Learn about the role discounted gift trusts play in inheritance tax planning.
A discounted gift trust is a trust based inheritance tax planning arrangement for those individuals who wish to undertake inheritance tax planning but who are unable to lose full access to their investment
The term "discounted" is used because the value transferred on establishing the trust is less than the amount invested
There are two basic types of discounted gift trust, but many variations on the general theme.
Nil or negligible discount is available where the settlor is, or is "rated" over 90. The value transferred in such cases is the policy premium.
The courts have previously considered discounted gift trusts
What is a discounted gift trust?
A discounted gift trust (DGT) is a trust-based inheritance tax (IHT) planning arrangement for those individuals who wish to undertake IHT planning but who are unable to lose full access to their investment. In a DGT access is typically provided by means of a series of preset capital payments to the investor who will be the settlor of the trust.
DGTs take many forms.
Why is the term ‘discounted’ used?
The term ‘discounted’ is used because the value transferred on establishing the trust is less than the amount invested. This is the logical consequence of the fact that the settlor is entitled to a stream of capital payments. The settlor is typically entitled to payments on specified dates subject only to be alive on those dates. The settlor's transfer or gift is the bond/policy premium less the value of the payments receivable during his/her lifetime.
What is the nature of the payments received from the trustees?
Payments from the trustees to the settlor in a DGT are capital, not income.
How is a DGT structured?
There are two basic types of DGT but many variations on the general DGT theme.
Those based on a bare/absolute trust structure and those based on a discretionary trust structure.
Use of a bare/absolute trust structure triggers an IHT potentially exempt transfer (PET) by the settlor. The trust fund is within the beneficiary's IHT estate. (In this context the trust fund is the policy/bond value less the value of the settlor's rights to payment.)
In a bare/absolute structure, where a chargeable event arises in the tax year following that in which the settlor dies, the gain is chargeable under section 465 (2) ITTOIA 2005, ie the individual who owns the rights under the policy. That individual will be the named beneficiary. For chargeable events arising during the settlor’s lifetime or in the year of the settlor’s death it is less clear. HMRC has advised that both the settlor and the named beneficiary will have a material interest in the rights under the policy under section 470. Section 471 (7) would then apply so as to apportion the interests on a just and reasonable basis. So for example an individual who has the right to withdrawals may (by virtue of section 467(7)) be apportioned all of the rights such that they are assessable on excess event gains whilst a termination event may give a different result. At the time of writing we await a response from HMRC regarding the practical interpretation of this.
Use of a discretionary trust structure triggers an IHT chargeable transfer (CLT) by the settlor and the trustees are thereafter within the relevant property regime. The discretionary structure gives greater flexibility.
In a discretionary trust structure, chargeable event gains arising on the trustees' bond/policy will be assessed on the settlor whilst alive and UK resident and thereafter, in tax years after death, on the trustees.
Joint settlor versions of both structures are widely available.
Advantages and disadvantages of DGTs
allow an IHT-effective transfer
allow settlor access through preselected payment stream
may attract a discount
tried and tested – ‘work as described’
payment stream can't be changed
payments generally capped so as not to exceed the 5% rule
There’s considerable HMRC comment on the valuation of the ‘transfer’.
It is generally acknowledged (based on comments in the Bower case) that HMRC accepts that DGTs work as intended.
Reservation of benefit
DGTs don’t trigger the reservation of benefit provisions because the settlor's rights are never given away. The settlor's gift to the trustees is subject to the pre-selected payment stream, the right to which is never given away.
Would the settlor's payment stream have a value on his/her death?
The settlor's contingent (contingent on his/her survival to the selected date) will have no value on death. There is nothing to be included in his/her estate in respect of the payments. Although the deceased is treated as making a transfer of value the instant before death, the value actually transferred takes account of the fact that he/she has died. So the value of the payment stream on death is nil.
The starting point is to estimate the settlor's life expectancy. This is done through an underwriting process. Once the settlor's life expectancy has been established the value of the payments receivable during his/her lifetime is calculated and reduced to current values by use of a discount factor (a reverse interest rate). An adjustment is made for various costs. The value of the settlor's entitlement is deducted from the premium to give the value transferred.
Nil or negligible discount is available where the settlor is, or is ‘rated’ over 90. The value transferred in such cases is broadly the policy premium.
The value transferred – the view of the courts
The case of HMRC v Bower (Executors of Estate of ME Bower) 2008 EWHC 3105 (Ch)
Another success for HMRC. The case concerned Mrs Kathleen Watkins who died on 18 March 2006 aged 91 years and one day. On 21 December 2004 (when aged 89 years and nine months) she established a DGT where there were specified level payments of 10% p.a. of the single premium for the trust property (the Skandia bond), payable quarterly for the life of the settlor. This was quantified at £4,250 per quarter, or £53,273 over the actuarially reckoned life expectancy of Mrs Watkins of 3.1337 years. A medical report on Mrs Watkins dated 20 October 2004 was taken into account in the actuarial projection. The value of her interest (ie the "discount") was assessed as £52,273. The HMRC view was that the appropriate discount was £4,250 (ie one quarter's payment).
Pre-owned asset tax (POAT)
The operation of a DGT should not trigger an income tax charge under the POAT regime.
Disclosure of Tax Avoidance Schemes (DOTAS) regulations were introduced way back in 2004 to provide early information to HMRC about schemes containing defined ‘hallmarks’ of tax avoidance. IHT was first brought into DOTAS in April 2011 but only in very limited circumstances. The Government widened the hallmark with new regulations effective from 1 April 2018. The aim is to catch IHT avoidance schemes but not ‘bread and butter’ IHT planning. In short, established IHT planning schemes (e.g. a DGT) whose workings are well understood and agreed are in the clear where
The scheme was sold and implemented at least once before 1 April 2018
HMRC has indicated its acceptance it achieves that well understood tax outcome, and
It is sold and implemented without being changed after 1 April 2018
On 7 November 2018, HMRC issued a consultation document “The Taxation of Trusts: A review”. In simple terms, the consultation sets out the government’s thinking on making trusts fairer, simpler and more transparent. At the time of writing, the government is notmaking specific proposals for reform.Instead, the government will weigh up the views and evidence presented and consider the options for targeted reforms.
On 23 November 2018, the Office of Tax Simplification published its First Report regarding its review of the IHT regime. This concludes that too many people have to fill in IHT forms, with the process being complex and old fashioned. The recommendations therefore relate to administrative issues. The second report covering wider areas of concern (technical and design issues) will follow in Spring 2019.