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Waiving income on a discounted gift trust – a ‘taxing’ decision?

Discounted gift trusts provide an ‘income’ for life in return for a ‘discount’ from a lifetime gift but what happens if the income is no longer needed?

Discounted gift trust

Under a discounted gift trust (DGT) the settlor makes a lifetime gift to trustees (usually in the form of an investment bond) but they carve out the right to receive an ‘income’ for life (usually up to 5% to benefit from the bond’s tax-deferred allowance). The income, based on life expectancy of the settlor and actuarial calculations, is given a market value, i.e. what someone might expect to pay for such an income stream. This figure is then used to establish a reduced value of the gift for IHT purposes.

The result of the discount is that an instant IHT saving can be achieved (as the discount is immediately outside the estate) and it allows for a more substantial investment to be made using a discretionary trust, above the level of the nil rate band (NRB).

It is important to note that the discount quoted by an insurer is not guaranteed and HMRC can challenge the underwriting opinion and therefore figures quoted. However, a prudent approach by the insurer, i.e. underwriting in advance for all cases and strict use of the HMRC-prescribed interest rate in the discount calculations, should help to minimise the likelihood of any challenge.

Options if income isn’t required after inception

The question of ‘how do I stop my income?’ and ‘what are the implications?’ arises more often than you would think. If the deed allows for income to be waived, it can be stopped or reduced. However, the loss to the estate must be valued and therefore a new gift for IHT purposes has been made.

Generally speaking income is often waived in three ways:

  1. Waive for a short period of time, i.e. settlor waives for six months.
  2. Waive indefinitely, i.e. settlor never wants any income again.
  3. Waive until further notice.

So what is the open market value of the asset in the transferor's hands before the action of waiving? In the first scenario this seems quite simplistic as six times the monthly income amount would give an idea of the value lost, with inflation/future value of money not really a factor.

With the second option the loss will simply be the open market value of the ‘income’ stream at the date of transfer, similar to estimating the initial discount but using the revised parameters. Most insurers will not undertake this process due to the costs involved with re-underwriting the individual for a second time. It is therefore down to the settlor to seek appropriate advice and record the value of the gift as it will need to be disclosed should they die within seven years of giving up their income.

The third option is difficult as ‘until further notice’ is an unknown period. The question is what value would an open market purchaser place on the ‘income’ stream in these circumstances? As it is unlikely that anyone would buy such an income stream, as it is unclear when it will start there, there is no market value retained. With this in mind the same approach as option two should be used, i.e. all income is being given up. There could be no question of any retrospective valuation as s160 IHTA 1984 confirms the ‘market value’ used for valuing assets is the value at that time.

Conclusion

Funds that are within the settlor’s estate are potentially liable to 40% IHT on death whereas the future income stream, prior to any decision to waive, is immediately outside the estate on death. Assuming the trust deed allows for the income stream established by a DGT to be waived, it might be worth seeing if the income can be used in other ways before recommending such action. This will avoid a new gift and seven year clock.  

If the ‘income’ from the DGT is not required and is just being accumulated within the estate other options might be available. The income, despite the name, is in fact seen as capital from an investment bond. So the settlor will not be able to use the ‘gifts out of income’ exemption, but other exemptions might be available including annual exemption, small gifts and charitable donations. 

For financial advisers only. Not to be relied on by consumers.

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

It is based on Old Mutual Wealth or Old Mutual International'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. We 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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