their conclusion in writing.

Where the total is within the donor’s nil rate band, HMRC will only consider the exemption after the death of the donor. The executors of the deceased’s estate will need to include a claim that the regular gifts should be treated as exempt as ‘gifts out of income’ using form IHT400 as well as form IHT403.

If you look at the final page of form IHT403, you can see what HMRC consider to be “income” (salary, pensions, interest, investment income, rents, etc). From that, income tax is deducted to produce a “net income” figure for the year (for those with fluctuating income, it is possible to take an average over a number of years). Arguably, income tax paid on chargeable event gains should not be deducted, if those gains themselves are not included as income.

The deceased’s “normal expenditure” is deducted from that net figure (“mortgages, insurance, household bills, council tax, travel,” etc - excluding gifts - again, as listed on the form).

That gives a balance of “net income minus total expenditure”. It is clear that, if that normal expenditure is zero or less the zero, then HMRC do not consider that the section 21 exemption will apply to any gifts made that year - only regular gifts out of that balance (if positive) would be covered by the exemption.

From this I conclude that HMRC works out whether a person has any surplus income on the basis that they have used their income to fund their normal outgoings for the year, even if the person had actually used capital to fund those outgoings, which seems perfectly logical to me.

Paul Davidoff
New Quadrant

I agree with Paul but not Jack.

It is true that there is no tracing but that, I think, is irrelevant.

“Capital” (eg the 5% withdrawals) may in fact be used to actually satisfy a normal outgoing but this amount will effectively be treated as having been made out of income in the calculation thus reducing the “net income minus total expenditure” figure.

Malcolm Finney

I agree with Paul Davidoff’s calculation. If the balance is a positive number it can be given away within the exemption (subject to the capable of recurring/actually recurring condition). It does not matter where the cash comes from to make the gift. It could come from the proceeds of a sale of an asset. If it comes from a 5% bond withdrawal it doesn’t matter. It also doesn’t matter that the “income” if identifiable, by some notional tracing procedure e.g. paid into a different bank account to that from to which the 5% is both credited and debited, is spent on something else.

Jack Harper

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Recently had this issue in an estate - IFA had advised the client to make regular gifts to children but client only had a small pension - the rest was made up of 5% withdrawals from different Investment bonds
In my opinion, the section in the HMRC guidance below seems clear that they would not accept the capital withdrawals as income (which unfortunately resulted in more IHT due than the family expected)

Insurance policies

A person may receive payments from insurance policies in a number of situations; on maturity, by full or part surrender of a policy, by regular withdrawals, by sale, assignment or loan. Some of these payments are chargeable to income tax but that does not make them income. Even if the payments are regular, the character of such payments is usually capital and they cannot be taken into account in calculating the income available to a transferor. A common situation is where a person takes annual withdrawals equal to 5% of the premium from a single premium policy.

If the taxpayer or agent argues that payments of this sort are income in nature, you should obtain all the relevant documents and refer the case to Technical.


Having advised on this type of estate planning for over 20 years. From an IFA perspective (only) - if the 5% income accumulates back into the estate (and is not spent) then the DGB is less effective and another strategy could be considered.

From a compliance perspective the client would need a clear and identifable income need.

I’m unsure why any IFA would consider the 5% withdrawals as income and then claim relief under IHTA 1984 s.21.

It should be noted bonds paid 7% commission pre 2012 and advisers IMO mis-advised many clients on this issue.

The legislation is under: s500(a) ITTOIA 2005

S.500 Events treated as part surrenders

The following events are treated for the purposes of this Chapter as a surrender of a part of the rights under the policy or contract in question—

(a) the falling due of a sum payable as a result of a right under a policy or contract to participate in profits where further rights remain under it.


To meet the capable of recurring test and aside from life assurance premiums (which may not always be appropriate) the donor could enter into a covenant. This is no longer liable to tax on the recipient so tax is not deducted from the payment: s727 ITTOIA 2005. Like LA premiums even the first payment should be accepted as exempt.

Jack Harper

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I am interested in your comment about fluctuating income and the ability to take an average over a number of years.

I have a situation where the deceased has for many years been giving each of his 4 grandchildren £6k a year. For the last three years of his life he was in a care home and only in receipt of a State Pension. He had negative “income” of say £40k a year. Prior to that, however, his surplus income was (going backwards) £50k, £65k, £90k and £65k.

The sum of the 7 years’ income is £150k. The sum of the 7 years’ gifts (after deducting the £3k each year) is £147k. Can I claim the exemption for all of the gifts?

Albeit HMRC guidance are not most of the answers here? : IHTM14250 - Lifetime transfers: conditions for normal out of income exemption: out of income - HMRC internal manual - GOV.UK (

The IFA is wrong and should know better!