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AF1 revision: Discounted Gift Trusts

17 February 2020

Discounted Gift Trusts are useful IHT planning schemes and are often tested in the CII AF1 Personal Tax and Trust paper. In this article Catriona Standingford, MD of Brand Financial Training, takes alook at their main features

First published in February 2020 issue of Professional Paraplanner.

A Discounted Gift Trust (DGT) is a very useful inheritance tax (IHT) planning tool for those individuals who have an IHT problem but would also like to receive an ‘income’ (remember this is not true ‘income’ but in fact payments of capital).

A DGT comprises an investment bond held in a trust; the trust can either be a discretionary trust (where the trustees have flexibility over the choice of beneficiary) or a bare trust (where they don’t). In this article we assume the use of a discretionary trust.

The trustees hold onto the trust asset for the ultimate benefit of the beneficiaries but in the meantime the settlor has the right to receive an ‘income’ for life; they do not however have any right to the capital.

Because the settlor is entitled to regular payments of ‘income’ for the rest of their life the value of the transfer into the trust is discounted for IHT purposes. If death occurs within seven years it is the discounted amount that is included in the estate. There is therefore an immediate IHT reduction with the discount based on the value of the payments, age and life expectancy calculated through underwriting. The longer the settlor is expected to live the larger the discount. Once seven years have elapsed then the gift becomes an exempt transfer and is outside of the estate anyway.

The gift into the discretionary trust is treated as a chargeable lifetime transfer for IHT purposes but as long as the transfer is below the nil rate band then the 20% upfront tax will not apply (assuming no previous gifts were made).

An example

An investment is made of £100,000 into a DGT. The settlor receives £5,000 per year as an ‘income’ for life. Based on health the value of their right to this £5,000 per year payment is £40,000. The amount of the discounted gift is therefore £60,000.

If death occurs within seven years the £60,000 is back in the estate for IHT not the £100,000.

Any growth on the bond is also outside of the settlor’s estate. However as it is a discretionary trust there are 10 yearly charges and exit charges to consider.

Upon the settlor’s death the fixed ‘income’ stops. The investment bond can continue if there was a second life insured and it can carry on being used as a tax efficient trust investment.

If the trustees use their discretion to cash in the bond this is a chargeable event and if this occurs in the tax year after the one when the death of the settlor occurred the tax charge will be assessed on the UK resident trustees.

Trustees don’t benefit from top slicing and the charge for a discretionary trust is 45% for income above the trust’s standard rate band and 20% for income within in. On a chargeable gain that exceeds the trust’s standard rate band therefore there is a 25% liablity on the trustees, assuming the bond is held onshore.

To avoid this tax charge the trustees could, instead of them cashing in the bond, assign it to a beneficiary first. This assignment would not be a chargeable event and the beneficiary could then as owner of the policy cash it in and the chargeable event would be assessed on them. Depending on their circumstances top slicing may be used and any resulting tax would be charged on them instead of the trustees.

In summary

A DGT is suitable for those people in good health (to secure a good discount) who want to make a gift of assets to reduce IHT (with some immediate effect) but who also wish to receive regular fixed payments from the gifted capital (albeit usually capped at 5%).

To be effective for IHT purposes remember the payments must be spent by the settlor.

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