The Finance Act 2006 has reduced some of the traditional opportunities for inheritance tax planning, but some of the exemptions which allow gifts to both individuals and trusts to be made free of inheritance tax remain unaffected. Most people are familiar with the £3,000 annual exemption but the 'normal expenditure out of income' exemption is less well known and can be considerably more valuable. An outright gift that qualifies for this particular exemption falls entirely outside the inheritance tax net – with no seven year wait, as there is for a 'potentially exempt transfer'.

The normal expenditure out of income exemption can also be used to fund a trust. In this case, the trust itself will be in the usual tax net for trusts, but the important point for many taxpayers is that they will have avoided the 20% 'entry charge' on getting assets into the trust.

Briefly, gifts will qualify for the normal expenditure out of income exemption to the extent that they are:

?? part of the normal expenditure of the person making the gift (the donor);

?? made out of his income; and

?? his standard of living was unaffected by making the gifts.

The Revenue adopt a fairly 'common sense' approach to its interpretation of the conditions of this exemption.

'Normal expenditure' can be demonstrated either by there being a regular pattern of giving or by demonstrating a settled intention, at the outset, to embark on a regular pattern of gifts. So you might, for example, make similar gifts at the same time each year, writing to the recipients explaining the nature of the gifts. Provided the right steps are taken, the income to be given away can be the income of a settlement of which you are a life tenant, not just personal income. The crucial thing in all cases is to keep the right records, and we can advise you about this.

'Income' is given its normal meaning. The Revenue do allow spare income from earlier years to be used, but this cannot be carried forward indefinitely.

Moreover, once income has been invested, it will be considered to have become capital. If your income fluctuates from year to year, the level of giving may also fluctuate.

The exemption will not be available where making the gifts has affected the donor's standard of living by forcing him significantly to alter his lifestyle. But an alteration in lifestyle which the donor wanted to make anyway – for example moving to a more modern house with fewer outgoings – may then put them in a position to make qualifying gifts.

It must be remembered that the gifts have to be disclosed in the inheritance tax return that has to be filled in on the death of the person who made them, and the exemption is then claimed. In claiming the exemption it is not enough simply to assert that the gifts were made out of income. The Revenue will want this to be demonstrated by completing a form setting out details of the donor's income and expenditure categorized into bills, expenses, gifts, nursing home fees etc., for the seven years before death. If this information is not readily available, assembling it will involve many hours of poring through bank statements, chequebooks and other records. It is, therefore, well worth keeping careful records of the gifts and carrying out approximate calculations of income and expenditure each year.