Inheritance Tax - Section 21 IHTA - meaning of income

Riedel

I'd be grateful for opinions on whether certain types of receipts could reasonably be included in determining a person's available income for the purposes of the IHT 'normal expenditure out of income' relief. 

First, a couple of quickies: Premium Bond winnings and the indexation on NS&I National Savings Certificates.  Could the former be said to be a return on an investment in the form of income and the latter be said to be interest, albeit set by reference to an index (as permitted by the National Loans Act 1968)?

My main query concerns the treatment of interest on bonds in general, be they fixed-term bonds offered by banks or NS&I Guaranteed Growth or Green Savings Bonds.  Specifically, I'm looking at those which have a term in excess of one year, the interest is credited yearly and there is no way of encashing the bond prior to maturity.  The interest is effectively capitalised and is clearly not accessible until the maturity of the bond.  So, let's take a three-year investment as an example.  Would all three years' interest be 'available income' for s21 purposes in Year 3 or would the correct approach be to limit the amount available to just the Y3 interest, as that for years 1 & 2 has become capital in nature?  (I appreciate HMRC's guidance talks of income retaining its identity for a couple of years but I'm not sure whether that's just in cases where it's been specifically earmarked to be used for a gift.  In my case I'm just trying to establish whether it could be treated as part of the available income to cover both gifts and normal living expenses.)  

Jeremy535897

Start with https://www.gov.uk/hmrc-internal-manuals/inheritance-tax-manual/ihtm14250
Income for these purposes is income under general legal principles.
Premium bond winnings are regarded as windfalls so are not income. Search Google:
"are premium bond winnings income for section 21 ihta 1984"
Google "is indexation on national savings income for section 21 ihta 1984"
The conclusion, which makes sense, is that this is not income for these purposes either.

On your main question, I think the second item above illustrates the problem you may face, as the sums are accumulated on encashment, so it is hard to see how they could retain their nature as income, and any transfers be "paid out" of income. But I am not aware of any specific ruling, and a deeper dive into those google searches may reveal something useful.

Dead_keen

First, listen to Jeremy.  He's renowned for being good at tax.

Second, you are not going to get a definitive answer.  There is little case law on this, and even less that is freely available.

Next, I'd ask why you care if the exemption is available or not.  If you are the giver, just be generous and make the regular gifts.  If the "uncertainty" in your regular gifts means the recipient might pay IHT on your death (because your PETs, CLTs and "uncertain" gifts out of income in the last seven years are above your IHT exemption) then warn them they may have to pay IHT on some of it.  But limit your gifts by what you want to give, not my some random piece of tax legislation.

If you are the executor then think about whether you want to take a cautious interpretation of income or a bullish interpretation.  If the latter, take care that you make adequate disclosure to avoid penalties.  That might mean paying someone like Jeremy.

Jeremy is good at tax but I disagree with:

Jeremy535897 said:

Income for these purposes is income under general legal principles.

I am not a lawyer but have never found any "general legal principles" of what income is.  My view is that is that "income" means income in the normal sense of the word, but bearing in mind the circumstances of the individual and the purpose of the IHT exemption.  Dancing on the head of a pin?  Probably.  But let's apply it to premium bond prizes. 

Let's say I have £1 of premium bond and I win £1m.  I'm happy to believe that in the context of a £1 investment and a £1m prize that the £1m is not income. 

But let's say I have £300,000 of cash in a mixture of premium bonds, one year fixed rate accounts and instant access accounts.  I have £50,000 of premium bonds and for the last ten years my prizes have averaged £1,500 per year (3%). Every few months I review interest rates, my balance between instant access / fixed terms, the tax benefits of ISAs and premium bonds and even whether I want to invest in gilts.  I can see that ABC Bank pays 4% and my premium bonds are 3% but tax-free.  As a higher-rate taxpayer that's a 5% gross equivalent yield and so I leave that in premium bonds.  So looking at this in a common sense way, I treat my premium bond prizes as (tax-free) interest.  It's not really interest but in my circumstances it economically is.  Yes, I may not get 3% (the average prize rate on premium bonds is 3.6%), or I might get more.  But in my life those premium bond prizes are economically similar to interest and so I don't see any reason for excluding them from my income for s21 purposes.  But there is no case law and many people will have a different view.  

On the three year bond point, my actionable advice would be: "do not invest longer than a year if you wanted to be certain from a s21 perspective". 

Saying that, if I was the executor and the deceased had one, I would recognise income in each of the three years for s21 purposes.  It can't be paid out of the account, but when I last looked at s21, it did not say anything about the income having being "paid out" - it uses "expenditure" instead (and there is a difference - if I buy something with a credit card, I'd say my expenditure is when I click the "buy" button, not when the credit card direct debit happens). 

Also, income and cash are very different things (e.g. try paying for a packet of polos with the cash in your pocket, now try putting "income" into your pocket).  Saying it differently, imagine you have two five pound notes that have been sitting in a coat that you have not worn for a good few years.  You then get £10 interest from Nationwide. Woohoo!  You are feeling rich and want to gift that "income" to your daughter (over 18, not in full-time education or training) so she can buy lunch.  Do you have to go to the cash point to withdraw a brand new tenner and give that to her if you want an IHT break? Or can you use the two five pound notes you've just remembered?  I don't see it matters from a s21 perspective as it does not talk about cash but "income" and "expenditure".

At the end of the day, none of this is certain though.


edited for shpelling

probate_slave

Back in 2011 it was relatively easy to speak with HMRC technical officers in Edinburgh. When I raised the question of income for NEOOI, I was told to include annual interest on National Savings Certificates, along with accumulation dividends on Unit Trust holdings as well as non-taxable income such as AA, winter fuel payment, Christmas bonus, and premium bond winnings. This may have just been his personal view, but it feels more in the spirit of the legislation than the answers quoted from Google AI. Therefore I would  include the interest on fixed rate bonds annually by tax year, even if interest only becomes available and subject to income tax on maturity. 

It took several attempts to persuade NS&I to give me the details of Savings Certificate interest, but eventually they provided a breakdown for the previous 7 years. These weren't index-linked certificates, so the question of indexation didn't come up, but I would consider it a return on the capital investment and therefore income for s21.

Jeremy535897

Dead_keen said:

First, listen to Jeremy.  He's renouned for being good at tax.

Second, you are not going to get a definitive answer.  There is little case law on this, and even less that is available that is freely available.

Next, I'd ask why you care if the exemption is available or not.  If you are the giver, just be generous and make the regular gifts.  If the "uncertainty" in your regular gifts means the recipient might pay IHT on your death (because your PETs, CLTs and "uncertain" gifts in the last seven years are above your IHT exemption) then warn them they may have to pay IHT on some of it.  But limit your gifts by what you want to give, not my some random piece of tax legislation.

If you are the executor then think about whether you want to take a cautious interpretation of income or a bullish interpretation.  If the latter, take care that you make adequate disclosure to avoid penalties.  That might mean paying someone like Jeremy.

Jeremy is good at tax but I disagree with:

Jeremy535897 said:

Income for these purposes is income under general legal principles.

I am not a lawyer but have never found any "general legal principles" of what income is.  My view is that is that "income" means income in the normal sense of the word, but bearing in mind the circumstances of the individual and the purpose of the IHT exemption.  Dancing on the head of a pin?  Probably.  But let's apply it to premium bond prizes. 

Let's say I have £1 of premium bond and I win £1m.  I'm happy to believe that in the context of a £1 investment and a £1m prize that the £1m is not income. 

But let's say I have £300,000 of cash in a mixture of premium bonds, one year fixed rate accounts and instant access accounts.  I have £50,000 of premium bodss and for the last ten years my prizes have averaged £1,500 per year (3%). Every few months I review interest rates, my balance between instant access / fixed terms, the tax benefits of ISAs and premium bonds and even whether I want to invest in gilts.  I can see that ABC Bank pays 4% and my premium bonds are 3% but tax-free.  As a higher-rate tax that's a 5% gross equivalent yield and so I leave that in premium bonds.  So looking at this in a common sense way, I treat my premium bond prizes as (tax-free) interest.  It's not really interest but in my circumstances it economically is.  Yes, I may not get 3% (the average prize rate on premium bonds is 3.6%), or I might get more.  But in my life those premium bond prizes are economically similar to interest and so I don't see any reason for excluding them from my income for s21 purposes.  But there is no case law and many people will have a different view.  

On the three year bond point, my actionable advice would be: "do not invest longer than a year if you wanted to be certain from a s21 perspective". 

Saying that, if I was the executor and the deceased had one, I would recognise income in each of the three years for s21 purposes.  It can't be paid out of the account, but when I last looked at s21, it did not say anything about the income having being "paid out" - it uses "expenditure" instead (and there is a difference - if I buy something with a credit card, I'd say my expenditure is when I click the "buy" button, not when the credit card direct debit happens). 

Also, income and cash are very different things (e.g. try paying for a packet of polos with the cash in your pocket, now try putting "income" into your pocket).  Saying it differently, imagine you have two five pound notes that have been sitting in a coat that you have not worn for a good few years.  You then get £10 interest from Nationwide. Woohoo!  You are feeling rich and want to gift that "income" to your daughter (over 18, not in full-time education or training) so she can buy lunch.  Do you have to go to the cash point to withdraw a brand new tenner and give that to her if you want an IHT break? Or can you use the two five pound notes you've just remembered?  I don't see it matters from a s21 perspective as it does not talk about cash but "income" and "expenditure".

At the end of the day, none of this is certain though.

I meant nothing more by "general legal principles" than the normal meaning of the word, which has been refined by legal cases over many years.
Looking further into the subject, there is an interesting discussion (not entirely on point) here:
https://trustsdiscussionforum.co.uk/t/gifts-out-of-surplus-income-s-21-ihta-1984/27566/6

poseidon1

Riedel said:

I'd be grateful for opinions on whether certain types of receipts could reasonably be included in determining a person's available income for the purposes of the IHT 'normal expenditure out of income' relief. 

First, a couple of quickies: Premium Bond winnings and the indexation on NS&I National Savings Certificates.  Could the former be said to be a return on an investment in the form of income and the latter be said to be interest, albeit set by reference to an index (as permitted by the National Loans Act 1968)?

My main query concerns the treatment of interest on bonds in general, be they fixed-term bonds offered by banks or NS&I Guaranteed Growth or Green Savings Bonds.  Specifically, I'm looking at those which have a term in excess of one year, the interest is credited yearly and there is no way of encashing the bond prior to maturity.  The interest is effectively capitalised and is clearly not accessible until the maturity of the bond.  So, let's take a three-year investment as an example.  Would all three years' interest be 'available income' for s21 purposes in Year 3 or would the correct approach be to limit the amount available to just the Y3 interest, as that for years 1 & 2 has become capital in nature?  (I appreciate HMRC's guidance talks of income retaining its identity for a couple of years but I'm not sure whether that's just in cases where it's been specifically earmarked to be used for a gift.  In my case I'm just trying to establish whether it could be treated as part of the available income to cover both gifts and normal living expenses.)  

The recent thread below on the pensions forum will be of specific interest -

https://forums.moneysavingexpert.com/discussion/comment/81774701#Comment_81774701

Worth noting Aberdeen's general guidance on meaning of income for the purposes of the exemption, but with regard to fixed rate bonds with durations longer than a year you should note HMRC's general presumption that income has been capitalised after 2 years, unless compelling evidence to the contrary.

The solution of course is to chose fixed rate bonds that pay out income monthly rather than accumulated until the end of the term. Charter Savings Bank bonds are a case in point.

Also worth noting the diligent record keeping that is required to eventually assist executors in making a successful claim.

Riedel

Just a quick 'thank you' for all your responses.  I'll look at your replies - and suggested reading - in detail and get back if I have any further queries or observations.  By way of some background, I assist my elderly mother with her finances and expect to be the executor of her estate.  I have been keeping very detailed records of her incomings and outgoings for some years now, so that won't be an issue.  I have researched this subject as much as I can but it's always helpful to seek other opinions.

Riedel

I've now had a chance to digest your replies and I've also put similar questions to three different 'AI' engines.  (Is that what you call them?)  As has been pointed out, there is next-to-no case law, minimal guidance in HMRC's IHTM and not much accessible discussion.  I think I'll take a cautious approach but I do have a few observations.

I've included premium bond winnings as income in my records to date but have always been somewhat uneasy about it.  I was thinking, on Dead Keen's lines, that this was just another investment producing a regular stream of 'income', with the slim chance of a bumper bonus.  I felt this would be justified if, taking one year with the next, the prizes did not significantly exceed the rate used to fix the prize fund.  I can see an obvious problem of where to draw the line if a big win is received.  Perhaps the answer would be to set the bar at that rate and treat anything above it as capital.  Or just treat the lot as capital.  It's interesting that, whilst two of the AI sources were confident that winnings were not income, Chat GTP was adamant that they were - even to the extent of a £1 million win.  Hmmm.

The indexation of Savings Certificates seems to be universally considered to be capital in nature.  I can live with this, although I'm not sure that I follow the rationale. (And none of the AI sources were able to provide links to the sources that support their conclusions.)  It seems a very fine line between treating the annual uplifts as capital growth and treating them as credits in the nature of interest - although the revenue/capital divide has exercised far greater minds than mine for an awful long time.  I wonder how HMRC would tax them in the absence of the IT/CGT exemptions?!

The most interesting - and unanimous - response from the AI sources concerned the treatment of bonds with terms in excess of 12 months.  (Excluding ISA's, those with interest paid out and those which can be redeemed early.)  In my example of a 3-year bond with interest credited annually, the view was that all three years' interest should be treated as capital.  I follow the reasoning for years 1 & 2 - the interest has been capitalised, it has earned further interest itself and it isn't being retained as income for a specific purpose - so HMRC's 'two-year' rule of thumb won't really come into play.  But year 3's interest?  I cannot accept that this is anything other than income.  

So I think I'll strip out the Premium Bond winnings and savings certificates indexation from my calculation of 'income' for s21 purposes.  If this has a material effect on the entitlement to the relief, I'll obtain a professional opinion before submitting the IHT account to HMRC.  

As regards the bonds I've mentioned, I'll exclude any interest assessed to IT for the year of maturity but credited to the bond in earlier years.  The amount excluded will be the interest assessed less the tax charged thereon.

Hopefully this prudent approach will cover my back!  

Thanks again for your comments. 

poseidon1

Riedel said:

I've now had a chance to digest your replies and I've also put similar questions to three different 'AI' engines.  (Is that what you call them?)  As has been pointed out, there is next-to-no case law, minimal guidance in HMRC's IHTM and not much accessible discussion.  I think I'll take a cautious approach but I do have a few observations.

I've included premium bond winnings as income in my records to date but have always been somewhat uneasy about it.  I was thinking, on Dead Keen's lines, that this was just another investment producing a regular stream of 'income', with the slim chance of a bumper bonus.  I felt this would be justified if, taking one year with the next, the prizes did not significantly exceed the rate used to fix the prize fund.  I can see an obvious problem of where to draw the line if a big win is received.  Perhaps the answer would be to set the bar at that rate and treat anything above it as capital.  Or just treat the lot as capital.  It's interesting that, whilst two of the AI sources were confident that winnings were not income, Chat GTP was adamant that they were - even to the extent of a £1 million win.  Hmmm.

The indexation of Savings Certificates seems to be universally considered to be capital in nature.  I can live with this, although I'm not sure that I follow the rationale. (And none of the AI sources were able to provide links to the sources that support their conclusions.)  It seems a very fine line between treating the annual uplifts as capital growth and treating them as credits in the nature of interest - although the revenue/capital divide has exercised far greater minds than mine for an awful long time.  I wonder how HMRC would tax them in the absence of the IT/CGT exemptions?!

The most interesting - and unanimous - response from the AI sources concerned the treatment of bonds with terms in excess of 12 months.  (Excluding ISA's, those with interest paid out and those which can be redeemed early.)  In my example of a 3-year bond with interest credited annually, the view was that all three years' interest should be treated as capital.  I follow the reasoning for years 1 & 2 - the interest has been capitalised, it has earned further interest itself and it isn't being retained as income for a specific purpose - so HMRC's 'two-year' rule of thumb won't really come into play.  But year 3's interest?  I cannot accept that this is anything other than income.  

So I think I'll strip out the Premium Bond winnings and savings certificates indexation from my calculation of 'income' for s21 purposes.  If this has a material effect on the entitlement to the relief, I'll obtain a professional opinion before submitting the IHT account to HMRC.  

As regards the bonds I've mentioned, I'll exclude any interest assessed to IT for the year of maturity but credited to the bond in earlier years.  The amount excluded will be the interest assessed less the tax charged thereon.

Hopefully this prudent approach will cover my back!  

Thanks again for your comments. 

I assume you will be the executor, so you are giving yourself a headstart in being able to launch a coherent claim for the relief when the time comes.

As to the Premium Bond conundrum, the following thread from TaxationWeb maybe of interest -

https://www.taxationweb.co.uk/forum/gifts-from-surplus-income-what-qualifies-as-income-t55713.html#:~:text=Re: Gifts from surplus income -- what qualifies as income?,-Mon Aug 19&text=PB wins are NOT income.

From a professional tax practitioner perspective  PBs are excluded as income on the grounds they are prizes, so your decision to exclude is in good company. However, interesting that an anonymous tax payer allegedly received word of mouth HMRC guidance to contrary. Certainly not something I would try to rely on.

Riedel

Thanks Poseidon.  I'll stick to my plan!

Dead_keen

Riedel said:

The most interesting - and unanimous - response from the AI sources concerned the treatment of bonds with terms in excess of 12 months.  (Excluding ISA's, those with interest paid out and those which can be redeemed early.)  In my example of a 3-year bond with interest credited annually, the view was that all three years' interest should be treated as capital.  I follow the reasoning for years 1 & 2 - the interest has been capitalised, it has earned further interest itself and it isn't being retained as income for a specific purpose - so HMRC's 'two-year' rule of thumb won't really come into play.  But year 3's interest?  I cannot accept that this is anything other than income.  

LLMs like ChatGPT have improved massively since I started asking them tax questions.  I'm lucky that I'm quite good at getting a feeling for the quality of the answers that they give.  For many of the common-or-garden tax questions I give them, the answers are fantastic: sensible, comprehensive, sourced and right.  But many of the questions I ask have answers that are just completely wrong.   

Where I found them to be most wrong is where there are parallels to other bits of tax.  So, for example, a three year bond where the interest is added to the balance each year is often described as the interest being capitalised.  There is also a common sense view that income that is not used must become capital after a while.  Otherwise, you would never have capital, it would always remain income. 

[As an aside another example is that an LLM will confuse a legal concept with a tax concept and use them interchangeably when they cannot be].

So there are two bits that have similar terminology: (i) adding interest to the balance in an account, and (ii) income being transmogrified into capital at some stage.   While the fact that there are these two distinct concepts is relatively easy for a person to get to grips with (when it is pointed out), it is something that is not possible for an LLM to get to grips with unless it has been properly trained on the point.   Whether there is insufficient training data for LLMs or whether there are issues with RLHF / RLAIF, I don't know.  But to me the issue you have identified is a prime example of the current limits of LLMs - they take stuff at the edge of the their training and extrapolate a bit too far.

Another issue I have is that HMRC are basically doing the same thing as LLMs.  There is a case called McDowall that was heard at the lowest level of tax tribunal and so it is not binding on any other tribunal or court.  The executors lost on the s21 point because the attorney had no power to make gifts. End of story. But being a helpful chap, the special commissioner made some comments on some bits and pieces of the case that he heard.  However, that really is just an aside as it didn't matter because the executors lost on a fundamentally different point. Nobody knows if what the special commissioner said in relation to the circumstances of that case are right or wrong.  They might be partially right, or partially right in those circumstances but partially wrong in other circumstance. However, HMRC quote that case because it is one of the few things that they can quote from a tax case.  Now it might be what HMRC say is absolutely right.  But it might not be, and I think that HMRC here risks being "all AI" (as the young people say).