Recently, Neil Jones of Canada Life International talked about the treatment of advice fees for trustess (click here) and referred to discounted gift trusts ( DGT).
DGTs are a popular Inheritance Tax (IHT) planning tool for UK- domiciles who have surplus capital that they wish to gift to future generations and who are relatively healthy (I will come back to this).
What is a DGT?
If a UK domiciled individual (this could be a non-UK resident that has been an expat for some time) gifts something, but still gets benefit from the gift, then this is termed a “gift with reservation of benefit”. Therefore, it would be treated as if the gift had never been made and would be included in th individual‘s estate for the calculation of UK IHT.
HMRC state “A discounted gift trust or plan is where the settlor makes a gift into settlement with certain ‘rights’ being retained by them. The retained rights may, for example, be a series of single premium policies maturing (usually) on successive anniversaries of the initial investment or on survival, reverting to the settlor, if they are alive on the maturity date; or the settlor carves out the right to receive future capital payments if they are alive at each prospective payment date. The gift with reservation provisions do not apply.”
This confirms that if a “carved out” interest is properly constructed within the trust, there is no gift with reservation. This means that someone can gift monies into trust and retain a right to an income from the trust, while obtaining immediate and longer term IHT savings.
How does the “carve out” work in practice?
There is a well-known phrase “You can’t have your cake and eat it”, so we can use the analogy of a cake to explain the carve out. In this case, a slice of the cake is reserved for the donor of the gift ( settlor). As this slice is not given away, there is no reservation of benefit issue.This slice will provide the settlor with a regular income, while the rest of the cake is given away for the ultimate benefit of the selected beneficiaries.
How does the discount work?
The “slice” needs to be valued by an actuary as it is not the same as the monetary amount within that slice. This is calculated by reference to the health of the donor, the amount of regular payments to the donor and the age of the donor. The actuary calculates the “value” of the future payments.
If, for example, a £100,000 gift was valued at £50,000, then the settlor would have received an immediate discount on the gift for IHT purposes; effectively saving £20,000 IHT during the first seven years of the trust.
How is the discount calculated?
To use another analogy, a theoretical buyer of the slice would want to pay a lower amount for the slice if there was a committment to paying a regular income for a long time to a healthy person and so would ask for a discount. This values the slice significantly lower than the actual capital.
Would a hypothetical buyer of the income slice expect to get a large discount for the future lifetime regular income of someone who is terminally ill? The answer is no, this means the value of the discount would be low/zero.
This shows why the discount must be underwritten at outset to ensure tax efficacy.
For those that have a life expectancy of over 3 years, but possibly less than seven years, then greater IHT savings are available after three years for the part of the gift that exceeds the nil-rate band ( currently £325,000), due to Taper Relief.
Trust structure
As with all of these structures, it is important that the correct trust wordings are used and that appropriate tax advice is given at outset. Additionally, it is important that the correct investment structure is established to maintain tax efficacy.
The DGT is very IHT efficient, if used correctly. This does allow people to ‘have their cake and eat it’. However, it is important to point out that the regular income to the donor must be paid for this to be effective.
