Over the past months, I have been looking at the tax treatment of the main insurance-based inheritan...
Over the past months, I have been looking at the tax treatment of the main insurance-based inheritance tax (IHT) planning trusts in light of the new IHT regime introduced by the Finance Act 2006. This month's article considers the position of discounted gift trusts (DGTs).
DGTs have probably been the most popular IHT planning vehicle in the marketplace and I do not see this changing under the new regime. DGTs work by placing an initial gift into a trust of which the settlor is not a beneficiary and making the gift subject to a carve out of a series of annual or more regular payments reserved for the settlor's benefit. These payments are fixed at the outset, in terms of the amount and the date on which they arise.
The main benefits of DGTs are the ability to remove the full value of the gift from your estate after seven years, but still retain access to capital in the form of regular payments for the rest of your life. Furthermore, because UK IHT is charged on the "loss to the estate" principle the value of the gift, should death occur within seven years, must take into account the value of the settlor's "income stream" based on his mortality. This is the "discount" and it essentially means DGTs give individuals an immediate IHT saving.
Under the old regime, the transfer would have been a potentially exempt transfer (Pet), but of course now it is a chargeable transfer, which means that should the value of the transfer exceed the nil rate band, there will be a 20% lifetime IHT charge.
The good news is the discounted amount will be the relevant figure for the purposes of the entry charge. This means that for those in good health, quite substantial amounts can be invested before an entry charge is levied. This is a good opportunity for advisers, because it is a great reason to start IHT planning at a younger age when clients are more likely to be in good health. An indication of the maximum gift into a DGT that can be made without creating a chargeable transfer is illustrated below.
In relation to the periodic and exit charges, these will be based on the value of the trust fund less the value of the settlor's income stream, based on his age and state of health at that time. HM Revenue & Customs has confirmed they would not expect fresh underwriting to take place unless there was clear evidence that the settlor's state of health had materially changed in the interim period.
Care needs to be taken if you are using DGTs based on contracts that cannot be surrendered during the lifetime of the settlor. The danger here is that, should a periodic charge arise, the trustees cannot take a withdrawal from the policy to pay it. Using part of the settlor's entitlement will effectively be an addition to the trust, so a further IHT charge could arise and some pretty complicated calculations would need to be done. It is also important to note that, under the new regime, when a beneficiary dies the trust fund will no longer form part of his estate for IHT. This was always a potential pitfall with DGTs under the old regime, because if a beneficiary already had assets in excess of the nil rate band, the IHT bill merely got passed onto the next generation and nothing had been achieved. This will no longer be the case and could actually mean some people will be better off.
For example, a settlor creates a DGT for £500,000 at age 65, carving out a series of interests equal to 5% pa. He dies after eight years and the capital remains on trust for his son, who subsequently dies in year 12. Assuming the fund is worth £640,000 at this time, and the beneficiary's other assets exceed the NRB, the total IHT would be as follows:
To promote 'long-term investment'
Switching 'hard and expensive'
Smaller funds still packing a punch
To drive progress