A transfer is exempt if:

• it was made as part of the transferor's normal expenditure
• it was made out of 'natural' income
• after allowing for all transfers which are part of normal expenditure, the transferor was left with sufficient income to maintain his or her usual standard of living
• it is habitual or regular.

Natural income includes dividends or interest from investments and bank accounts net of taxes, comparing one year with another.

HMRC have stated that ‘we agree that payments received in the form of income benefits from Alternative Secured Pension (ASP) or Unsecured Pension (USP) should be regarded wholly as income for the purposes of the exemption under section 21-IHTA 1984’. This means that sums withdrawn from registered pension schemes in the form of USP or ASP are wholly income and therefore can use the normal expenditure out of income exemption.

Where a gift is assigned into trust, for example large premiums on a whole of life policy, they may still be liable to 10-year periodic and exit charges in future years, but the initial charge of up to 20% of the gift would be avoided where the normal expenditure exemption has been used.

Regular withdrawals from a life assurance or redemption bond are not regarded as ‘income’ as they are from a non-income producing asset and therefore do not satisfy the rules.

As gifts can be of varying amounts, the normal expenditure exemption can be considered for regular and single premium investments, provided the rules are followed.

It was established in the tax case of Bennett v IRC (1995) 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.

HM Revenue & Customs (HMRC) have a form which must be completed on the death of the Settlor where ‘normal expenditure out of income’ is being claimed. The IHT403 form has replaced the old D3a form and asks for a breakdown of expenses to justify the claim that the standard of living has not been affected.

This form must be completed by the Settlor's family, who are likely to seek help from a financial adviser. Therefore, it’s worth keeping a record of all yearly gifts that your clients make 'out of normal expenditure'. A letter should help with your client’s audit trail. We also advise that you hold an IHT403 form (see page 6) on file and complete it each year so that you don’t have to back-capture data from the last seven years.

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 annual exemption and normal expenditure out of income exemptions to the full could significantly reduce entry, exit and periodic charges on existing and future trusts created.