Case study: How to use discounted gift trusts effectively

Paul Thompson, tax & estate planning consultant at Canada Life, explains how a Discounted Gift Trust can be a highly IHT-efficient planning tool.

Many clients have an inheritance tax (IHT) problem that, in theory, can easily be solved: make substantial gifts and live for seven years. In practice, however, most clients cannot afford such a simple solution. They have investments that they rely on in maintaining their 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 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.

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 GWR.

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 IHT liability on his estate. Even if his reservation of benefit stopped before his death, this cessation would be regarded as a potentially exempt transfer (PET) and would be subject to IHT on his death within seven years.

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 could not be a GWR; the slice he has retained has not 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 GWR or offending the POAT legislation.

The slice of the cake 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.

Instead of a metaphorical cake, let’s assume Mr Baker puts £100,000 cash into a DGT. 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.

These will usually be 5% of the amount invested, to take advantage of the 5% tax-deferred withdrawal facility under the bond.

The remainder goes into a discretionary trust for the benefit of other beneficiaries, excluding Mr Baker. (Alternatively, the remainder might go into another bare trust for other beneficiaries but, as this option tends to be the exception, this article will concentrate on the discretionary trust route.)

Valuation

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. But how much value should be placed on that slice? This will depend on many factors, including Mr Baker’s age and state of health, the amount of each capital payment he will receive and current interest rates.

So, taking all these into account, let’s say that an actuary calculates the value of the retained slice to be £55,000. In other words, if Mr Baker was a hypothetical willing seller and approached a hypothetical willing buyer with a view to selling his right to receive £5,000 a year for the rest of his life, an actuary would say that a fair price to pay would be £55,000.

It should be noted, first of all, that this figure does not necessarily represent the amount that Mr Baker will in fact receive. If he survives for only five years, for example, he will receive 5 x £5,000 = £25,000. On the other hand, if he survives for 20 years, he will receive 20 x £5,000 = £100,000.

The figure of £55,000 simply represents the current value at outset of all of the future capital payments he is expected to receive, based on the assumptions mentioned previously. But it also means that 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, which will be a chargeable lifetime transfer (CLT). 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.

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 DGT’s creation.

IHT efficiency

The biggest benefit of the DGT 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 the CLT by more than seven years, there will be nothing from the DGT that 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.