Investing in a bond via a Discounted Gift Trust is one of the ways an elderly person can get an immediate reduction in the Inheritance Tax liability as soon as the scheme is set up with the remainder of the investment falling out after 7 years. Discounted Gift Trusts are the most widely used of all the trust arrangements containing investment bonds for Inheritance Tax mitigation.
A Discounted Gift Trust, creates two separate funds:
- One fund is for the trust beneficiaries and this takes 7 years to become completely exempt from inheritance tax. All investment growth in the value of the investment bond falls outside the Settlor’s estate.
- The other fund is for the settlor absolutely, and consists of a right to regular periodic income payments, usually of 5% per annum. The Settlor has to take this income for the rest of their life. This means HMRC regard some of the investment as falling immediately outside the estate and will not fall back even if the investor died the day after setting up the trust. This portion is called is called the “discount”.
Calculating the “discount”
This “discount” is calculated by assessing the life expectancy of the Settlor and so depends on their age, state of health and the amount of income paid to them. At the inception of the plan an estimate will be made, of the investment which is unlikely to be returned to the investor and a discount is applied to the value of the gift. The investor can retain a right to withdrawals from the investment and, providing they do so, the value of the gift can be reduced for Inheritance Tax Purposes.
Each Life Office offering Discounted Gift plans can give an indication of how much they would consider would fall immediately outside of the Estate, assuming withdrawals of 5% per annum. These indicative quotes are subject to further medical underwriting and could be enhanced or reduced, depending on life expectancy. Please note that after 7 years, the whole value of the investment would fall outside of the Estate for Inheritance Tax purposes. If the investor’s health is better than would normally be expected for someone of their age, we can request that their medical records are assessed by the underwriting department of the Life Office, and it may be possible to revise the discounted value of the gift they are making to enhance it.
Taxation treatment of Discounted Gift Trusts
Discounted Gift Trusts can be established as an absolute (sometimes referred to as “bare”) trust where the beneficiaries cannot be changed in the future or it can be established as a discretionary trust where the beneficiaries can be changed later. It is also possible to arrange a Discounted Gift Trust as a flexible interest in possession trust.
If the Discounted Gift Trust is set up on an absolute basis, sometimes called a “Bare Trust”, transfers into this trust will be treated as Potentially Exempt Transfers (PETs) PETs are not subject to any immediate inheritance tax charge even if they exceed the Nil Rate Band but can become taxable should death occur within 7 years. In this event, “taper relief” may reduce any inheritance tax due on death after 3 years. In addition, there will be no entry, periodic or exit charges on the investment bond held within the DGT.
If it is set up on a discretionary basis, or as an “Interest in Possession” trust, transfers to this trust will be treated as Chargeable Lifetime Transfers so any transfers exceeding the available Nil Rate Band are immediately chargeable to inheritance tax at 20%. In addition, there may be entry, periodic and exit charges applied to the investment bond held within the trust.
- An immediate reduction in the value of an estate for inheritance tax purposes. So even if the Settlor died immediately after setting up the DGT there would be an instant IHT benefit.
- The generation of an income stream which can be useful for making gifts out of normal expenditure, such as funding a Whole of Life insurance policy to insure against any additional inheritance tax liability.
- For DGT’s written on a discretionary or Interest in Possession basis, the Settlor’s income from the trust is not subject to any exit charges. In addition, any periodic charges will be based on the value of the investment bond minus any discount available. If this amount is less than any available nil rate band, there is no periodic tax charge to pay.
- Discounted Gift Trusts can be relatively inflexible. If the Settlor decides not to take the income, usually of 5% per annum, payments can cease but this will have taxation consequences since it will be regarded as a further gift into trust.
- Until the Settlor’s death, the trustees usually have no right to surrender the bond in excess of the income payments made to the settlor.
- The payments may be due to last for a lifetime, but become chargeable to income tax after 20 years of 5% withdrawals. The withdrawal level may become inadequate after a time, especially in times of high inflation.
- The decision to use a DGT is more likely to be driven by a need for the immediate inheritance tax efficiency rather than a need for flexibility. If the gift falls within the Nil Rate Band, the discretionary trust is the most usual arrangement since this is not subject to an immediate IHT charge of 20%.
Case Law and regulation relating to Discounted Gift Trusts
Whilst HMRC has never “approved” Discounted Gift Trusts, they have been aware of their existence for a long time and have not challenged DGT’s either under the “Gift With Reservation” rules or the “Pre Owned Assets Tax”.
Bower v. Revenue and Customs Commissioners (2008). HMRC did not dispute the legality of the use of a Discounted Gift Trust but the key to this case was the age of Mrs Bower when she died aged over 90 having written the DGT 5 months prior to her death. HMRC only disputed the size of the discount, in other words the amount deemed to fall immediately outside of her Estate for inheritance tax purposes. HMRC argued that if a client is uninsurable because of their age, little or no discount should apply.
The same issue was debated during another case regarding the size of the discount relative to the Settlor’s age in the case Watkins and Harvey v. Revenue and Customs Commissioners (2011). In this case the Settlor was 89 and died 2 years after making writing the DGT. The High Court upheld HMRC’s argument that little or no discount should be applied given the age of the Settlor.
The amount of discount is calculated using a rate of interest based on a 1% differential over short dated gilt yields which vary. Discounts are calculated using unisex rates. The methodology of calculating the discount as well as how to apply any periodic 10 year charges has been codified by HMRC and can be found here: https://www.gov.uk/government/publications/revenue-and-customs-brief-22-2013-discounted-gift-schemes/revenue-and-customs-brief-22-2013-discounted-gift-schemes–2
For more on Discounted Gift Trusts, please see the Wikipedia article which you will find here: