There is a highly beneficial, if slightly obscure, tax break that has been largely overlooked by the financial planning community when considering the IHT affairs of high-net-worth, high-earning clients, writes Paul Wilcox.
This is what is technically termed the ‘normal expenditure' rule but, for people in the know, is more commonly called ‘gifts from income'.
Not only is this a wonderful tax break but the other, very specific benefit, which is not really available anywhere else - particularly in the case of gifts linked to normal conservative investment strategies - is the instant full exemption from inheritance tax (IHT) … not after two years or even seven years, but from the very same day that gifts are made. Such gifts do not use any other allowance or exemption but are instantly out of any future IHT calculation for the donor.
This exemption has been available since the Inheritance Tax Act 1984 and remains unchanged to this day. The Act states a transfer of value is an exempt transfer if, or to the extent that, it is shown:
* That it was made as part of the normal expenditure of the transferor; and
* That (taking one year with another) it was made out of their income; and
* That, after allowing for all transfers of value forming part of their normal expenditure, the transferor was left with sufficient income to maintain their usual standard of living.
There are several caveats attached to this exemption, relating to such things as annuity purchase but, in essence, the conditions stated above represent a useful summary. Translated into everyday English, this means a regular gift made out of surplus after-tax income is exempt from IHT so long as:
* Its regularity means an intention to make gifts for at least three consecutive years; and
* The gift literally comes from traditional taxable income and not from capital; and
* The donor does not suffer a reduction in their usual standard of living - which must be out of income - as a result of the gifts.
Subject to these conditions, there is no limit on the size of such gifts and they will automatically achieve instant exemption from IHT. The catch, of course, is that most professionals see this facility as a bit of a damp squib because they wrongly believe such gifts have to be made on an absolute and unconditional basis to the extent that the donor loses all control of what was their money.
Fortunately this is not the case, because gifts into trust also qualify under this rule. If the trust in point is carefully crafted as a flexible discretionary trust, with all the appropriate well-considered clauses, then the appointed trustee can manage the trust and its underlying value - normally a managed portfolio or collection of portfolio style collectives - for the benefit of the donor and their family with ongoing and informal guidance from the donor (the ‘settlor' of the trust) via regular ‘letters of wishes'.
One can imagine various kinds of taxpayers who have surplus after-tax income every year - in some cases, very substantial surplus income - even if only for a fairly short period of time. Here, think entrepreneurs, City traders, celebrities, successful sportsmen and women.
As she did in my previous column Use it or lose it, Cilla Black comes to mind as a possible example because she was earning big money right until her recent demise, and yet £6m from the £15m she retained in the UK, and subject to IHT when she died, went to the taxman, leaving £9m to be divided between her family.
It seems pretty certain she was in receipt of substantial income right until her death and she could have progressively parked much of this in such a trust, tax-free. So long as the donor has the ‘intention' of making gifts over several years, then any such gift will be immediately exempt - even if only one or two gifts had actually been made at the time of death.
For any young celebrities tempted to simply spend, spend, spend - whether on sex and drugs and roll 'n' roll or anything else - rather than accumulate wealth for later, when their earning power and wealth may diminish, there are other benefits of this strategy.
For instance the appointment of sensible trustees to manage the accumulating wealth within such a trust will ensure the settlor's family security will be well looked after, so requirements for school fees, health issues, long-term care or virtually any other unforeseen eventuality, can still be catered for in the future.
Interestingly, expats working around the world are also able to use this exemption to accumulate surplus income during their period abroad - remember, IHT will continue to apply because they will generally not be changing domicile - in a permanent IHT-efficient environment. So long as any regular gifts are from net income (net of all local taxes, if any) in their country of temporary residence and they can maintain their lifestyle, then the gifts will still qualify.
Flexible, discretionary trusts are a wealthy client's dream, whether established from nil-rate band gifting - currently up to £325,000 every seven years - or, in the case discussed above, via instantly exempt gifts from income.
Paul Wilcox is chairman of WAY Tax & Trustee Advisory Services
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