Cash clinic

Q: I have a number of elderly clients who are interested in using discounted gift trust arrangements...

Q: I have a number of elderly clients who are interested in using discounted gift trust arrangements to mitigate inheritance tax liability. I know there has been a court case recently revolving around whether a client was too old to derive any meaningful discount from such a trust. I was wondering if there is any hard and fast rule as to how old is too old for a DGT, and what strategies might be appropriate for clients who are deemed too old?

A: Discounted gift schemes have become very popular in recent years. The most common form of these schemes is a trust where the settlor retains an interest in a defined income stream, which is then 'carved out' from the original gift into the trust. The amount carved out is the estimated value of the income selected to be paid over the lifetime of the investment, and is commonly known in the industry as a 'discount'. This normally creates an immediate reduction to the client's estate for inheritance tax (IHT) purposes to the value of the discount.

The balance of the investment after deducting the discount is the gift, and will be regarded as a potentially exempt transfer if an absolute trust has been selected or a chargeable lifetime transfer if a discretionary trust has been chosen.

The income stream must be valued in accordance to section 160 of IHTA 1984 - that is, the 'open market value' - but in simple terms the amount is calculated to provide an income for the rest of the settlor's life. This means the younger the settlor, assuming he/she is in good health, the longer the requirement for income, therefore the greater the discount. Conversely the older the person, or that person being in ill health, will reduce the amount required to create the income and the discount will be less.

The 'open market value' is the deemed value someone would be assumed to pay to obtain the income stream. In October 2007 HM Revenue & Customs argued that a notional purchaser would want to cover the risk of capital loss if the person selling the income stream was elderly and died before the income at least matched the money paid to purchase it. To do this they suggested that a buyer would always wish to cover their risk by taking out insurance on the life of the settlor, and they were of the view that it was not possible to obtain life insurance for persons over age 90. HMRC concluded therefore that no discount could be made available to such clients.

This view has been challenged and has already been considered by the Special Commissioners but is subject to an appeal to the High Court, which is to be heard in early November this year.

Until the outcome of the appeal to the High Court is known, clients who are over 90, or medically rated over 90, may wish to consider other options. Such elderly clients may use straightforward gifts to try to remove assets from their estate on death; these could be to individuals or into suitable trusts. However, broadly speaking, such gifts rely on the settlor surviving seven years to be fully effective at avoiding IHT (ignoring any taper relief that may be available after three years). Alternatively, schemes such as loan trusts may help mitigate any future growth on the gifted capital from falling within the client's estate.

Kevin Dean is CEO of Axa Isle of Man.