IHT Gifts Out of Income UK: The Normal Expenditure Out of Income Exemption

The Section 21 Exemption: Why It Matters

Most IHT planning involves either the annual exemption (£3,000 per year) or potentially exempt transfers (PETs) — gifts that escape IHT if the donor survives seven years. Both routes have limits: the annual exemption is small, and PETs require the donor to outlive the gift by seven years, creating uncertainty and the risk of a deathbed IHT charge.

Section 21 of the Inheritance Tax Act 1984 provides a third route. It exempts gifts that are part of the donor’s normal expenditure from income — immediately, unconditionally, and without any cap on the total amount. A pensioner who gives their adult children £1,000 a month from their pension income, month after month, and can afford to do so without touching their capital, can exempt those gifts from IHT the moment they are made. If that donor dies the next day, those gifts do not form part of their estate for IHT purposes.

The exemption is widely underused. Many people — and some advisers — focus on PETs and overlook the section 21 route, which for income-rich individuals can shelter substantially more than any annual exemption allowance.

The Three Conditions: Normal, Income, Standard of Living

Section 21(1) IHTA 1984 provides that a transfer of value is an exempt transfer if it is shown that:

• Condition 1 — Normal: it was made as part of the normal expenditure of the transferor, and
• Condition 2 — Income: (taking one year with another) it was made out of his income, and
• Condition 3 — Maintained standard of living: after allowing for all transfers of value forming part of his normal expenditure, the transferor was left with sufficient income to maintain his usual standard of living.

All three conditions must be satisfied. The burden of proof is on the taxpayer (or, after the donor’s death, the personal representatives). HMRC will request evidence during the administration of the estate, and will disallow the exemption if insufficient records are produced.

Condition 1: What Does ‘Normal’ Mean?

‘Normal’ does not require years of established practice before the exemption applies. The courts have held (and HMRC accepts) that a pattern of giving can be established from the outset: the relevant question is whether, at the time of each gift, the donor intended to make similar gifts in the future and whether those gifts were in fact made. Bennett v IRC [1995] STC 54 (Ch) confirmed this approach: a recently initiated pattern of regular giving qualifies, provided the intention to continue was genuine.

Common examples of normal expenditure include:

• Monthly or annual cash gifts to children or grandchildren (e.g. paying school fees, insurance premiums, or a flat contribution to living costs).
• Regular premiums on a whole-of-life policy written in trust for beneficiaries.
• Annual lump-sum payments made each year on a birthday or at Christmas.
• Rent top-up payments to help a child afford housing in an expensive area.

A single large one-off gift — even a very generous one — is unlikely to qualify as ‘normal’ unless it can be shown to be part of a pattern.

Condition 2: Made Out of Income

The gift must be made from income, not capital. In this context, ‘income’ means the donor’s after-tax receipts from income-generating sources: salary, pension income, rental receipts, interest, and dividends. Capital receipts — including proceeds from selling shares, withdrawing from ISAs, surrendering insurance bonds, or liquidating savings — are capital, not income, and do not count.

The phrase ‘taking one year with another’ gives some flexibility. If income fluctuates — for example, a self-employed donor whose profits vary — HMRC may look at income over a period of years to assess whether the gifts were, on average, funded from income. A donor who gives £20,000 in a high-income year and nothing in a low-income year may still satisfy condition 2 if the average pattern of giving is consistent with income levels over time.

One practical point: where a donor has both income and accumulated savings, HMRC will want to see that the gifts were funded from income rather than from capital. Having a separate bank account into which income is paid and from which gifts are made provides the clearest evidence.

Condition 3: Surplus Income Test

After making the gifts, the donor must retain sufficient income to maintain their usual standard of living. This is sometimes called the ‘surplus income test’. There is no fixed figure: the test is subjective and based on the donor’s own lifestyle. A donor who spends £80,000 a year on living expenses and receives £120,000 in pension and investment income clearly has £40,000 of surplus income available for gifts. A donor who receives £30,000 in pension income and spends £28,000 on living expenses has only £2,000 of surplus income — gifts exceeding that amount would fail condition 3.

HMRC will examine whether the donor was, in practice, maintaining their usual standard of living. If the evidence shows that the donor was cutting back on holidays, eating out, or other habitual expenses in order to fund the gifts, that suggests the gifts were not truly from surplus income.

Record-Keeping: Form IHT403

When a taxable estate is administered, the personal representatives must complete form IHT400 (the main IHT return) and may need to complete supplementary form IHT403, which covers gifts and other lifetime transfers. Form IHT403 includes a schedule in which the donor’s income and expenditure must be set out year by year for each year in which a section 21 exemption is claimed.

The information required includes:

• Total income from each source (pension, salary, interest, dividends, rent, other) in each tax year.
• Total income tax paid in each year.
• Total normal expenditure (living costs, household bills, leisure, travel) in each year.
• Total gifts claimed as section 21 exempt in each year.
• The resulting surplus income calculation.

If this information cannot be provided, or can only be reconstructed partially from bank statements, HMRC may refuse or reduce the exemption. Personal representatives who cannot substantiate a section 21 claim may face an IHT assessment on gifts they believed were exempt, plus interest and potentially penalties.

Section 21 vs Annual Exemption vs PETs: Choosing the Right Route

In practice, the best approach is to use the annual exemption and section 21 in combination. The annual exemption (plus any carried-forward allowance from the prior year) shelters up to £6,000 of capital gifts each year without any conditions. Section 21 can then exempt unlimited regular income gifts on top. PETs are useful for larger one-off capital transfers where the donor is healthy and has a reasonable life expectancy.

Frequently Asked Questions