Taxation Readers’ Forum: Determining disposable income

‘I act on behalf of a client whose estate will be liable to inheritance tax; consequently, we are looking at how this might be minimised. The client has more than enough income for their personal requirements and it seems that making gifts out of disposable income would be possible. My question concerns the determination of a taxpayer’s disposable income.

Page 8 of HMRC’s form IHT403 (tinyurl.com/y9ooxrcw) is helpful in establishing disposable income and then maintaining a record of this across several years. One subheading on page 8 in the types of income section is ‘investments’, but no further detail is provided. Clearly, this is expected to include investment income such as dividends, but no mention is made of capital gains. Given that the thrust of the legislation is to tax any diminution of the estate, I wonder whether capital gains should be included as income for these purposes. For example, some investment trusts may yield a return in the form of gains as well as income.

If the answer is positive, which logic supports, should those gains be included on an ‘as realised basis’ or, as I think would be more correct, by marking the value of those investments to market each year. In this way the taxpayer’s income would reflect not only gains but also losses whether they are realised or not.’ Query 19,593 – Befuddled.

Terry Jordan’s reply: A capital gain is regarded as capital rather than income

‘Befuddled observes that the thrust of the inheritance tax legislation is to tax any diminution of the estate and wonders whether capital gains should be included as income for the purposes of the exemption in IHTA 1984, s 21 (‘Normal expenditure out of income’). He also wonders, further, whether such gains should be periodically calculated on a mark to market rather than realised basis.

My understanding is that the exemption is available because inheritance tax is a charge on capital. Potentially, it is unlimited in its application and so can be very valuable but, by definition, it merely prevents a person’s capital growing as quickly as it otherwise would and does not reduce the capital base.

The Inland Revenue, as was, in a letter in the Law Society Gazette of 9 June 1976, set out its interpretation that normal accountancy rules apply and imply taking income after tax. The position is summarised in Dymond’s Capital Taxes at 13.314 : ‘“Income” is not defined. The Revenue consider it must be ascertained in accordance with normal accountancy principles, on an annual basis, but it need not have the same meaning as for income tax purposes (bear in mind that under the income tax code capital sums may be taxed as income: eg premiums paid on the grant of short leases). A capital gain, even though made within a single year, is regarded as capital. It is the net income, after deduction of income tax, which is material. The words “taking one year with another” permit some carrying over of income from year to year – which corresponds to the broad view that was usually taken for estate duty purposes without express statutory authority.’

The capital element of purchased life annuities and 5% annual withdrawals from insurance bonds are not treated as income for the purposes of the exemption. Accordingly, I fear Befuddled’s proposal is a non-starter.

The reports of the Office of Tax Simplification (OTS) and the all-party parliamentary group for inheritance and intergenerational fairness (www.step.org/appg) both suggested that the exemption might be abolished and replaced with an increased annual exemption, so those with substantial surplus income might be best advised to use this while it remains on the statute book.’