Mrs Brown is a high net worth, income-rich widow with two adult daughters who are both higher rate taxpayers. She has four grandchildren, ranging in age from one to seven. Mrs Brown made a £325,000 gift into a discretionary trust last year. Her financial adviser has explained that any further lump sum gifts into discretionary trust would trigger lifetime inheritance tax liabilities.
Mrs Brown would, however, like to fund school and university fees for her grandchildren in a tax efficient manner. She is aware that potentially exempt transfers could be made without lifetime IHT consequences but is reluctant to make inflexible outright gifts.
Mrs Brown’s adviser explains the IHT “normal expenditure out of income” exemption. For this to apply, a gift from her must meet three conditions: it must be part of her normal expenditure, be made out of her income, and leave her with enough income to maintain her normal standard of living.
Mrs Brown applies for an offshore insurance bond with a modest minimum premium of £10,000 and gifts it into a discretionary trust. Thereafter, the appointed trustees, Mrs Brown and her two daughters, regularly top up that bond for similar amounts with the funds provided by Mrs Brown. Assuming the “normal expenditure out of income” exemption applies, these gifts into trust will be IHT exempt rather than chargeable lifetime transfers. The trust fund will, however, be subject to 10-yearly and periodic charges as appropriate.
Mrs Brown must keep a record each tax year to provide the necessary evidence should she die within seven years. HMRC provides a pro forma for doing this.
Availability of the exemption
Gifts must be “normal”. Although this does not necessarily mean regular or annual, gifts made regularly are more likely to meet the normality test. There is no set time span to establish a pattern, although three to four years would normally be reasonable in the opinion of HMRC. If Mrs Brown were to make a single gift close to death, HMRC will require strong evidence that the gift was genuinely intended to be the first in a pattern and that there was a realistic expectation further payments would be made. A single gift by way of regular commitment may be accepted as normal. Mrs Brown may, therefore, formalise her commitment in writing.
In terms of meeting the income condition, “income” is regarded as Mrs Brown’s net income after payment of income tax and includes employed and self-employed earnings, property rents, pensions, interest and dividends. Payments received regularly may appear to be income but are in fact capital. An example would be 5 per cent insurance bond withdrawals. The exemption will not apply if Mrs Brown has to resort to capital to meet her normal living expenses.
The discretionary trust provides the flexibility and control that Mrs Brown requires. The trustees can take withdrawals within 5 per cent limits as and when required to fund education costs.
But what if larger sums are required and the trustees trigger chargeable event gains? Mrs Brown, who is a higher rate taxpaying settlor, would be chargeable. The trustees are chargeable in tax years after her death. A more tax efficient option may be for the trustees to gift segments to adult grandchildren and any subsequent encashment gains would then crystallise on the grandchild. Minor grandchildren could not sign a deed of assignment. In this case, the trustees could exercise a power of appointment by way of deed to irrevocably appoint that specific segments are held absolutely for that child. If the trustees then encashed, the gain would be taxable on the child. Children, like adults, are entitled to the personal allowance.
From 6 April, the starting rate band of income tax will be increased to £5,000 and the rate reduced from 10 per cent to zero. Savings income includes insurance bond gains. In the order of taxation, an offshore bond gain comes before dividend income.
Consider a child or student with no income. In 2015/16 the starting rate band for savings income of £5,000 will sit on top of the personal allowance of £10,600. In that case, an offshore bond gain of up to £15,600 could be realised with no income tax payable. Prior to encashment, that offshore bond would have enjoyed gross roll up.
For the avoidance of doubt, if an individual’s taxable non-savings income exceeds the starting rate limit, then the reduced starting rate for savings will not be available.
So in conclusion, by utilising the “normal expenditure out of income” exemption Mrs Brown’s adviser has provided her with a means of funding school and university fees for her grandchildren in a manner that offers her control and flexibility as well as income tax and IHT efficiency.
Graeme Robb is technical manager at Prudential