‘My adviser says I’m on shaky ground. Please help’

‘Am I breaking the rules by making regular £11k gifts out of my Isa income to beat inheritance tax?’

I have a documented arrangement for making regular (exempt) gifts out of annual income.

However, my adviser suggests that I cannot add £ 11,000 of an annual Isa income to my total, whereas a recent article in The Telegraph seemed to suggest that I could. (Separately, I appreciate that income can be regarded by HMRC as becoming capital after two years and that in another of my Isas – not the one to which I am referring – I do automatically recycle the income to reinvest.) Am I right to add my £11,000 income from this particular Isa to the annual income against which I can make regular gifts?

– John

Dear John

Many readers have asked me how the inheritance tax “normal gifts out of income” rules work. There are essentially three tests that all have to be satisfied for the relief to apply. The gifts must be regular, out of income and should not reduce the donor’s standard of living. Your adviser has questioned whether regular income from an Isa would count as income for the purpose of the second part of the test.

There is little detail about this in the legislation but fortunately HMRC manuals provide helpful guidance here. This notes that the issue should be determined in accordance with normal accountancy rules and is not necessarily the same as income for income tax purposes. This is the order: you first apply the normal expenditure out of income relief on a factual basis, without regard to other exceptions. You then apply other exemptions and apply the annual £3,000 exemption last. Remember that the annual exemption can be carried forward for one year only if not already used. Another question frequently asked is: what happens if the donor spends money on a large purchase such as a new car? The answer depends on how it is financed. If bought for cash, the money is likely to come from a longer term savings account. If so both the purchase and the money used would be capital in nature and should not have an impact on the calculation of the relief.

However, if the car is bought using a finance arrangement, the regular repayments will be relevant in calculating the amount of surplus income available to the donor. Likewise, if you downsize your home, that may release capital from which greater income could be generated. If, however, you then move into rented accommodation, the rent would reduce your available income.

You may choose to pay for an expensive holiday cruise but that should not become an issue. Where it may become a problem would be if you took expensive holidays on a regular basis.

I explained previously that 5pc withdrawals from a “single premium insurance policy” are treated as capital despite being regular income. This is because the law treats them as a part withdrawal of the original investment.

Suppose you took a single tax-free withdrawal from your Sipp as part of a plan to crystalise some of your fund into drawdown. The additional pension drawn would clearly be income but I would expect the lump sum to be treated as capital. However, suppose as an alternative you agreed with your Sipp provider to take a series of tax-free lump sums? I think there is a reasonable case to say that the character of such payments could be regarded as income if operated for an extended period.

Also, as a point of clarification in applying the third test (that the regular gift does not affect standard of living), HMRC says there is no need to demonstrate that income has actually been spent on living expenses. It follows that such expenses could be paid from capital without failing to qualify for the relief. I recognise that these rules might come across as rather complicated. However, my experience in dealing with HMRC in claims for this particular relief is that it tends to take a common sense approach as long as the executors are entirely open about the facts.

It is wise to keep a detailed record of income and expenditure and please keep your executors informed as to where these records are kept.

‘The gifts must be regular, out of income and should not reduce the donor’s standard of living’

Mike Warburton was a tax director with accountants Grant Thornton and is now retired. His columns should not be taken as advice, or as a personal recommendation, but as a starting point for readers to undertake their own research