By Gary King
A Discounted Gift Trust (DGT) allows a Settlor to make an Inheritance Tax (IHT) effective gift into trust whilst still retaining access to a fixed income (in the form of regular withdrawals) for their lifetime (or until the trust fund is exhausted). The value of the gift for IHT may be reduced by the assumed value of any retained payments based on the donor’s age and health at outset, and the size of the capital payments.
Access to capital
Normally for a gift to fall outside of an individual’s estate for IHT assessment after 7 years the individual has to have given up all rights and access to the gift, otherwise it could be looked at by HMRC as a ‘gift with reservation of benefit’ which remains assessable to IHT.
However, a DGT can help individuals to reduce the value of their estate for IHT purposes and still receive payments from the trust to supplement income. The trust is worded so that regular capital payments, which are fixed at outset for the life of the settlor (settlors if joint), are payable during the lifetime of the recipient.
For example, £500,000 invested into a DGT with fixed withdrawals for 4% each year payable for the Settlor’s lifetime would total £20,000 per annum. The underlying investment vehicle for a DGT is usually an investment bond which will allow the 5% to be withdrawn each year for up to 20 years without immediate payment of tax (although tax is only deferred and will ultimately be payable on full or partial surrender, or when the 5% withdrawals are used up).
How tax on the withdrawals is paid depends on the type of bond. For an onshore bond basic rate (20%) tax is already deemed paid on the fund and all future tax is deferred, providing the 5% withdrawals are not exceeded. If the Settlor is a basic rate taxpayer when the bond becomes subject to tax there is no further tax to pay on the withdrawals, provided the average gain per year when added to their income does not make them a higher rate taxpayer. If the Settlor is a higher rate (40%) or additional rate (45%) taxpayer, they will pay the difference between the basic rate already incurred and the higher/additional rate.
For an offshore bond, all tax within the bond is deferred, providing the 5% allowance is not exceeded, and when tax becomes due income tax is paid on the withdrawals. Top-slicing is available when assessing whether higher or additional rate tax is due.
Inheritance tax situation
Depending on the age, health and level of fixed payments, part of the value of a gift into a DGT may provide an immediate discount from the Settlor’s estate which results in a reduction of the amount of money in the estate assessable to IHT. The remainder of the gift will fall outside of the estate after 7 years as with any non-exempt gift into trust.
A DGT will typically offer two trust options; a discretionary trust or an absolute trust. How IHT is treated with regards to the DGT will depend on which of these types of trust is used.
Under a discretionary trust the amount put into the DGT, minus the discount, is a chargeable lifetime transfer (CLT) and is subject to an immediate tax charge if the amount of this gift is above the IHT threshold, known as the nil-rate band (NRB), when added to any other CLTs in the last 7 years. The NRB is currently £325,000 (as at 2021/22 and frozen until April 2026). Importantly the value less the discount available is the amount that is considered as being a chargeable transfer, not the entire gift.
If the CLT does not exceed the NRB there will be no immediate tax charge. Where the CLT exceeds the NRB, there will be an immediate tax charge of 20% payable on the excess above the NRB and a further tax charge of up to 20% if the Settlor dies within 7 years (although taper relief may apply and reduce the tax charge).
Where an absolute trust is used the amount put into the trust, minus the discount, forms a potentially exempt transfer (PET) which has no immediate liability to IHT even if it exceeds the NRB. However, the gift, less any discount will fall back into the Settlor’s estate if they die within 7 years and will use up any of the remaining NRB with any excess over the NRB subject to tax at up to 40% (again taper relief can apply).
Gifts and chargeable transfers made in the previous 7 years will be taken into account when determining the IHT treatment of a CLT or PET on death within 7 years.
If the Settlor survives for 7 years from the date of the gift, the full amount of the gift into the DGT will be outside the estate for IHT assessment.
The discount is best described as a reduction in the value of the initial gift based on the potential value of the withdrawals that could be received by the Settlor during their lifetime.
The discount is based on the hypothetical price a buyer would be willing to pay for the rights to the Settlor’s future withdrawals under the DGT. So the four factors that affect this price would be:
- the level of the payments (which is fixed for life),
- the Settlor’s life expectancy (based on age and health),
- the cost of the life assurance to the DGT provider in order to protect against the Settlor dying early and
- the tax due on any future payments.
The DGT provider makes an actuarial calculation based on these factors to decide what the value of the discount would be and clearly this varies greatly depending on the above factors.
Please note; HMRC have stated that a discount is only justified if sufficient evidence of health was provided at the time the discount was offered and this evidence has to be roughly equivalent to that undertaken for a life cover contract. As such the minimum requirements for a discount to be in place are a health statement from a GP or Medical Attendant’s report, and in some cases a full medical examination will be required.
What do the Trustees have to do?
The Trustees apply for a bond using the money the Settlor wishes to gift, and the Trustees then become the legal owners of the bond. Amongst other duties the Trustees must ensure that the level of payments is made to the Settlor throughout their lifetime as long as there are sufficient funds available. The withdrawals selected at outset are fixed and cannot be changed at a later date and the level of payments is linked to the discount offered. As such at least some withdrawals must be taken for a discount to apply and the lower the withdrawals, the lower the discount.
Usually, only after the Settlor dies can the Trustees pay out any trust proceeds to the beneficiaries, or make loans from the trust to any beneficiaries. Up until this time, the Trustees can only pay a fixed payment to the Settlor. While the Settlor is alive, the payments are usually made automatically from an investment bond.
The Trustees generally have the power to reinvest the trust fund in any way they see fit and can encash the investment bond, although this power may be restricted during the life of the Settlor with some DGTs. If the Trustees do reinvest, the Trustees must always maintain the level of income payments whilst the Settlor is alive and funds are held within the trust.
What happens when the Settlor dies?
If the Settlor dies within 7 years of the setup of the trust, the discount will be taken into account for any IHT assessment. HMRC have the final say in this relative to the underwriting that has taken place. The Trustees must ensure no further withdrawals take place and this should be done by confirming to the bond provider to cease payments.
The actual investment, if required, can continue to be held within the trust which may be sensible for generation planning.
What taxes, other than IHT, may have to be paid if a Bond is the only investment held by the trust?
The Settlor, the Trustees and any beneficiaries may have a personal liability at any time to income tax on chargeable event gains arising from the investments within an investment bond. However, there is no liability to Capital Gains Tax (CGT) at any time.
A limited amount can currently be taken from an investment bond without having to pay any tax at that time. That limit is 5% each year of the amount originally invested until 100% of the amount invested has been taken. If the bond is cashed in at a later date any withdrawals taken will be included in the tax calculation.
This factsheet only briefly covers the aspects relevant to Discounted Gift Trusts (DGTs) and you should be aware that the wider tax and trust implications need to be considered in greater detail. Please contact us at email@example.com to discuss this further or telephone 01223 233331.