Income, Expenditure and Gifting from Excess Income

EnglishMohican

I am trying to get my head round income, capital and gifting from excess income. The figures are for discussion purposes and are not real or well thought through.

Suppose I have a pension income of £40k (from DB schemes and the state) My yearly expenses on food/energy/holidays/housing are £30k leaving an excess of income over expenditure of £10k. I save £5k into a cash ISA and  gift £5k to my children.

I also have a shares ISA with £100k which earns dividends in the ISA each year of £4k. Each year, the £4k dividends are used to buy more shares in the ISA.

After 5 years, I now have £130k in the ISA due to share values increasing plus £20k from the 5x£4k so a total of £150k I also have £25k in my cash ISA from the 5 x £5k (Ignoring interest).

If I withdraw £25k from the shares ISA how much of it counts as income and how much as withdrawal of capital.?

Do all the dividends (which were surely income in the year I received them) still count as income? (I see references to HMRC considering that dividends stay income for two years before becoming capital - but that may only be if they are held as cash without being re-invested.)

Suppose I take more out so it may/probably counts as a capital withdrawal - I spend it buying a Picaso to hang in the lounge (yeah I know!). Have I exchanged one form of capital for another?

If so, do I need to count the amount I spend to buy the Picasso as part of my yearly spend and balance it against my income ruling out any gift from excess income for that year?

If instead of buying a Picasso, I buy a car, its still a capital purchase, just a more useful one - so does that change anything, The money will have gone through my bank account but can I persuade HMRC that my total capital has stayed the same - so I have not spent it.

I guess I then get into depreciation - am I spending the depreciation and does that count against income?

If the car is a capital purchase, then presumably so are carpets, sofas, curtains, dental implants? Where is the line?

Is it any different if I take the money from the Cash ISA?

It seems to me that capital is simply stored excess income. But I bet HMRC don't agree.

Can anybody clarify any of this for me? All thoughts welcome.

Linton

EnglishMohican said:

I am trying to get my head round income, capital and gifting from excess income. The figures are for discussion purposes and are not real or well thought through.

Suppose I have a pension income of £40k (from DB schemes and the state) My yearly expenses on food/energy/holidays/housing are £30k leaving an excess of income over expenditure of £10k. I save £5k into a cash ISA and  gift £5k to my children.

I also have a shares ISA with £100k which earns dividends in the ISA each year of £4k. Each year, the £4k dividends are used to buy more shares in the ISA.

After 5 years, I now have £130k in the ISA due to share values increasing plus £20k from the 5x£4k so a total of £150k I also have £25k in my cash ISA from the 5 x £5k (Ignoring interest).

If I withdraw £25k from the shares ISA how much of it counts as income and how much as withdrawal of capital.?

Do all the dividends (which were surely income in the year I received them) still count as income? (I see references to HMRC considering that dividends stay income for two years before becoming capital - but that may only be if they are held as cash without being re-invested.)

Suppose I take more out so it may/probably counts as a capital withdrawal - I spend it buying a Picaso to hang in the lounge (yeah I know!). Have I exchanged one form of capital for another?

If so, do I need to count the amount I spend to buy the Picasso as part of my yearly spend and balance it against my income ruling out any gift from excess income for that year?

If instead of buying a Picasso, I buy a car, its still a capital purchase, just a more useful one - so does that change anything, The money will have gone through my bank account but can I persuade HMRC that my total capital has stayed the same - so I have not spent it.

I guess I then get into depreciation - am I spending the depreciation and does that count against income?

If the car is a capital purchase, then presumably so are carpets, sofas, curtains, dental implants? Where is the line?

Is it any different if I take the money from the Cash ISA?

It seems to me that capital is simply stored excess income. But I bet HMRC don't agree.

Can anybody clarify any of this for me? All thoughts welcome.

You are overthinking this.  The rules really are pretty straightforward.  The objective of the GFI rules alongside the 7 year rule is to prevent tax avoidance by people giving away large sums of money on their deathbed whilst permitting reasonable ongoing spending of excess income on gifts.

A reasonable interpretation seems to me to be that cash receipts like dividends count as income for up to two years but if you buy capital with them they become capital. Buying and selling of assets is not income. Paying into a cash ISA is adding to savings.  Plus you have the constraint that the gifting should be a regular part of your normal expenditure.

The only doubtful case I can think of is drawdown from a pension.  Clearly that is the whole purpose of a pension and should in pronciple be no different to buying an annuity.  As I understand things drawing down a steady amount over time can be counted as income.  One-off lump sums cannot.

You are not going to get a precise definition covering all possible circumstances.  Just use common sense and the normal meaning of words bearing in mind the objective of the rules.  I suggest you dont try to be over-clever and look for loop-holes.  It's your executor who will have to demonstrate what is gifts from income, you should aim to make their job easy.

EnglishMohican

Thank you both - forgive me if I check my understanding of your answers by putting them in my own words and adding a bit from other sources.

Firstly, I am not trying to be over-clever and find loopholes. I am trying to make it easy for my executors by sticking to the straight and narrow and not gifting anything over what they can genuinely show is excess income. Ideally to make sure the records are easily available to demonstrate that.

Some things are clear, my pension is income, my food bill is expenditure. Both happen every month so they are simple.

HMRC mention averaging over a number of years - which seems reasonable. One year of heavy expenditure does not mean that gifting has to stop providing that over a number of years, the total expenditure can be shown to be less than the total income. The good years can cover the bad one. I guess that a follow up is that the year after the bad one needs to look hopeful as a normal expenditure year, that would help a forward looking justification immensely.

Where the extra money comes from (Cash ISA or Selling shares) is not important as long as that cash or those shares can reasonably be shown to be the result of the last "something" years  of income.

And if that heavy expenditure is not caused by something that I do in a pattern (two yearly, three yearly, whatever) it does not count in any case - as it is not normal.

Not a mention of capital in that! Have I got it about right now?

poseidon1

EnglishMohican said:

Thank you both - forgive me if I check my understanding of your answers by putting them in my own words and adding a bit from other sources.

Firstly, I am not trying to be over-clever and find loopholes. I am trying to make it easy for my executors by sticking to the straight and narrow and not gifting anything over what they can genuinely show is excess income. Ideally to make sure the records are easily available to demonstrate that.

Some things are clear, my pension is income, my food bill is expenditure. Both happen every month so they are simple.

HMRC mention averaging over a number of years - which seems reasonable. One year of heavy expenditure does not mean that gifting has to stop providing that over a number of years, the total expenditure can be shown to be less than the total income. The good years can cover the bad one. I guess that a follow up is that the year after the bad one needs to look hopeful as a normal expenditure year, that would help a forward looking justification immensely.

Where the extra money comes from (Cash ISA or Selling shares) is not important as long as that cash or those shares can reasonably be shown to be the result of the last "something" years  of income.

And if that heavy expenditure is not caused by something that I do in a pattern (two yearly, three yearly, whatever) it does not count in any case - as it is not normal.

Not a mention of capital in that! Have I got it about right now?

Anyone contemplating instigating a gifts out of income iht mitigation strategy should first take a  look at form IHT 403 and the gifts out of income schedule at page 8.  This gives an indication of the level of granular detail expected of  executors to demonstrate ( to HMRCs satisfaction) that excess income was indeed available  for each year of the purported gifts. 

 It is recommended that if anyone is serious about the exemption being invoked by their executors on eventual death, they complete each year a detailed income and expenditure schedule for their executors' assistance.

It is apparent from the queries raised by OPs on this subject, that there is often a vague understanding of the distinction between capital and income in determining excess income on a year to year basis. In this regard, OPs are  directed to HMRCs internal manuals, a link to part of the manual is shown below, and scrolling backwards and forwards from that page will give a more complete understanding of the hoops executors will need to jump through in successfully claiming the exemption.


https://www.gov.uk/hmrc-internal-manuals/inheritance-tax-manual/ihtm14250


OPs should be aware that although income in the IHT legislation is not specifically defined, it is to be determined by HMRC officers  ' in accordance with normal accountancy rules'.

 If you are not accountancy trained, you are already at a disadvantage here.  As an example the 5% withdrawal facility from investment bonds is often characterised as income by insurance companies. It is not, its a return of your original capital. However, contrast this with pensioners taking regular UFPLSs from their SIPP. One might assume the element related to tax free cash should not be considered income, but apparently the entirety of the payment is income for the purposes of the exemption.

 Also take a look at the annuities heading in the HMRC manual link above. In the case of purchased life annuities ( ie, purchased from your own capital rather than from accumulated pension funds), the return of  capital element is not income for the purposes of the exemption.

What of ISA income which has not been distributed to the investor in the year, is that to be considered available income in subsequent years in ascertaining excess income? Well HMRC concede that although there are no hard and fast rules,  in the absence of evidence  to the contrary they  rather arbitrarily state that in general, unspent income becomes capital after two years.

The above examples are indicative of the sort of things a trained tax accountant should know if advising a client, but would the ordinary lay person be cognizant of these nuances in attempting DIY planning of their own?

In summary, in drawing attention to the schedule to IHT403, and HMRC's extensive guidance manuals on the subject,  OPs should acquaint themselves with the challenges their executors may face in proving the validity of  gifts out of excess income claims, and provide them with coherent records to do so. This is especially the case where OPs may also wish to utilise any of the various other capital gifts exemptions in a particular year, such as PETs and the £3,000 gifts  exemptions.

cfw1994

(caveat - I haven’t clicked links or read around this much!)

What kind of records should one keep if gifting more than the 3k pa to offspring?
A spreadsheet?
A signed and witnessed sheet for each transfer?

SouthCoastBoy

I an just starting gifting to my two children, 25k each at the moment. I have updated my records that sit alongside my will informing the executor of amount, date and who it was gifted to. 

As I am leaving everything to my wife as long as one of us survives the next 7 years we will be OK for iht from this gift perspective 

Linton

cfw1994 said:

(caveat - I haven’t clicked links or read around this much!)

What kind of records should one keep if gifting more than the 3k pa to offspring?
A spreadsheet?
A signed and witnessed sheet for each transfer?

An annotated bank statement should be sufficient, perhaps with annual summaries of income, expenditure and gifts .

The main purpose is not to provide evidence for HMRC but rather to enable the executor to make sense of what has been happening and then complete the IHT forms accurately.

SVaz

I can’t believe people are going to these ridiculous lengths.   Take £200 ( or whatever) a week in cash out, give it away and nobody will ever know what it’s been used for,  you could be spending it at the bookies or on fine wine for all anyone knows. 

No wonder they want us to stop using cash. 

The recipient can use the cash for their weekly shop etc. and their own money stays in the bank.

Keep_pedalling

SVaz said:

I can’t believe people are going to these ridiculous lengths.   Take £200 ( or whatever) a week in cash out, give it away and nobody will ever know what it’s been used for,  you could be spending it at the bookies or on fine wine for all anyone knows. 

No wonder they want us to stop using cash. 

The recipient can use the cash for their weekly shop etc. and their own money stays in the bank.

Because most of us are honest and don’t want to leave our executors in a position of committing fraud when there are legal ways of achieving the same end. 

Madeinireland101

Keep_pedalling said:

SVaz said:

I can’t believe people are going to these ridiculous lengths.   Take £200 ( or whatever) a week in cash out, give it away and nobody will ever know what it’s been used for,  you could be spending it at the bookies or on fine wine for all anyone knows. 

No wonder they want us to stop using cash. 

The recipient can use the cash for their weekly shop etc. and their own money stays in the bank.

Because most of us are honest and don’t want to leave our executors in a position of committing fraud when there are legal ways of achieving the same end. 

I’m sure no one wants to commit fraud but I very much doubt my executor would have a clue about what I used £200 on if I took it out in cash 6 years ago. Actually I’m pretty certain I wouldn’t remember what I used it on myself 😀 - I’d maybe remember a month ago at best

Madeinireland101

I think what I’m saying is that surely the executor in that position will simple think it must have been used for normal expenses in some way. I presume they wouldn’t have to default to assuming a gift if there was no other documentation?