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.

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.

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.

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'. A letter, such as the one shown below, should help with your audit trail. We also advise that you hold an IHT403 (page 6 shown below) on file and complete it each year so that you do not need to back-capture 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.

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

Our award-winning life assurance product, The Skandia Plan, is one of the few remaining qualifying whole life policies in the market. It can ensure that there is no surprise income tax liability for the estate once the last of the lives assured has died, providing premiums have been maintained. Alternatively, our Skandia 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 non-qualifying policy is greater than the premiums paid, an income taxcharge can arise on death. This can be avoided using The Skandia Plan or a Skandia Protect guaranteed whole life policy.

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

Both The Skandia Plan and the Skandia Protect guaranteed whole life cover trust fund will be valued on the premiums paid or market value for the 10-yearly 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 nil-rate band (provided no other trusts were created on the same day), premiums would have to exceed £325,000 (2010/11 tax year) for the previous 10-year period for any tax to be due, for a single Settlor trust, or £650,000 (2010/11 tax year) for a joint Settlor trust.

Exit charges will be based on the rate established at entry and the 10-yearly periodic charge. In most instances, this will be zero but, where poor health or death occurs close to the 10-yearly 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 Skandia's technical article ‘Inheritance tax treatment of trusts (post finance act 2006)’.