Many people have an inheritance tax issue that, in theory, can easily be solved. If they make substantial gifts and live for seven years, then their families will have a lower or even non-existent inheritance tax bill. In practice, however, most people cannot afford such a simple solution. They have investments that they rely on to maintain their own standard of living. What they need to do is get investments out of the estate but retain the ability to receive regular payments from them for the foreseeable future.
But how can they achieve this without getting caught up in rules designed to prevent inheritance tax manipulation, such as creating a gift with reservation (GWR) or offending the pre-owned assets tax (POAT) legislation? Ideally, they would like to have their cake and eat it too.
Taking this analogy a little further, let’s say that Mr Baker has a metaphorical cake worth £100,000 which he wants to give away. If he does so with strings attached, so that he can get all or part of it back at any time, this would be a classic gift with reservation. In other words, if his reservation of benefit still existed at the time of his death, the whole value of the cake at that time would be taken into account when calculating the inheritance tax liability on his estate.
Even if he decided to ‘release the strings’ before his death, this would be regarded as a potentially exempt transfer and he would need to live for a further seven years, otherwise the cake would be added back to his estate, which means it will be subject to inheritance tax.
Keep a slice
However, as an alternative, what would be the position if he cut a slice out of the cake and kept it for himself, giving away the remainder of the cake? This arrangement couldn’t be a Gift Without Reservation; the slice he has retained hasn’t been given away and there is no reservation of benefit in the remainder given away.
This is precisely what a discounted gift trust (DGT) is intended to achieve. It is designed to allow Mr Baker to give away a substantial sum, yet retain the right to receive regular capital payments for the rest of his lifetime, without creating a Gift Without Reservation or offending the pre-owned assets tax legislation.
The slice of the cake here retained by Mr Baker represents his right to receive future capital payments. What is left after this right has been satisfied is the remainder of the cake, which is given to a trust or settlement for beneficiaries excluding Mr Baker. This is perfectly acceptable tax planning.
Instead of a metaphorical cake, let’s assume Mr Baker puts £100,000 cash into a discounted gift trust . Trustees are appointed and they invest the cash in an investment bond. The arrangement will be structured so that some of the £100,000 in effect goes into a bare trust for Mr Baker’s sole benefit, providing regular capital payments to Mr Baker for the rest of his life or simply until the value of the bond is exhausted.
These will usually be 5% of the amount invested, to take advantage of the 5% tax-deferred withdrawal facility under the bond – a benefit of investment bonds that means no tax has to be paid immediately. The remainder goes into a discretionary trust for the benefit of other beneficiaries, excluding Mr Baker.
Clearly, the ‘slice’ of the £100,000 that is used to provide Mr Baker with future capital payments cannot be a gift – it is retained for his own benefit. So a value has to be placed on that slice for accounting purposes. How much will depend on lots of factors, including Mr Baker’s age and state of health, the amount of each capital payment he will receive and current interest rates.
This calculation is made by an actuary and simply represents the current value at outset of all of the future capital payments he is expected to receive.
Say, the initial value of the ‘slice’ retained by Mr Baker is £55,000. This, in turn, means that Mr Baker has actually made a gift of only £45,000; therefore tax will have to be paid on the £45,000. In other words, there is in effect a 55% discount on his total investment of £100,000, which is why the arrangement is known as a discounted gift trust.
So, why should Mr Baker’s state of health be relevant? In truth, this aspect will be entirely immaterial if he survives for at least seven years. To illustrate why, let’s assume that he dies sometime after the twelfth anniversary of the creation of the discounted gift trust.
The biggest benefit of the discounted gift trust is that, on the death of the client, the value of his retained ‘slice’ immediately reduces to zero. As a result, since Mr Baker survived more than seven years, there will be nothing from the discounted gift trustthat will be in his estate for the purposes of IHT and the whole value of the bond at his death will be within the discretionary trust. This means that Mr Baker transferred £100,000 out of his estate, received regular capital payments for the rest of his life and no IHT was payable with the possible exception of a small charge at the tenth anniversary of setting up the trust. It can hardly be more IHT-efficient.
But what if he fails to survive the seven-year period? Let’s say that, instead of surviving twelve years, Mr Baker unfortunately dies within the first year as a result of terminal cancer. This means that the value of the discount would be zero.
This illustrates that discounted gift trusts are not suitable for people who are in very bad health at the outset.
In the right circumstances, the DGT is a very IHT-efficient planning tool, allowing people to have their cake and eat it. However, it should be recognised that the payments derived from the arrangement are compulsory and, if they are not spent, they could exacerbate the IHT on the settlor’s estate. As with many other types of estate planning, matching the complex options available to an individual’s personal circumstances means professional financial advice is a must.