Myth and reality

Discounted Gift Trusts (DGTs) are a one size fits all inheritance tax planning solution, suitable in almost every circumstance. Individuals can give away their money, without really giving anything away at all.

THIS ISN’T TRUE. However, you would think so from the way they are sold by many financial advisors. They are a very useful tool in the right circumstances, but not the panacea that many believe them to be. In many cases, they have been sold by advisors (often for high levels of commission) without the expertise required to ensure they are appropriate.

It is possible that some who have been sold a DGT, or their beneficiaries, will get a nasty shock in the form of unexpected tax at some time in the future.

What is a DGT?

A DGT is a trust based investment where a settlor can immediately reduce the value of their estate but receive an income.

How does it work?

• A settlor makes a gift into an investment bond.The DGT can be based on a discretionary or an absolute trust.
• The settlor retains an income for their lifetime, funded by capital withdrawals from the investment bond. This is not a gift with reservation.
• There is no immediate tax on income, provided it is less than 5 per cent of the initial investment.
• The settlor should complete a health questionnaire and submit this to underwriters who will make an estimate of life expectancy.
• Life expectancy and income determine the discount.
• The discount is the present value of the income. As income ceases on death, this amount is effectively outside the estate immediately.
• The discount is greater the longer the life expectancy and the higher the level of income.
• The remaining fund is a chargeable lifetime transfer (CLT) or a potentially exempt transfer, depending on the type of trust.

Case study

Bob and Mary Smith are both 60. They are wealthy, would like to reduce inheritance tax and would be comfortable giving GBP600,000 away. However, they would like to receive additional income to fund their lifestyle.

They would like to give money to their children or their grandchildren, but they have not yet decided who should get what.

Their advisor recommends they each gift GBP300,000 to separate DGTs, based on discretionary trusts. He suggests that all their children and grandchildren be potential beneficiaries, and that Bob and Mary together with an independent third person be trustees.

The advisor recommends that they each take 5 per cent per annum income, meaning they each receive GBP15,000 a year.

Bob has a life expectancy of 23 years and Mary, 26 years.

Bob and Mary each complete a health questionnaire and obtain an opinion from underwriters of the discount they may receive. The advisor chooses the insurance company to use based on which suggests the biggest discount. Their underwriters believe Bob would receive a discount of 50 per cent and Mary would receive a discount of 58 per cent.

If these figures are correct then a total of GBP324,000 would be immediately ‘discounted’ from their joint estate. This could be a tax saving of GBP129,600. Any growth on the investments would also be outside the estate immediately.

The balance would be treated as a CLT, however as each gift is below the nil-rate band there is no immediate tax to pay.

The advisor does not check whether Bob and Mary have made any other recent gifts.

Each bond is set up on the life assured of one of their children only.

What is wrong with this advice?

On first glance a DGT looks suitable. Bob and Mary have spare capital, require additional income, want to reduce the value of their estate, but have not yet decided on their beneficiaries.

However, there are one or two things wrong with this advice.

What would happen:

• If they both survived to their estimated life expectancy?
  • Even though 'income' (actually return of capital) is 5 per cent per annum, tax is only deferred until all their original capital has been repaid, in this case 20 years. Both have a life expectancy greater than 20 years so there may be a tax liability.
• On death of the life assured?
  • On death of the last life assured the bond must end and tax may be due.
  • There is only one life assured. Income would cease on their death and neither the settlors nor the beneficiaries can access the capital as the settlors are still alive.
• If Bob died in five years’ time?
  • Say Bob had a medical condition that the insurance company did not pick up in the underwriting.
  • When Bob dies, HMRC would may their own assessment of the discount.
  • HMRC decide that the client should only receive a minimal discount because of the medical condition. There may be an unexpectedly large IHT bill.
• If the clients had made gifts in the previous seven years?
  • As the advisor has used a discretionary trust, there could be a lifetime transfer charge of 20 per cent if the gift is over the nil-rate band.
  • The advisor has chosen an amount below the nil-rate band, but did not take into account any gifts over the previous seven years.
  • If Bob or Mary had made substantial gifts prior to setting up the DGT, there could be tax on the gift.

The implications

Although the advisor made a number of mistakes, the main one is that age 60 is usually too young to lock up capital with no inflation-proofing on the income.

In 20 years time, if 10 per cent per annum growth is achieved, the bond could be worth GBP795,000, however the income would still only be GBP30,000 per annum. If we assume inflation is 3 per cent a year, the income has reduced to GBP16,313 a year in real terms, which may no longer be sufficient.

The capital is literally ‘locked’ until death. Neither the children nor the settlors can access any more of the fund. This could be potentially disastrous, for example if they had to enter care and needed to pay the fees.

Other planning solutions may be more appropriate, such as:

• Gift and loan trust
• A straight gift to a trust for a smaller amount
• Whole of life assurance written under trust, as a temporary solution until further gifting becomes appropriate.
• If capital is used to create additional income, Bob and Mary could give this away under the gifts out of normal expenditure rules.

Where a discounted gift would be more appropriate

Let’s assume that Bob and Mary were 75 when they began to address their IHT problem. All other circumstances are the same.

This time their life expectancies are around 13 years (Mary) and 11 years (Bob).

This time, the advisor obtains three underwriting quotes, but decides which insurance company to use based on the quality of their contract, not the discount offered. The average discounts calculated by the three underwriters are:

• Mary – 35 per cent
• Bob – 43 per cent

The advisor recommends that Bob and Mary’s three children are lives assured on the bond.

On death

Let’s assume Bob, again, died after five years.

Even though Bob died, the investment can continue and be surrendered when appropriate.

The executors show HMRC the three underwriting estimates. Due to the weight of evidence provided, HMRC agree that the discount of 43 per cent is correct. Therefore, GBP129,000 is outside the estate. The remaining GBP171,000 may be subject to further IHT, but taper relief may apply.

The children are all higher rate tax payers, and if they cash the bond they will pay 20 per cent tax. All the grandchildren are now grown up and are basic rate tax payers.

Following advice, Mary and the other trustee decide to split the proceeds of the trust equally between their six grandchildren. There is no further tax to pay.

A minefield

Inheritance tax is a complex area, but with good planning and enough time, individuals should be able to reduce the inheritance tax on their estate to zero.

A DGT would be suitable as part of this planning where a client:

• can afford to give away capital;
• requires income;
• has a life expectancy of below 20 years;
• needs an immediate reduction in their estate.

It is vital to obtain specialist advice. Particular points to note are as follows.

• There should be multiple lives assured.
• It is important to take into account previous gifts.
• DGTs based on discretionary trusts can be subject to periodic or exit charges, but these can be kept to a minimum with suitable planning.
• Clients should obtain multiple underwriting quotes.

Investment planning

Remember that the trust is an investment first and foremost. If performance of the investment does not exceed the level of income, the amount left to beneficiaries could be much less than expected.

The trust should therefore be regularly reviewed by an investment specialist.

These case studies are intended to be examples only and should not be viewed as offering advice. In all instances personal advice should be sought from an appropriately qualified professional.

This topic will be discussed further as part of the STEP Manchester lunchtime learning programme in February 2009, with a workshop on Discounted Gift Trusts.