Balancing clients' needs

Julie Hutchison takes a look at discounted gift trusts

Discounted gift trusts (DGT) help clients to balance the need for access to regular withdrawals from an investment, while also making a gift for inheritance tax (IHT) purposes. These trusts, and the underlying methodology and underwriting options which support the discount valuation, have evolved over the years. The most recent change came in February 2009, when discounts increased as a result of HM Revenue & Customs (HMRC) reducing the interest rate assumption. This was the reverse of what happened in September 2007, when discounts for clients decreased due to increasing interest rates at that time. This article will get under the bonnet of these changes to look at the underlying reasons for some of the shifts.

Budget 2006

In tracking recent developments, the starting point is to go back to Budget 2006 and the changes to the IHT rules for gifts to trusts. Formerly, a gift to a flexible, or interest in possession trust was a potentially exempt transfer (PET) and its status from 22 March 2006 changed to being a chargeable transfer. In response to this, Standard Life (and some other providers of DGTs) moved to launch a discretionary trust as well as an absolute/bare trust. A full discretionary trust is seen as more 'professional' in some circles, and has become part of mainstream estate planning in the three years since those IHT changes. Equally, an absolute trust has been favoured by clients looking to make a PET. Overall, client choice with trusts has widened in the last three years as a result of Budget 2006.

Methodology for the discount

In the past, some providers of DGTs had informal conversations or exchanges of correspondence with HMRC in relation to discount methodology. There had never been one fixed set of tables which all providers used (and there still isn't today). These conversations with HMRC had to be re-visited during 2006 as providers had to reassess the operation of DGTs in the post-Budget 2006 world. HMRC then took the step of publishing a Technical Note in May 2007, which set out the methodology it preferred for DGTs. This was a helpful step, since it gave far greater transparency to the process for calculating discounts. It would also place the spotlight on those providers whose approach deviated from the Technical Note. HMRC said it would keep this Technical Note under review, so that it reflected changing market conditions. Changes have since been seen twice, in relation to interest rate assumptions, discussed in more detail below.

On a practical note, for those advisers working with law firms and accountancy firms who may be less familiar with DGTs, this Technical Note gives a helpful insight into the HMRC approach to DGTs.

Maximum client age for DGT

One final development in relation to client age is still working its way through to finalisation. For several years now, HMRC has made it clear that, in its view, someone aged 90 or over would not receive a discount. This position was reflected in the Technical Note of 2007. Historically, some providers did however give discounts over this age, and one court case was heard on this very point, involving the executors of the late Mrs Bower. HMRC was, I understand, successful on appeal and it doesn't appear that the family will pursue a further appeal.

Changing interest rates

With IHT, it is crucial to find the value of the loss to the donor's estate. The principle applied here is to assume a hypothetical willing buyer and seller of the item in question. For DGT, this means assuming that the settlor's retained rights are being sold on the open market, to arrive at their value, and hence to arrive at the discount figure which represents the property not being gifted.

In the hypothetical purchase of the client's retained rights, the price a willing buyer will pay is affected by interest rates. This is because the buyer will expect the rate of return on the investment to exceed the prevailing risk-free rate (the risk-free rate taking some reference points from gilt rates and Bank of England base rates). The higher the interest rate, the less attractive the DGP withdrawals may become, so the buyer is willing to pay less which means the discount is lower. Conversely, the lower the rate of interest, the more attractive the DGP withdrawals may become as a rate of return, hence the higher discount since it will 'sell' (hypothetically) for more. This is what affected DGTs from 1 February 2009, which was good for clients since the gifted portion fell in value for IHT, with discounts increasing.

Underwriting

Finally, the options for client underwriting have varied over the years. Historically, some providers offered 'sealed envelope' underwriting, which allowed some medical evidence to be recorded, but not actually evaluated and the discount not personalised at outset. The underwriting information was generally only reviewed in the event of the client's death in the first seven years. HMRC prefers full underwriting at outset, since it increases the accuracy in the valuation process, which is all the more important now that gifts over the nil rate band to discretionary trusts attract 20% IHT at outset. There is also a relationship point here, acknowledged by HMRC, since it is intrusive and upsetting for the bereaved family to search around for answers to HMRC questions about state of health of the (now) deceased, due to insufficient health information being recorded at outset. For a host of reasons, full underwriting at outset brings as much certainty to the process as possible, always acknowledging that HMRC reserves the right to consider the value of any lifetime gift, as reported on an IHT100 or on death, on the new form IHT403.