Techzone

What is a Discounted Gift Trust?

A discounted gift trust allows the settlor (or settlors) to make an inheritance tax effective gift whilst retaining a right to fixed regular payments for the remainder of their lifetime. The value of the settlor's gift for IHT will be discounted by the estimated value of these future retained payments.

The trust establishes two distinct rights:

• The settlor's right to pre-agreed regular payments for life
• The beneficiaries' right to the trust fund after the settlor's death

As it is separately identifiable as to what has been given away and what is retained for the settlor, there's no gift with reservation for IHT.

Who is it appropriate for?

A discounted gift trust is an estate planning vehicle designed for individuals, or married couples/civil partners, who have excess capital they are prepared to give away but still need payments from their capital to supplement their income.

The gift into trust will provide an immediate IHT saving if a discount is agreed*. The whole value of the gift will be free from IHT if the settlor survives it by 7 years.

The settlor receives pre-agreed regular payments that are fixed for their lifetime. The payments cannot be amended once the policy has commenced. This will suit those that are looking for the certainty of receiving known amounts for the rest of their days. If the regular payments are not being spent and are being accumulated within the estate, it may undo the effectiveness of the estate planning.

* Any discount is subject to satisfactory underwriting

Joint settlor v two single settlor plans

Discounted gift trusts may be set up on a single or joint settlor basis (for spouses and civil partners only). When spouses or civil partners consider creating a discounted gift trust (DGT) they will need to decide whether one joint settlor or two single settlor DGTs is most appropriate.

The Retained Payments

The right to the retained payments on a joint settlor DGT will typically continue at the full amount after the first settlor's death.

However, if two single settlor DGTs are selected, the right to the retained payments on one trust will cease upon the first death. This could be an issue where the surviving settlor relies on the retained payments.

Where the surviving settlor is also a beneficiary of the first settlor's trust then they can of course still benefit from that trust, either in the form of regular payments or larger lump sum payments.

The Discount

Joint discounts are calculated based upon combined life expectancy, that is, on the probability of both settlors dying. The discount is not appointed equally but split based upon each settlor’s own life expectancy. This may give a slightly different overall discount compared with two single settlor DGTs, but it will depend upon individual circumstances.

Trust Creation

The trust is typically established by the settlor making a cash gift to the trustees. It isn't normally possible to use an existing bond or other investment to create the trust - these will generally need to be encashed and the proceeds used to establish the discounted gift trust.

The trustees then invest the trust funds by taking out an investment bond (onshore or offshore) although some schemes use a series of endowments. Regular withdrawals are set up to provide the settlor's capital payments.

The use of non-income producing assets, such as bonds or endowments, means there's no trust tax reporting needed unless there's a chargeable gain. 

Trust options

A discounted gift trust will typically offer three trust options. These are:

• Discretionary trust
• Flexible (interest in possession) trust
• Absolute trust.

Under the discretionary trust, no beneficiary has a right to either income or capital. The trustees are able to appoint income or capital at their discretion to any beneficiary within the class of potential beneficiaries named in the trust deed.

The flexible trust names the beneficiaries who are entitled to any trust income. However, if the trust is invested in an investment bond, no income is produced. The trust includes an overriding power of appointment which allows the trustees, which will usually include the settlor, to alter the beneficiaries or their respective shares in the trust. This is especially useful where the settlor may want to alter the beneficiaries in the future. For example, where there are new beneficiaries born after the trust is created, such as grandchildren, or perhaps where the named beneficiary falls out of favour.

Under the absolute trust, the beneficiaries are fixed at outset and cannot be amended by the trustees at a later date. The beneficiary of the absolute trust only becomes entitled to the capital and income from the trust after the retained payments cease upon the death of the settlor. When selecting the absolute trust, the settlor should be certain of who they ultimately want to benefit from the trust.

IHT at outset

The creation of a discounted gift trust (DGT) will be a transfer of value for IHT. The IHT treatment will depend upon the type of trust used:

• Flexible & Discretionary Trusts - chargeable lifetime transfer (CLT)
• Absolute/Bare Trusts - potentially exempt transfer (PET)

The value of the transfer for IHT may be discounted by the value of the settlor's retained payments.

Where a flexible or discretionary DGT is created, IHT may be payable if the value of the CLT, net of any discount, exceeds the available nil rate band taking into account any other chargeable transfers made by the settlor in the previous seven years. Provided the settlor survives for seven years from making the transfer, no further IHT is due on death.

Where an absolute trust DGT is created, there's no IHT payable on creation. Provided the settlor survives for seven years from the date of the transfer, there will be no IHT payable.

DGTs are not caught by either the IHT gift with reservation rules or the pre-owned asset tax charge. HMRC has also confirmed that they're not within the scope of the general anti-abuse rule (GAAR).

Calculating the discount

The value of the settlor’s retained future payments can offer an immediate reduction in the amount treated as being a gift for IHT. The discount is often described as a reduction in the value of the gift based on the present day value of the payments the settlor might receive during their lifetime.

The actual discount is the market value of the settlor's retained payments. This is based on the hypothetical price a buyer would be willing to pay for the settlor's right to future capital payments. This price would depend on:

• the settlor's life expectancy
• the level of the payments
• the cost of life assurance to insure the life of the settlor so that if they died unexpectedly early, the income stream would be protected and
• whether any tax would be due on these payments (for example, if they were above the 5% tax deferred level). HMRC assume any gain will be taxed at 40% (with a 20% tax credit for onshore bonds)

There is also an amount deducted to represent the costs paid by the purchaser, typically around £1,000. The future payments the settlor could expect to receive are then converted into a 'present day' cash value using the interest rate given by HMRC. This is to allow for the effect of inflation on a fixed income stream.

Life expectancy

Life expectancy is calculated on the basis of age and health. HMRC require evidence that medical underwriting was carried out at outset to agree a discount. Current HMRC practice doesn't allow discounts at outset for settlors aged 90 and over, or where ill-health means that they have the life expectancy of someone aged 90 or over.

A discounted gift trust can still be created even where no discount is available. The settlor is still making a gift which will be outside of the estate if they survive for seven years and they will continue to benefit from retained regular payments.

Joint settlors

The discount on a joint settlor DGT is calculated on the combined life expectancy, as the retained payments will continue in full until the second settlor dies. However, it's split between the two settlors on the basis of their own individual life expectancy.

Before 1 June 2007, many joint settlor DGTs apportioned the joint discount equally between the two settlors, regardless of any disparities in their ages and states of health.

HMRC's approach from 1 June 2007 is to take the joint discount (based upon their combined life expectancy) and apportion it based upon each settlor's own life expectancy.

For joint DGTs taken out before 1 June 2007, HMRC state that they will continue to accept discounts apportioned on the old basis. However, they will investigate cases where there's a large differential between the ages of the settlors, or where one settlor has adverse health. If this results in the settlor obtaining an unreasonable level of discount, they may apply the revised apportioning basis.

Lifetime of the settlor

The settlor’s right to the capital payments is for life or until the funds run out.

The trustees of a discounted gift trust (DGT) can normally only make payments of capital to the beneficiaries after the death of the settlor (or both settlors in the case of a joint settlor plan). This is to protect the settlor by ensuring that, as far as possible, the trust has sufficient funds to meet the settlor's entitlement to retained payments.

During the settlor's lifetime, the trustees can normally only make withdrawals to pay the settlor's entitlement or to meet liabilities of the trust. This is the case regardless of whether an absolute, flexible or discretionary trust is used.

Changing the trust assets

The trust provisions will determine whether it's possible to change the underlying investments. If they do, there are some important considerations for the trustees.

• The surrender of the original bond could give rise to a chargeable gain, which could result in income tax upon the settlor
• The trustees must be able to replicate the settlor’s right to capital payments under any new investment. The trust assets may have fallen in value if the withdrawals taken exceed the investment growth. Investing the proceeds into a new bond will mean the available 5% tax deferred allowance may be lower than the amount needed to pay the settlor’s retained payments. As a result, there may be chargeable gains each year
• There may be no support from the original provider and no access to the original underwriting to agree discounts with HMRC should the settlor die within the first seven years.

Chargeable gains

Any chargeable gains which arise during the settlor’s lifetime - by either surrendering the bond or taking more than the cumulative 5% allowance - will be assessed upon the settlor. This is because the settlor’s retained rights are deemed to be held upon bare trust for the settlor. As they are assessable as the beneficiary of a bare trust rather than as the settlor, there's no automatic right to reclaim from the trustees any tax suffered as a result of the chargeable gain.

IHT periodic & exit charges

DGTs that are subject to the relevant property regime (mainly discretionary and post 22 March 2006 flexible trusts) are potentially subject to a 10 yearly charge to IHT on each tenth anniversary of the trust and to an exit (or 'proportionate') charge when capital is distributed from the trust.

10 yearly charge

The value of the trust at the 10 year anniversary will be discounted if a settlor is alive. It will be calculated on the market value of the fund, reduced by a factor based on

• the number of income payments likely to be made by the trustees during the settlor’s lifetime and
• how much a purchaser would pay at the 10 year anniversary for a fund that they could not access until an unknown future date (the death of the settlor).

Due to these two factors, discounts at the 10 year anniversary can be very generous. The provider of the DGT will usually assist with a calculation of the 10 year discount. It cannot  be calculated using the same method as outset, for example using a quotations sytem and the settlor's age at next birthday.

To determine the settlor’s life expectancy HMRC don't require full underwriting at the each 10 year anniversary. They are prepared to accept a pragmatic approach based on the age of the settlor at his or her next birthday and any underwriting rating given when the trust was set up. Any changes to health since inception are ignored.

Unlike the discount on the creation of the trust, discounts can be given where the settlor is 90 or older. Where two settlors set up a discounted gift trust but only one is alive at the 10 year anniversary, the trust is treated as two settlements and both will usually receive a discount.

Exit Charge

The regular withdrawals made to the settlor as part of the settlor's retained payments are not treated as exits. This is because the settlor's retained payments are held upon a bare trust for the settlor and are not relevant property.

Where capital is paid to a trust beneficiary - for example, after the death of the settlor or where the trust provisions permit, advanced to the beneficiary during the settlor's lifetime - there will potentially be an exit charge.

The IHT on the exit is charged at a proportion of the effective rate applying at the last 10 yearly charge or 30% of the effective rate on creation. This means that where the effective rate was 0% at the last review date - for example, where the original transfer was below the available nil rate band - there will be no charge applied when capital leaves the trust.

Death of the settlor

When the settlor of a DGT dies, the regular payments being made to them will cease. Any remaining funds are available to the trustees who may choose to distribute them to the beneficiaries or continue to hold them in the trust.

In the case of a joint settlor DGT, the specified level of withdrawal payments chosen at outset will continue to be paid out until the death of the survivor.

IHT on the death of the settlor

The value of the discounted gift trust (DGT) fund does not form part of the settlor's estate for IHT on death. The settlor's right to the capital payments ceases upon death and therefore has no value for IHT. This means that, provided the settlor survives for seven years, no IHT will be payable.

If the settlor dies within seven years of creating the DGT, IHT may be payable on any potentially exempt transfer (PET) where an absolute trust is used, or a chargeable lifetime transfer (CLT) where a discretionary or flexible trust is used. The value of the transfer for IHT may be discounted by the value of the settlor's retained payments. The IHT liability is calculated using the nil rate band available in the year of death.

If the failed PET or CLT, when added to any chargeable transfers within the preceding seven years, exceeds the nil rate band, IHT is chargeable at 40%. Taper relief may reduce the IHT payable where death occurs between three and seven years from creating the DGT. Any 20% tax paid on a CLT at the time of creating the DGT can be offset against the IHT payable on death.

If the failed PET or CLT, when added to any chargeable transfers within the preceding seven years, does not exceed the nil rate band, then no further tax is due on the PET or CLT. However, this will reduce the settlor's available nil rate band, which may mean that IHT is payable on any equivalent amount of the settlor's remaining estate at a rate of 40%.

Chargeable gains following the settlor’s death

If the trustees decide to surrender the bond and distribute the proceeds to the beneficiaries, there may be a chargeable gain. Who the gain is assessable on will depend upon the type of underlying trust used and when the chargeable event takes place.

All chargeable gains on absolute trusts will be assessed upon the beneficiaries after the settlor’s death.

Gains on flexible and discretionary trusts will be taxable upon the settlor if the bond is surrendered before the end of the tax year of death.  For joint discounted gift trusts where one of the settlor's died in a previous tax year,  half of the gain will be taxed at the trust rate with no top slice relief.  The other half of the gain can still be assessed on the last settlor to die,  with top slice relief in the tax year of death.  The settlor’s personal representatives will be responsible for paying any tax to HMRC, but they will have a right to reclaim any tax they pay from the trustees. .

If the trustees surrender the bond in a subsequent tax year, any gain will be assessed against the trustees at the trust rate of 45%.

Alternatively the trustees may assign the bond (or segments) to the beneficiaries and any future gains will be assessed upon the beneficiary at their own marginal rates and with the benefit of top slicing.

Death of a beneficiary while the settlor is still alive

A beneficiary may die before the settlor. In the case of a discretionary or post-22 March 2006 flexible trust, this has no IHT consequences for the beneficiary.

If the beneficiary of an absolute DGT pre-deceases the settlor, the value of their share of the DGT will have a value. This will be included in the beneficiary's estate, even though the estate will not receive anything until after the settlor has died.

The value of the deceased beneficiary's share is the market value of the beneficiary's rights to the trust. They are calculated in a similar way to the 10 yearly charge in that the present value of the trust fund is discounted to account for the fact that the settlor is continuing to receive payments and nothing is payable to the beneficiary's estate until after the settlor dies.