Sharing a windfall - is there a tax cost?

IHT and gifts

Gifts by one individual to another don’t trigger an immediate inheritance tax (IHT) bill. They are potentially exempt transfers (PETs). That means only if the person who made the gift dies within seven years will the gift be chargeable to IHT, unless covered by an exemption. 

Note. The income exemption is called the “normal expenditure out of income” or s.21 exemption.

Normal expenditure

The s.21 exemption exists to allow individuals to spend their money as they see fit, including using it to make gifts to whoever they wish. Essentially, all that’s needed for the exemption to apply to a gift is for it to come from their income and be part of their normal expenditure. To meet the second condition there must be a pattern. This means a single gift, even if it’s from income, won’t qualify unless there is a clear intention to repeat it (it doesn’t have to be for the same amount). On that basis making a one-off gift from the sale of assets won’t be exempt from IHT, it will be a PET.

Repeated gifts

The parent could consider spreading the gifts over a few years; this would probably be enough to get around the requirement for there to be a pattern of expenditure, especially if they also spread the sale of the assets used to fund the gifts over more than one year. The trouble is the exemption also requires the gifts to be “out of income”.

What is income?

In the broadest sense income is, stating the obvious, money coming in. However, tax rules distinguish between capital income and earned or investment income. As far at the s.21 exemption is concerned gifts of capital, whether in cash or in assets, won’t meet the requirements. It must be income derived from earnings or investments. The trouble is the tax rules don’t explain or define what does or doesn’t count as capital.

HMRC’s interpretation

HMRC internal guidance is helpful but should be taken with a pinch of salt. There are clearly holes in some of its assertions, for example, that all payments from insurance bonds are capital; this is clearly nonsense where the original investment has grown in value and what is received must therefore contain an element of income. It appears that even HMRC isn’t confident in its view; most of its internal manuals are open to public scrutiny but it has withheld some of the text on this point.

HMRC issued a statement some years ago indicating that usually it follows general accounting standards in categorising what is income or capital. In this case accounting principles would count the money received from the sale of an asset as capital, as would we. Therefore it can’t be used to make an exempt gift out of income though other exemptions might apply.