In the UK, everyone can pass on £325,000 of their estate on death without paying any inheritance tax, and, as of last April, there is an additional amount of £100,000 available (subject to conditions). For a UK domiciled or deemed domiciled individual, any assets over this wherever in the world they are located are generally subject to tax at 40%. This can be a significant amount and can leave Her Majesty’s Revenue and Customs as a major beneficiary to an estate.
Many people look at ways of mitigating inheritance tax and the correct use of a trust can offer a tried and tested method of getting money outside of an estate during someone’s lifetime. For this purpose gifts, using a discretionary trust, should not exceed the £325,000 nil rate band as tax charges could apply at outset.
A discounted discretionary gift trust is a popular solution and, whilst reducing the potential inheritance tax payable, also allows the investor to retain access to a series of regular payments that can be used to supplement income.
When an individual invests a lump sum into a discounted gift trust the money is invested in an investment bond. This can be an onshore solution through a provider based in the UK or an international provider based overseas, such as the Isle of Man or Ireland. As part of the application process regular payments from the bond are selected at the outset and once the bond has been established it is assigned to a specially designed trust: a discounted gift trust.
The trust uses a ‘carve-out’ so the individual who creates a trust, the settlor, retains the right to the regular withdrawals during their lifetime and, after their death, the value of the fund is then available to the trustees. At that time the trustees can then either distribute the trust assets to the beneficiaries or retain them until a later date if they choose.
Inheritance tax benefits
When making lifetime gifts, the inheritance tax position is based on the ‘loss to the estate’ principle – how much has the individual’s estate reduced by making a gift. For a cash gift the estate is normally reduced by the value of the cash gift, however, sometimes it is not that simple.
When investing in a discounted gift trust, the settlor retains the right to the regular payments and these payments have a capital value. As part of the application process the provider will need to calculate the actuarial value of these payments and this will depend on a number of factors, such as interest rates, the amount of the payments and the health and lifestyle of the settlor. This enables the provider to establish the life expectancy of the settlor and how long the payments are likely to be paid for.
The younger and healthier the settlor, the longer the payments will be paid for and therefore the greater the value of the regular payments. Conversely, if the settlor is older or in poorer health, their life expectancy will be shorter and the fewer payments are likely to be made, so the lower the capital value.
The value of the regular payments is not a gift for inheritance purposes as the settlor is retaining a benefit from this amount of the investment - they are effectively applying part of the investment as a regular income that ceases on death and therefore this is not a gift for inheritance tax purposes.
The gift to the trust is ‘discounted’ by the capital value of the regular payments. Any amount invested over the value of the discount is treated as a gift for inheritance tax purposes and will remain in the settlor’s estate for the next seven years. For example, if a client invested £100,000 and requested withdrawals of £5,000 each year, depending on underwriting the value of the regular payments could be £53,000. This is outside of their estate immediately and the remaining £47,000 would be a gift.
When making any lifetime gifts there can be tax charges where discounted gifts over the available nil rate band are made and in many instances the gift should be limited to £325,000 in order to avoid any lifetime inheritance tax. Under a discounted gift trust the settlor can sometimes invest significantly more than the available nil rate band.
The discount calculation should be based on assumptions provided by HMRC and they also prescribe the actual calculation that should be used. If the provider is too aggressive in the calculation, not following HMRC guidance, or the settlor has withheld vital information then HMRC can choose to recalculate the discount in the future. This can impact not only the treatment of the whole investment but also any estate planning done before or after.
As the discount is offered at outset and based on future payments, the payments to the settlor cannot be varied during their lifetime, unless of course the investment is exhausted. Also, the trustees are unable to distribute money to the beneficiaries until their obligation to the settlor is removed on the settlor’s death.
Income tax benefits
The use of an investment bond allows the settlor and trustees to utilise the favourable tax treatment.
An investment bond is a non-income producing asset and any growth or income achieved by the underlying assets remain in the bond, and do not give rise to any immediate tax liability.
It is possible to take regular withdrawals from the bond without any immediate liability to UK income tax. Withdrawals of up to 5% of the amount invested can be taken each year and for tax purposes are deemed to be a return of capital – hence the withdrawals are termed as regular payments rather than income. This allowance is cumulative, so a policyholder can take 5% for 20 years, 4% for 25 years and so on, but if this is exceeded then a chargeable gain will arise.
If the regular payments are kept within this 5% allowance, then there should be no immediate liability on the settlor or the trustees. In some instance an ongoing adviser charge may form part of the 5% allowance so this would have to be factored in.
An investment bond can therefore be a very efficient way of generating regular payments and as any growth or income achieved by the fund remains in the bond it is a simple solution for trustees. In the normal course of events, there should be no need for the client or trustees to complete annual tax returns.
If a chargeable gain arises, then depending on the timing and type of trust used a tax charge could arise on the settlor, the trustees or the beneficiaries, so it is important to work with the settlor to make sure any potential tax liability is minimised.
Many clients will want, or need, regular payments to supplement their income, for example in retirement, and receiving a fixed amount every month, quarter, six months or year could be attractive. In such circumstances a discounted gift trust can appear inflexible, as the payments to the settlor cannot be varied or money paid out to a beneficiary during the settlor’s lifetime, but this may not be a concern.
The arrangement allows a client to budget easily for known expenditure and could form part of an overall strategy in later life. The deferral of income tax provided by the investment bond can provide tax-efficiency and could reduce the amount of taxable pension income required, preserving a larger amount in a pension wrapper.