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IHT planning and a discounted gift trust

The following article provides information about inheritance tax planning for UK domiciled individuals where a gift has been made and the individual still requires access to withdrawals.

Case study

Paul Davis (aged 65) has always lived in the UK. His salary is £85,000. He divorced 3 years ago. He has £400,000 to invest. He wants his children to eventually receive the money and would like to limit any inheritance tax (IHT) payable by them. He would also like to use this capital in the meantime to top up his income when he retires in 5 years time.

Paul could invest his money in a Collective Redemption Bond (which has no lives assured) or a Collective Investment Bond (which has lives assured) subject to Discounted Gift Trust (DGT).

Paul would then be able to make a gift of capital, whilst retaining the right to fixed or escalating withdrawals during his lifetime. He could also defer the start date of the withdrawals for up to 5 years in line with his retirement plans and appoint himself as one of the trustees in order to retain some control over the trust.

If he chooses a discretionary version of the DGT, this will allow not only his current children but also any future grandchildren to benefit from the trust fund. Alternatively, he could set up a bare version of the DGT if he requires certainty as to who will benefit from the trust.

The gift into trust will be either a potentially exempt transfer (PET) or a chargeable lifetime transfer (CLT), but the value of the PET or CLT can be reduced by the open market value of the right to receive withdrawals that Paul is entitled to. This discount is calculated on actuarial principles taking account of Paul’s age, state of health, level of income (when it starts) and assumed interest and inflation rates at the time the trust is created. The PET or CLT will fall out of Paul’s estate after 7 years and any growth on the capital is immediately outside his estate.

How can an offshore bond subject to either discounted gift trust may help

  • Ability to make a gift of capital but retain the right to fixed or escalating withdrawals during lifetime.
  • The significance of the discount is that the settlor’s estate should immediately be reduced by the calculated discounted value.
  • The remainder of the investment (the amount over and above the discount) will initially form part of the settlor’s estate but will gradually fall outside their estate over a period of 7 years.
  • No IHT is payable at the time the PET or CLT is made, unless the value of the CLT exceeds the nil rate band.
  • Growth on the investment is immediately outside estate.

Where this is a bare discounted gift trust

  • The gift is a PET.
  • Define who they want to benefit by naming them. 
  • No liability to periodic and exit charges in future years as not subject to the discretionary trust tax regime.
  • If withdrawals are limited to 5% per policy year for up to 20 years then no immediate tax charge.
  • Chargeable events are assessable on the settlor provided he is alive and resident in the UK and in the tax year of his death.
  • Chargeable events are assessable on the named beneficiaries if resident in the UK following the tax year of the settlor's death.

Where this is a discretionary discounted gift trust

  • The gift is a CLT.
  • No IHT is payable at the time the CLT is made if it and other CLTs made in the previous 7 years are within the Nil Rate Band. 
  • After 7 years the CLT will fall outside the settlor’s estate for IHT purposes.
  • Flexibility to change beneficiaries. 
  • No liability to IHT if one of the beneficiaries dies as no beneficiary has an interest in the trust fund until the trustees appoint in their favour. 
  • If withdrawals are limited to 5% per policy year for up to 20 years then no immediate income tax charge.
  • Chargeable events are assessable on the settlor provided he is alive and resident in the UK and in the tax year of his death.

Additional points to consider for either DGT

  • The level of withdrawals and deferral period cannot be changed once the arrangement is set up.
  • The discount is illustrative and therefore not guaranteed. 
  • Deferring withdrawals reduces their market value because the settlor will receive less withdrawals and therefore an open market purchaser would pay less for the value of the withdrawals. 
  • To ensure no question of a gift with reservation the settlor or the settlor spouse should not be included as a life assured.
  • If all the lives assured die, the policy comes to an end and the withdrawals will stop.
  • Client can be a trustee to retain some control.

Additional points to consider for the bare DGT

  • Trustees cannot change the named beneficiaries.
  • When an absolute beneficiary dies, their share of the trust fund will form part of their estate for IHT purposes.
  • Withdrawals above 5% in any policy year will be a chargeable event.

Additional points to consider for the discretionary DGT

  • Trustees will use their discretion to decide who should benefit from the trust fund, whilst the settlor can make their wishes known to the trustees, the trustees will ultimately decide.
  • The trust fund may be subject to periodic and exit charges in future years.
  • Withdrawals above 5% per policy year will be a chargeable event. 
  • If not assessed on the settlor, the chargeable event gains would be assessable on UK resident trustees then any UK beneficiary when they receive the benefit under the trust.

The information provided in this article is not intended to offer advice.

It is based on Old Mutual Wealth's interpretation of the relevant law and is correct at the date shown at the top of this article. While we believe this interpretation to be correct, we cannot guarantee it. Old Mutual Wealth cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained in this article.

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