Techzone

Inheritance tax receipts for the year to March 2025 reached £8.2bn, a rise of nearly 11% on the previous year. With the inclusion of pensions in the taxable estate from 2027 receipts are set to increase significantly.

This is driving a corresponding increase in demand for estate planning advice. One area which has seen a particular uptick in activity has been the normal expenditure out of income exemption (NEOOI). This stems largely from concerns about pension funds becoming subject to IHT and a desire from some clients who intended to use their pension savings for wealth transfer purposes rather than as an income.

There are obvious benefits to this exemption. Firstly, the gift will be outside the estate immediately with no seven-year clock. Secondly, the amount gifted is only limited by the donor's surplus income.

However, there some downsides to the exemption too. The exemption can generally only be claimed on death meaning there is uncertainty at the time of gift that all the conditions for a successful claim have been met.

For the exemption to apply the gifts must:

• form part of normal expenditure
• be made from income
• leave the donor with sufficient income to maintain their usual standard of living

These are clearly open to a degree of interpretation and with no guarantee that gifts will qualify it is often best to err on the side of caution rather than push at the boundaries of HMRC acceptability. In this insight we examine the most common questions about the exemption.

Normal expenditure

1. When is a gift regarded as 'normal' expenditure?

Gifts will usually be made in cash and must form part of a habitual pattern of gifting. This can be shown from the history of gifts made by the donor. Typically, HMRC will look at a history of say three or four years to establish a regular pattern. Sometimes a shorter period may be accepted where it can be shown that the donor had made a commitment to future gifting, such as paying the premiums on a life policy or setting up a standing order.

2. Do gifts have to be made to the same person?

Gifts do not have to be to the same recipient every year. The exemption should apply as long as gifts are paid to the same class of beneficiary, for example children or grandchildren. Alternatively, the gifts could be to a discretionary trust where the trustees will ultimately determine who benefits from within the class of possible beneficiaries.

3. Do gifts have to be for the same amounts?

The amount of the gifts will typically be of comparable size. This could mean that they are the same value each year, or that they are the same percentage of surplus income. Equally, the gifts could be for a specific purpose where the amount required may be subject to change, such as gifts to pay for grandchildren's school fees.

Where this is not the case the pattern will not necessarily be broken, but where the size of a gift is disproportionately larger than other regular gifts in the pattern HMRC may disallow relief on some or all of the gift.

For example, if the normal pattern of outright gifting is £10,000 per annum, but in one year a gift of £100,000 is made, £10,000 may be accepted as normal expenditure (if it is part of a pattern of similar £10,000 gifts) with extra £90,000 deemed to be a PET at the time it was made. If it is clear that the gift is for a different purpose from other gifts in the pattern relief may be denied on the whole amount.

4. Do gifts have to be made at the same intervals?

There are no set intervals between gifts when determining regularity. Gifts could be monthly, quarterly, half yearly or yearly. The pattern of gifting could even start off on a monthly basis and later change to say annually as long as the annual amounts remain proportionate to each other and are made to the same group of beneficiaries. Gifts made every two years may also be acceptable but obviously it could take longer to establish a pattern.

Income

5. What is included as income?

Gifts must normally be made from current net income received in a tax year (spendable income after income tax has been deducted) and not capital. Income for the purposes of the exemption is not the same taxable income.

It is broadly income received after tax from employment or pension, the natural yield from investments such as interest or dividends and rental income. It also includes the natural income from ISAs if the taxpayer actually receives the distribution rather than accumulating it within their ISA.

Regular payments from a purchased life annuity will normally be received as part interest and part return of capital – only the interest element can be included in income for the exemption.

6. Can pension tax-free cash be included in income?

Pension drawdown withdrawals, including any tax-free cash element, are also treated as income for this purpose. Of course, they will still need to satisfy the other conditions of the exemption to qualify. For example, stripping out all the tax-free cash and gifting it over a couple of tax years would typically fail to establish a regular pattern of gifting. The withdrawals would not look like income. However, spreading withdrawals over a longer period, similar to an annuity, is more likely to satisfy the exemption.

7. Can bond withdrawals be included in income?

Bond withdrawals are normally regarded as a return of capital even if they result in a chargeable event gain subject to income tax. Payments received from a discounted gift trust, or a loan trust are also not regarded as income.

8. Can accumulated income be included?

Generally, income which is reinvested into other investments will be deemed to have been capitalised. This includes income automatically reinvested if an individual holds 'accumulation' units. It does not matter that the accumulated income is taxable in the year it is received.

Although 'income' will usually be income received in a tax year, it is possible to carry income over from a previous year if it has not been capitalised, for example income received and kept in the donor's bank account. However, HMRC will generally deem that it has been capitalised if left in the bank account for more than two years.

9. Can income be transferred between spouses for joint gifts?

The UK has independent taxation, so where joint gifts are made, each spouse will be assessed separately and their surplus income determined. A surplus can't be determined using total household income.

Where spouses or civil partners have different levels of income, for the purposes of the exemption HMRC will generally not accept a transfer of income from the high earner to the low earner to increase the latter's surplus.

Where this is the case, it may be beneficial to consider each spouse making separate rather than joint gifts. This may allow the higher earner to make larger regular gifts as they will have a larger surplus.

Usual standard of living

10. What is surplus income?

Gifts must be made from surplus income. This is simply the amount by which an individual's income exceeds their usual spending each year. Making a gift from income that is truly surplus should not affect the donor's usual standard of living.

If they have to resort to capital to maintain their lifestyle this is an indication that the surplus is insufficient to cover the gift, and the exemption may be lost or limited. Having calculated income, normal living expenses must be identified to arrive at the surplus.

11. What is included in normal living expenses?

These include costs of subsistence, such as mortgages, heating and electric bills, council tax and insurances plus those additional costs relating to standard of living, including travel costs, regular holidays and club memberships.

Although not exhaustive, the HMRC form IHT403 lists the main items of expenditure that should be considered. Where a larger one-off cost arises, it could be argued that these don't count as 'normal' and therefore not count in the list of expenses (and so don't reduce a surplus), for example, home improvements such as a new kitchen.

Similarly, the purchase of a new car around every 10 years may also be excluded, but the costs of a lease car or one purchased on a monthly contract is likely to be regarded as a normal living expense. There are no guarantees, and treatment will depend on individual circumstances.

12. Can household expenses be allocated between spouses?

As with income, one spouse or civil partner may have more expenditure than the other. However, household expenses such as council tax and heating will normally be regarded as being shared equally. While the actual payment may be made by the higher earner, this does not affect the allocation of the expense for the exemption which is likely to be split equally. Other expenses clearly attributable to one partner do not have to be split, for example the costs of a hobby or a gym club membership.

13. What is regarded as a 'usual standard of living'?

This will differ from person to person. The usual standard of living will generally be the standard at the time of making the gift. However, where unexpected circumstances cause a change to their standard of living, for example, unemployment, the exemption may not be lost even if they do have to temporarily resort to capital to continue making future gifts.

Claiming the exemption

14. Do gifts have to be reported?

Gifts do not have to be reported to HMRC at the time they are made. The exemption is claimed on death and planning the deceased was relying on could be denied by HMRC.

The exception to this is for regular gifts into a discretionary trust. These will need reporting if in the absence of the exemption the gift would result in a 20% tax charge. Therefore, an IHT100 will need to be completed if the gifts when added to any other chargeable lifetime transfers in the preceding seven years exceed the nil rate band.

HMRC will then notify the donor of their decision on the claim for NEOOI. If they accept the claim, then no tax will be payable on the regular gifts. If the claim is rejected tax may become due immediately.

15. How is the exemption claimed?

The exemption is typically claimed by the executors following the death of the donor. They will need to send detailed records of gifts made and income and expenditure details for the seven years prior to death on form IHT403.

Thorough record keeping during the donor's lifetime is essential to help the executors make a successful claim. Trying to retrospectively reconcile seven years' worth of income, spending and gifting can be challenging for executors. This can mean the planning is only as good as the record keeping.

Summary

Pushing the boundaries of what is included in income and expenditure to arrive at a surplus will leave clients more at risk of a claim being rejected by HMRC, either fully or partially. Any part of a claim that is turned down will be treated as a failed PET and taxed accordingly. This could use up the nil rate band available to the estate and possibly the nil rate band available at the 10-year anniversaries on any subsequent trusts created.