Neil Macleod, Senior Technical Manager at M&G, shares four of the most commonly asked questions about insurance company trusts, and why the answer is usually “no”.
Insurance company trusts have been around for decades, yet some questions never seem to go out of fashion because the answers are often counterintuitive. What appears to be a straightforward conclusion at first glance can look rather different once trust law and tax rules are examined more closely.
Here are four of the most commonly asked questions about insurance company trusts, and why the answer is usually “no”.
Can a gift trust be unwound?
Generally, no.
For IHT planning to be effective, the gift must be genuine. Once assets have been transferred into a gift trust, they belong to the trustees to hold for the beneficiaries under the terms of the trust.
The settlor cannot simply change their mind and reclaim the funds.
The trustees’ can end the trust by appointing the trust assets in favour of the beneficiaries however, the assets belong to the beneficiaries, not the settlor.
Ending the trust does not result in the gifted capital returning to the person who created it.
The practical lesson is straightforward, a gift trust should only be used where the client is genuinely comfortable parting with access to the gifted capital.
Where future access may be required, a loan trust, discounted gift trust (DGT) or reversionary interest trust (RIT) may be a better fit.
Do the settlor’s payments from a discounted gift trust qualify for the normal expenditure out of income exemption?
No.
One of the most common misunderstandings surrounding DGTs is the belief that the settlor’s regular withdrawals are income because they are paid periodically. In reality, the payments are capital, not income.
A defining feature of a DGT is that the settlor retains a right to a predetermined series of payments for life. Although these payments may look like income, HMRC treats them as capital receipts.
As a result, they cannot be included when calculating surplus income for the purposes of the normal expenditure out of income exemption.
This distinction is important when clients intend to use DGT withdrawals to fund further gifts. While they are free to make those gifts, the funds originate from capital rather than income.
Consequently, the gifts cannot rely on the normal expenditure out of income exemption and must be assessed under the usual IHT gifting rules.
The key point is that regular payments are not automatically income. Advisers must consider the legal nature of the receipt rather than how frequently it is paid.
Does the settlor receive a discount on the gift into a reversionary interest trust?
The short answer is no.
When a settlor creates a reversionary interest trust (RIT), they retain the right to receive the trust fund, or part of it, at a future date.
It is therefore often assumed that the value transferred should be reduced in a similar way to a DGT. However, the two arrangements are fundamentally different.
In a DGT, the settlor’s rights are generally fixed and indefeasible, creating a measurable retained value that can reduce the amount treated as gifted for IHT purposes.
With a RIT, the settlor’s reversionary rights can usually be defeated or postponed by trustee action. Because the trustees can interfere with those rights, their open market value is generally regarded as negligible.
As a result, although the settlor retains future rights under the trust, those rights do not typically create a meaningful discount against the value of the initial gift for IHT purposes.
With a loan trust, can the loan be repaid without triggering a chargeable event?
Technically, yes (but in most cases, no!).
Clients often assume that because a loan repayment is simply a return of their own capital, it should be free from chargeable event consequences.
The reality is that the tax outcome depends on how the trustees generate the funds needed to make the repayment.
Most loan trusts invest in an investment bond. The bond does not contain separate “loan” and “growth” elements. It is simply a standard investment bond subject to the normal chargeable event regime.
If trustees need to access bond funds to repay the loan, they may do so through partial surrenders, segment surrenders or a full surrender.
Unless there is sufficient tax deferred allowance available, this means a gain is likely to arise when repaying the loan.
Normal chargeable event rules apply to those transactions just as they would for any other bond. Consequently, repaying the loan does not automatically prevent a chargeable event gain arising.
The crucial point is that any chargeable event is triggered by the bond transaction, not by the loan repayment itself. For that reason, trustees and advisers should carefully consider how withdrawals are taken.
Appropriate segment planning can often improve tax efficiency, but there is no blanket exemption simply because the payment represents repayment of loan capital.
If there is a lesson from these four questions, it’s that trust planning is often as much about understanding what a trust cannot do as what it can.
While the answers may not always be the ones clients hope for, knowing the limitations before a trust is established is far preferable to discovering them afterwards.
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