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TaxationWeb by Bob Fraser MBE, MBA, MA, FPFS, TEP

Bob Fraser, MBE, MBA, MA, FPFS, TEP of Towry Law Financial Services Ltd provides an introduction to a popular inheritance tax planning arrangement.

Aim

The Aim of this article is to clarify readers’ understanding of discounted gift trusts, since interest in these is greatly increasing.

Background

It is normally the case that if an individual gifts an asset and subsequently continues to obtain a benefit from it, then this will be considered a gift with reservation of benefit (GROB) by Capital Taxes. If the GROB rules do not bite, then one also needs to overcome the new Pre-Owned Assets Tax restrictions. However, HMRC have confirmed that properly structured discounted gift trusts will not be construed as gifts with reservation, nor will they be subject to POAT because the retained interest is ‘carved out’ before the gift is made. The gift is subject to the rights that have been retained. As settlor cannot otherwise benefit from the trust fund, there is no reservation of benefit in what is given to the beneficiaries of the trust.

Suitability

The discounted gift trust may be suitable for:

• Individuals who have surplus capital which they are certain that they will never require in the future, but from which they do need to obtain regular withdrawals.

• Individuals who are confident that they have a life expectancy of at least 7 years.

• Alternatively, individuals who, whilst not certain of surviving the full seven years, are prepared to make a gift into the trust in excess of the nil rate band, expect to survive for at least 3 years subsequently, and wish their estate to benefit potentially from the IHT taper relief. This reduces the tax charge by 20% if death occurs 3-4 years after the gift; by 40% after 4-5 years; by 60% after 5-6 years and by 80% after 6-7 years. However, taper relief only applies to an amount in excess of the nil rate band.

How the Trust Works

The amount that is to be gifted is invested in a life insurance investment bond, and this is gifted to a Discounted Gift Trust established at the same time the investment is made. This can be by either single or joint settlors.

This gift to the trust will constitute a potentially exempt transfer for Inheritance Tax purposes. However, under the terms of the trust the settlor(s) will be entitled to regular withdrawals determined at outset, and paid at a pre-determined frequency during the settlor(s) lifetime to provide an effective regular income. These payments cannot be subsequently altered.

Most trusts require the lives assured (ie the individuals on whose death the life assurance bond will automatically pay out) to be different from the settlor(s) – most commonly children or grandchildren over the age of majority. Thus whilst payments from the trust will cease on the death of the settlor(s), the bond will continue. This allows the trustees the flexibility to choose to retain the investment within the trust, encash the investment or assign out the policy to the (adult) beneficiaries. This can be significant, since any encashment of the policy will trigger a chargeable event for income tax purposes.

Capital Gains Tax

The proceeds of the life assurance bond are payable free of any liability to capital gains tax.

Income Tax

Many investors are unaware that a bond within a discounted gift trust does potentially give rise to an income tax charge, even though the 7 year period has been achieved before death. This can arise where a ‘chargeable event’ occurs.

A chargeable event will occur:

• on the total encashment of the bond within the trust

• if the whole or part of the bond is assigned for money or money’s worth – this is an unlikely scenario

• if the withdrawals or partial encashments in any year exceed 5% of the amount invested

• if the cumulative total of partial encashments exceeds 100% of the amount invested

• on payment of the death benefit

If any of these events occurs whilst the settlor(s) are alive and resident in the UK for income tax purposes, then any gain will be deemed to form part of their income for the tax year in which the chargeable event occurs. However, a tax charge of 20% will only arise if the settlor(s) are already liable to higher rate tax in the year the chargeable event occurs, or if the gain is sufficient to take the total income into the higher rate tax bracket.

If any of these events occurs after the settlor(s)’ death or when they are not resident in the UK for income tax purposes), then any gain will form part of the income of the (UK based) trustees for the tax year in which the chargeable event occurs. The tax is chargeable at the trustees’ rate (currently 40%) but will have a credit of 20% to reflect tax paid in the underlying funds.

For this reason, having the lives assured being other than the settlor(s) allows the trustees to plan the encashment or assignment of the bond to best tax advantage.

The ‘Discount’

This arrangement is all too often recommended on the basis of the ‘discount’, which can be misleading. All the ‘discount’ does is to try to take account of the market value of the rights that the settlor(s) have retained, which will reduce the actual residual value of the gift. This discount will vary depending on the level of income that has been chosen and the actuarial life expectancy of the settlor(s), adjusted for any individual medical factors. It is important to note the level of discount for any particular age has never been agreed by the HMRC Capital Taxes. What some providers have agreed with Capital Taxes is the basis for calculating discounted values. This means that where a discounted value has been certified by a Life Office that has an approved calculation basis, the discount is less likely to be disputed in the event of death within seven years provided a full disclosure of all relevant health matters has been made. It does not mean that Capital Taxes is in any bound to accept the certified discount. It is for this reason that many Life Offices have the health of the applicant medically underwritten, to provide evidence of the health of the applicant at the time of proposing for the contract. Since the discount becomes irrelevant on survival for seven years from the date of the gift, I recommend to clients that they view the discount as a potential reduction in the value of the gift in the unfortunate event of premature death, but certainly not as a planning factor since it cannot be guaranteed.

Context and Pitfalls

Proposing for a discounted gift plan should be carried out as part of an overall estate planning exercise, since there may be alternative solutions to inheritance tax mitigation that are more appropriate. It has to be realised that the capital gifted to a discounted gift plan has been placed beyond the reach of the settlor(s), which may have implications for long term financial security. It should go without saying that anyone contemplating such a plan should seek properly qualified independent financial advice from an inheritance tax specialist duly authorised to advise on these products.

February 2006

Bob Fraser MBE, MBA, MA, FPFS, TEP
Chartered Financial Planner
Registered Trust and Estate Practitioner

Towry Law Financial Services Ltd
Towry Law Group plc

Office Telephone: 028 2563 8563
Mobile phone: 07769880476
E-mail: bob.fraser@towrylaw.com

Authorised and Regulated by the Financial Services Authority