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Regular premium policies and exemptions

Various exemptions are available to individuals who wish to give assets away so that they are immediately no longer included in their ‘estate’ for inheritance tax (IHT) purposes.

Using annual exemptions

The main exemptions are:

  • Annual exemption of £3,000 – with the ability to carry over the previous year’s allowance, if unused.
  • Small gifts exemption of £250 – this can be used a number of times in any tax year for the benefit of different people.
    However, it cannot be used in conjunction with the annual exemption, ie to allow a gift to an individual of £3,250 in a tax year.

Additionally there is a series of other gift exemptions available, where gifts are made:

  • In consideration marriage or Civil Partnership.
  • For education and maintenance.
  • For charities and some political parties.
  • For the national benefit.

The annual exemption of £3,000, plus the ability to carry forward any unused yearly allowance, is ideal for small gifts and can be used for regular premium policies as well. However, there is another exemption where gifts are classified as 'normal expenditure out of income’. This exemption can be combined with the annual exemption to cover all or part of a single gift.

Gifts out of normal expenditure – how does it work?

For a transfer to be covered by this exemption:

  • it must be made as part of the transferor's normal expenditure
  • it must be made out of 'natural' income (eg salary, dividends or interest from investments)
  • after allowing for all transfers which are part of normal expenditure, the transferor must be left with sufficient income to maintain his or her usual standard of living
  • the transfer has to be habitual or regular.

The yearly 5% withdrawal from a bond does not satisfy 'out of income' requirements and if this withdrawal were used to 'replace' income to maintain the standard of living, this exemption would not be available.

How does it work in practice?

Where a client has sufficient income, gifts which satisfy the above criteria can be exempt where they exceed the annual allowance.

In the tax case of Bennett v IRC (1995) it was also established that the gifts do not have to be of a fixed amount and can vary from year to year. In the case of Bennett, one payment was £9,300 and the next £60,000. This was due to fluctuating income and each payment did not reduce the transferor’s standard of living.

Recording the evidence

HM Revenue & Customs (HMRC) has a form which must be completed on the death of the Settlor or Donor where ‘normal expenditure out of income’ is being claimed as part of the IHT400 submission. The IHT403 form asks for a breakdown of expenses etc to justify the claim that the standard of living has not been affected.

This form must be completed by the Settlor or Donor’s family, who are likely to seek help from a financial adviser. Therefore, it is worth keeping a record of all annual gifts that your clients make ‘out of normal expenditure’.  We would advise that you hold an IHT403 (as at the attached link) https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/497798/IHT403.pdf   on file and complete it each year so that you do not need to back­capture data from the last seven years.

Keeping a clear audit trail will help you in the long run should the inspector of taxes query any claims for 'normal expenditure out of income'. This is because HMRC will not allow a claim under this exemption until the death of the donor.

Note: Clarifying income and expenditure is never easy, especially where it is generated from non­-taxable assets like ISAs. Extra care should, therefore, be taken when recording income from ISAs.

Opportunities with Old Mutual Wealth

Using the 'normal expenditure out of income' exemption to fund regular premium policies to meet future IHT bills combines tax­efficient premiums with tax­efficient death benefits where a suitable trust is involved.

Our Protect guaranteed whole life contract offers certainty of premium and no income tax liability on death, as the plan does not have a surrender value. The sum assured is always paid 'income tax free’. In contrast, if the surrender value of a non­qualifying policy is greater than the premiums paid, an income tax charge can arise on death.

Combining the exemption with a discretionary trust

Where a discretionary trust is used and the ‘normal expenditure out of income’ exemption is applied, the premiums should avoid entry charges on the amount gifted.

The Protect guaranteed whole life cover trust fund will be valued on the premiums paid or market value for the 10­yearly periodic charge. Assuming the lives assured are in good health, the trust fund will be valued on premiums paid and, as the trust benefits from its own nil­rate band (provided no other trusts were created on the same day), premiums would have to exceed £325,000 (2016/17 tax year) for the previous 10­year period for any tax to be due, for a single Settlor trust, or £650,000 (2016/17 tax year) for a joint Settlor trust.

Exit charges will be based on the rate established at entry and the 10­yearly periodic charge. In most instances, this will be zero but, where poor health or death occurs close to the 10­yearly periodic charge, tax may be payable at significantly reduced rates, a maximum of 6% at the 10­ year point, plus a percentage of this based on the number of full quarters completed before exit.
For further details on the taxation of discretionary trusts please see the latest version of Old Mutual Wealth's technical article ‘Inheritance tax treatment of trusts (post finance act 2006)’ .

Summary

 Product

 Discretionary  trust  available

 Entry tax

 10-  yearly  periodic  charge

 Exit
 charge

 Reviewable
 premium

 Guaranteed
 premiums

 Qualifying
 policy

 Protect  guaranteed  whole life

 Yes

 Annual  exemption  of £3,000,  then normal  expenditure,  then  chargeable  lifetime  transfers  (CLTs).

 Yes.  Based on  premiums  paid or  market  value. If  in good  health,  based on  premiums  paid, so  tax is  unlikely.

 Yes, but  only  applicable  if tax paid  on entry  and at  end of  last 10-  year  period.

 No

 Yes

 No, but  policy does  not have a  surrender  value so no  additional  tax liability


An absolute trust is also available and premiums would be classed as potentially exempt transfers (PETs) if not otherwise exempt. Entry, 10-year periodic and exit charges are not applicable to absolute trusts.

Finally, where creating 'life policies' in trust alongside single premium investments into trust, the order in which the gifts are made is important. Generally, exempt premiums should be created before CLTs and PETs. For a full explanation please see the technical article 'Making gifts – order of gifting'.

Full details of The Protect guaranteed whole life plan can be found in the client brochure, Key Features Document and Policy Terms, which can be found on the literature library. These are available from any Old Mutual Wealth Consultant.

The information provided in this article is not intended to offer advice.

It is based on Old Mutual Wealth's interpretation of the relevant law and is correct at the date shown at the top of this article. While we believe this interpretation to be correct, we cannot guarantee it. Old Mutual Wealth cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained in this article.

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