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Arnold Aaron, Financial Planning Consultant, offers an insight into a popular IHT planning tool, and explains how the arrangements work.

Please note that this article has been updated - please see Arnold Aaron's new article here - Discounted Gift Trusts

Introduction 

There has been a lot of publicity around Inheritance Tax (IHT) recently, and in this article, we focus on the Discounted Gift Trust (DGT) offered by life assurance companies through Investment Bonds. This remains a unique and invaluable vehicle and although it has been available for some years, many investors and sometimes professional practitioners, fail to comprehend how they actually work.

Overview of the Mechanism

The DGT allows you to gift cash assets to a Trust, which is held for the ultimate benefit of your nominated beneficiaries. When set up under a bare trust it is a potentially exempt transfer (PET) and takes 7 years to fall outside of your estate for IHT purposes. A condition of the DGT is that you take a fixed regular withdrawal for life from the Trust. You spend this withdrawal as ‘income’, so it does not increase the value of your estate.

On setting up the arrangement, an actuarial forecast, (based on age, sex and health) is made as to how much you are going to withdraw over your lifetime. This amount is known as the donor’s fund. In essence you are carving out this amount for your own benefit and it is deemed not part of the gift you have made to the Trust for IHT purposes and so the gift element is therefore less than the amount you have actually placed in the Trust and hence it is a discounted gift.

For example, a male aged 70 in good health, gifting £100k and taking 5% withdrawals each year (£5kp.a.), equates to a donor’s fund of £45k. It follows then for IHT purposes that he has only made a gift of £55k, which takes 7 years to fall out of the estate. The surprising part of the arrangement is what happens to the donor’s fund.  While one might think it still belongs to the estate and is liable for IHT, this is in fact not the case. Why you ask, and this is the bit little understood.

Tax Treatment

As the assets are in the Trust, the only access he has to the ‘donor’s fund’ is in the form of a regular fixed withdrawal over his lifetime (5% pa) which ceases immediately on his death. It follows then, on death there is no value in the estate in respect of the residual donor’s fund since it remains physically in the Trust, not in his estate, and hence no IHT on it. Previous withdrawals have of course been spent.

The net result is that on establishing the Trust at the beginning, the donor’s fund is immediately outside of the estate for IHT purposes, as indicated in Fig. 1.

Fig.1 Gift of £100k to a Discounted Gift Trust 

Once 7 years have passed, IHT is avoided on the ‘deemed’ gifted element, but the donor still receives withdrawals for life, regardless of how long he actually lives. While the above example illustrates the concept, with larger sums involved the DGT offers significant incentives and is a compelling proposition in the right  circumstances.

For example, say £1m was gifted to the Trust in the above case, the figures would be:

• A withdrawal of £50k p.a. for life, for the donor to spend as income (tax free in many cases)
• £450k removed from the estate immediately, saving £180k in IHT instantly
• A £550k PET, which would become fully exempt from IHT after 7 years, with savings after 3 years

For a younger donor, the discount is even larger. For example, a 60yr-old female in good health removes £670k from her estate on gifting £1m, with a 5% withdrawal.

The Discretionary Trust Option 

The above examples assumed a bare Trust is used. This means the beneficiaries cannot be changed.  If a discretionary Trust is used instead, beneficiaries can be altered, but one may trigger an entry tax charge if the gift is greater than the investor’s available Nil Rate Band, as per the rules for a discretionary Trust.  The important term here is ‘gift’ – it is the discounted value of the gift which is taken into account for the purposes of the entry charge, and providing this is less than the available Nil Rate Band there is no entry charge. One could therefore place substantially more than the Nil Rate Band in a discretionary Trust without triggering an entry tax charge - an unrivalled estate planning opportunity.

HM Revenue & Customs' Position 

While the DGT might seem too good to be true, HMRC certainly recognise it and even outline the scheme on their website;

http://www.hmrc.gov.uk/manuals/ihtmanual/ihtm20424.htm

Conclusion

The DGT, available both as a discretionary or bare trust is unprecedented in that it achieves an immediate reduction in the estate and fully exempts an asset from IHT after 7 years, yet it allows access to the asset in the form of a life-long ‘income’ – an invaluable and truly unique IHT planning tool.

When embarking on a DGT, however, one must tread carefully. The discount is of course largely dependent on life expectancy, and to avoid scrutiny by HMRC over this all-important figure, (which usually happens on death of the settlor/donor within 7 years), one must have the the DGT underwritten by the life company, preferably by obtaining a medical report from the settlor’s GP.  There have been cases where HMRC did not believe the settlor was in good health when the Trust was set up, and successfully challenged the discount because of lack of medical evidence.  

Further, on a discretionary Trust an entry tax charge can easily be triggered inadvertently if the investor’s available Nil Rate Band is not determined correctly, or if the discount comes into question, not to mention periodic and exit tax charges further down the line.

These points highlight the absolute need for experienced professional financial advice from an advisor specialising in this area. This must not be left to the layman – an unwitting error could prove costly.