Understanding the Inheritance Tax Loophole: Could the Budget Close it?
As the search intensifies for ways to mitigate the £22 billion “black hole” in public finances, Rachel Reeves, the shadow chancellor, is contemplating various measures in the upcoming Budget. One area where significant financial adjustments could occur is in the realm of inheritance tax (IHT), particularly concerning a little-known exemption known as the “normal expenditure out of income” rule. This loophole allows individuals to make unlimited gifts without incurring tax, but this could soon be a thing of the past.
What is the “Normal Expenditure Out of Income” Rule?
The "normal expenditure out of income" provision permits individuals to gift money without facing inheritance tax charges if the gifts are made regularly from their income and do not diminish their standard of living. This exemption has been underutilized; while around 41,000 estates faced IHT liabilities last year—a 20-year high—only 430 families benefited from this exemption, collectively saving £67 million.
To qualify for this exemption, gifts must come from a consistent income stream and must not adversely affect the giver’s lifestyle. In other words, an individual can provide financial support—such as school fees or living expenses—for family or friends, without worrying that these gifts will be taxed as part of their estate.
Potential Changes to Inheritance Tax Legislation
The possibility of restricting or eliminating this exemption is on the table as the government seeks to boost revenue. Mark Routen, director of taxation at Hoxton Wealth, suggests that its limited usage makes it a prime candidate for revision or removal. The implications could be significant, particularly for families who rely on these gifts for budgeting educational expenses and other regular costs.
Eliminating the exemption could also complicate the probate process. Should these payments be classified as gifts instead of normal expenses, they would need to be factored into the entirety of the estate, creating extra work for executors to determine tax liabilities.
The Broader Landscape of Inheritance Tax
Current IHT rates sit at a hefty 40% on estates exceeding the threshold of £325,000, prompting many to explore avenues to reduce tax burdens. Under the existing rules, gifts made by an individual are included in the estate for IHT purposes if the giver dies within seven years of making the gift. However, there is no such stipulation regarding the normal expenditure out of income, meaning that these regular gifts can fall outside the estate quickly.
Legal and financial experts, like Alexa Collis of Harbottle & Lewis, believe that this exemption may indeed be reevaluated in the upcoming Budget. They argue that by its nature, it acts as a relief for individuals with a significant disposable income, thereby drawing scrutiny from policymakers concerned about equity in taxation.
The Complexity of Implementing Changes
The complexity of determining what constitutes regular income and how to integrate these transactions into estate evaluations creates a daunting challenge for the government. Sarah Coles, head of personal finance at Hargreaves Lansdown, highlights the intricacies of proving that gifts came from surplus income without affecting an individual’s lifestyle. Attempts to reverse or modify this exemption could lead to administrative headaches for Her Majesty’s Revenue and Customs (HMRC), making such changes potentially unpopular and complicated.
Andrew Marr, managing partner at Forbes Dawson, echoed similar sentiments, suggesting that despite the government’s interest in tightening IHT rules, any move to amend this exemption may not yield sufficient fiscal benefit to justify the effort.
Future Directions in Inheritance Tax Reform
In addition to the “normal expenditure out of income” rule, other aspects of IHT could also be under review. For instance, the seven-year rule—one that impacts the taxation of gifts depending on the timeframe of the donor’s death—could see adjustments. Lengthening this period would further challenge wealth transfer, especially for affluent families seeking to pass on assets without incurring tax liabilities.
The conclusion regarding potential changes in the inheritance tax landscape won’t become clear until the Budget announcement is made. However, it is certain that with the growing pressure to address public financial shortfalls, every viable option, including the potential closing of invaluable loopholes, is likely to be considered.
Final Thoughts
As policymakers weigh options to address the pressing financial challenges ahead, the intricacies of inheritance tax regulations will occupy a central position in these discussions. The little-known “normal expenditure out of income” exemption may be a target for reform, and if so, it could reshape the financial landscape for many families. While the possibility of administrative challenges looms large, the quest for more equitable revenue generation remains a priority, and the outcome of the upcoming Budget promises to spark significant dialogues on wealth distribution and taxation in the UK.
