IHT Planning for those with cash: Access to regular payments throughout life required: the role of Discounted Gift Trusts
Tony Wickenden, Managing Director at Technical Connection, explains the role of Discounted Gift Trusts.
Whilst reducing your estate by making gifts is one of the key inheritance tax (IHT) mitigation strategies, for many people it will not be practical on a large scale given that to be IHT effective a gift must have “no strings attached”. Most if not all advisers will be familiar with the “gift with reservation” (GWR) provisions introduced in 1986 to stop individuals reducing their estate by making gifts while retaining access (or even potential access) to the assets “given away”.
So, simply put, if a client transfers an asset to a trust under which they can benefit, it will be a gift with reservation and the value of the trust fund will be in the client’s (as settlor’s) estate for IHT purposes. So, no IHT saving will be achieved. However, thanks to the principles of English law, more than one right in the same property can exist. This is where a discounted gift trust (DGT) comes into play. The condition for such a trust to be IHT effective is that the settlor’s rights (to regular payments throughout life) must be pre-determined at the outset and cannot be changed. In effect the settlor’s rights in the asset being transferred into the trust are “carved-out” and retained for the settlor from outset and therefore not actually gifted. This means that the GWR provisions will not bite.
Of course, a practical pre-condition for this strategy to work is that the client has cash available to make an investment into such a trust. If they have and their requirement for regular payments can be quantified, for example as a % of the intended investment on a regular basis, and they are certain that they will not need to access more than that %, a DGT may be an ideal choice.
DGT in practice
Under a typical DGT the settlor specifies at outset the level and frequency of payments they want to receive from the investment. Typically, the most tax efficient investment for a DGT will be a life insurance bond where the level of payment to the settlor is kept within the 5% annual withdrawal allowance. The settlor’s entitlements are satisfied by those regular withdrawals from the bond. This way there will be no income tax implications for the settlor or the trustees at the time of the withdrawal. A charge to tax through a chargeable event could only be possible if withdrawals in excess of the cumulative 5% allowances take place or a total surrender of the bond (or any of the policies making you the bond) takes place. The former after 20 years of 5% withdrawals and the latter, usually, after the death of the settlor.
The trust fund (subject to the settlors rights to regular payments) is held for the intended beneficiaries and the settlor has no access to it. There are different versions of DGTs on the market, depending on the nature of the trust in relation to this gifted part. Under a bare (absolute) DGT, there will be a named beneficiary or beneficiaries entitled to the residual fund. Discretionary DGTs are more popular as they offer flexibility to the trustees (often taking account of a non- binding “expression of wishes” by the settlor) to decide which of the potential beneficiaries should benefit. The chosen beneficiary(ies) would normally only receive the value of the trust fund following the death of the settlor.
When a DGT is set up, the settlor makes a gift for IHT purposes. This will be either a potentially exempt transfer (PET) for a bare DGT or a chargeable lifetime transfer (CLT) for a discretionary DGT. However, the value of the gift will be “discounted” to take account of the value of the settlor’s rights to receive the payments they have “carved out” for themselves. This value will be determined actuarially based on the settlor’s age, state of health and the amount and frequency of payments. For this reason, most DGT applications will require medical underwriting. HMRC has issued guidelines on calculating discounts.
On the death of the settlor within seven years of establishing the DGT
(i) There will be no value attributed to the settlors rights which will have ceased on death,
(ii) The amount of the chargeable transfer to be taken into account in determining how much of the nil rate band is available to the death estate will be the discounted value of the gift but
(iii) The beneficiaries will receive the full value of the trust fund
In practice, clients investing in a discretionary DGT should be advised to ensure that any discounted gift is covered by their available nil rate band so that no lifetime charge to IHT should arise. .
During the lifetime of a discretionary DGT, in theory, there may be IHT exit charges when capital payments are made to beneficiaries as well as periodic charges, every 10 years.
Helpfully HMRC has confirmed that no exit charge will arise on payments made to the settlor under a discretionary DGT because this property is already treated as being held absolutely on bare trust for the settlor.
The value of the settlor’s retained rights will also reduce the value of the trust fund for the purpose of periodic charges.
Other tax implications
As long as the underlying investment is a bond and the withdrawals are kept within the 5% allowances, there will be no income tax implications during the settlor’s lifetime. After that, the usual rules for the taxation of bonds will apply.
This income tax simplicity is the reason why DGTs work best with bonds. In theory a different investment vehicle could be used but that would involve a number of complex and potentially unattractive tax consequences for the settlor and trustees.
Capital gains tax
Capital gains tax is not relevant to investment bonds
Pre Owned Asset Tax (POAT) provisions
HMRC confirmed in 2005 that POAT does not apply to DGTs.
Disclosure of tax avoidance schemes (DOTAS) provisions
HMRC has confirmed that if an insurance company offered the arrangement under what was deemed to be acceptable in accordance with HMRC practice before 1 April 2018 and the trust continues to be offered on the same basis then it would not to be notifiable under the IHT DOTAS hallmark.
Trust registration service (TRS)
Since 1 September 2022, the trust will need to be registered within 90 days of its creation, as will any changes to the trust details and/or circumstances.
A DGT is an excellent, tried and tested, method of allowing an investor to make an IHT effective gift while retaining a right to a series of tax-efficient cash payments on set dates in the future throughout life and leaving a residual fund for their beneficiaries after their death.