Learn about changing the underpinning investment on a discounted gift trust (DGT) which has been used for lump sum inheritance tax (IHT) planning.
Changing the underpinning investment will have tax and legal implications
In some arrangements a non-surrenderable life policy is used. Changing the investment is therefore not possible
It is essential that the beneficial rights of the settlor are not changed in any way as a consequence of the investment change
Chargeable event implications need to be considered
Why change the investment?
Advisers and/or trustees sometimes investigate a change in the underpinning investment within DGTs. There may be a desire to change a poorly performing investment.
Changing the underpinning investment will have tax and legal implications.
What is a DGT?
A DGT is a trust-based IHT planning arrangement, under which the settlor is entitled to a stream of capital payments. The entitlement of the beneficiaries is subservient to the settlor’s entitlement.
DGTs are usually structured on a bare (absolute) or discretionary trust basis.
DGTs established before 22 March 2006 would normally have a flexible interest in possession structure. A discussion of the impact of changes to investments held by trustees of interest in possession trusts is outwith the scope of this note.
DGT and IHT – initial gift
The gift establishing the DGT may be discounted from the amount given to the trustees. This reflects the fact that the settlor has an inalienable right to the selected payment stream. The value transferred depends on the settlor’s life expectancy and the pattern of repayments.
The value of the initial gift is unaffected by a change in the underpinning investment.
Where the arrangement is on a bare trust basis the initial gift is a potentially exempt transfer (PET).
Where the arrangement is structured on any other basis (eg a discretionary trust basis) the initial gift is a chargeable lifetime transfer (CLT).
DGT and IHT – ongoing
Where the arrangement is on a bare trust basis the value of the trust fund (which reflects the settlor’s rights) falls into the IHT estate of the beneficiary.
Where the arrangement is structured on any other basis (eg a discretionary trust basis) the trustees will be potentially subject to ten yearly IHT charges and to exit charges when funds are distributed to beneficiaries. These charges will of course be subject to the trustees' available IHT nil rate band.
Reinvestment powers – trustee considerations
It is necessary to establish whether the trustees have power to change the investments. This requires examination of the trust deed and the contract conditions of the life policy forming the trust fund.
In some arrangements a non-surrenderable life policy is used. Changing the investment is therefore not possible. In bare trust arrangements the settlor’s rights are usually carved out of the policy and the policy (subject to those rights) is transferred to the trustees. Changing the investment is therefore not possible if the settlor still needs to receive payments from the trustees.
It is essential that the beneficial rights of the settlor are not changed in any way as a consequence of the investment change. The IHT effectiveness of any DGT depends on the rights of the settlor being unalterable.
Missing a payment will mean the terms of the trust have not been complied with and the IHT effectiveness of the arrangement will have been compromised. One way of dealing with this is to hold enough cash in the trustee bank account to make the specified payments to the settlor ‘between investments’.
What are the tax consequences of a bond surrender?
The settlor’s entitlement will be set out in the trust fund. If the settlor’s right is expressed in terms of a percentage of the original bond premium and the bond has fallen in value, a change will mean a smaller premium for the new bond. The payments required to pay the specified percentage of the original bond premium may then be more than 5% of the investment in the replacement bond. If withdrawals exceed the 5% tax-deferred allowance, there will be a chargeable event every year in respect of the replacement bond. This tax charge will fall on the settlor of a discretionary trust (whilst alive and UK resident).
If the original bond has grown in value, its surrender will trigger a chargeable event. The tax charge will fall on the settlor of a discretionary trust (whilst alive and UK resident).
The settlor will need to consider the provisions of S538 ITTOIA 2005 with regard to recovery of tax from the trustees.