A Discounted Gift Trust (DGT) is a strategic financial instrument that enables individuals or married couples/civil partners to make tax-efficient gifts while retaining a guaranteed stream of fixed regular payments for the duration of their lifetime. The value of the gift for Inheritance Tax (IHT) purposes is reduced by an estimated value of the future retained payments.
This trust establishes two distinct rights:
- The settlor’s entitlement to predetermined regular payments throughout their lifetime.
- The beneficiaries’ right to access the trust fund after the settlor’s passing.
Because it is clear which assets have been given away and which are retained by the settlor, there are no implications of a “gift with reservation” for IHT.
Who Is It Suitable For?
A Discounted Gift Trust is primarily designed for individuals or married couples/civil partners who possess surplus capital they wish to gift while still requiring income from their assets to support their livelihood.
The transfer of assets into the trust can result in immediate IHT savings if a discount is negotiated*. If the settlor survives for seven years after the transfer, the entire value of the gift becomes exempt from IHT.
The settlor receives fixed regular payments for life, with no possibility of altering these payments once the trust is established. This certainty is appealing to those seeking consistent income throughout their lifetime. However, if the regular payments accumulate within the estate and are not spent, it may undermine the effectiveness of the estate planning.
Note that any discount is subject to satisfactory underwriting.
Joint Settlor vs. Two Single Settlor Plans
Discounted gift trusts can be structured with either a single settlor or jointly by spouses or civil partners. When couples contemplate establishing a DGT, they must decide whether a joint settlor arrangement or two separate single settlor DGTs is more suitable.
The Retained Payments
In a joint settlor DGT, the right to retained payments typically continues at the full amount after the first settlor’s demise. However, with two single settlor DGTs, the right to retained payments in one trust ceases upon the first settlor’s death. This may pose an issue if the surviving settlor depends on these retained payments.
If the surviving settlor is also a beneficiary of the first settlor’s trust, they can still benefit from that trust, either through regular payments or larger lump sum distributions.
The Discount
Joint discounts are calculated based on the combined life expectancy of both settlors, taking into account the probability of both passing away. The discount is not evenly divided but is allocated based on each settlor’s individual life expectancy. This may result in a slightly different overall discount compared to two single settlor DGTs, depending on individual circumstances.
Trust Creation
Typically, the trust is established by the settlor through a cash gift to the trustees. It is usually not possible to use existing investments, such as bonds, to create the trust, as these assets are typically liquidated, and the proceeds are used to establish the discounted gift trust.
The trustees then invest the trust funds, often through an investment bond (onshore or offshore) or a series of endowments. Regular withdrawals are arranged to provide the settlor’s predetermined capital payments. The use of non-income generating assets, such as bonds or endowments, usually eliminates the need for trust tax reporting unless there is a taxable gain.
Trust Options
A discounted gift trust typically offers three trust options:
Discretionary Trust: In this trust, no beneficiary has an automatic entitlement to either income or capital. The trustees have the discretion to allocate income or capital to any beneficiary within the specified class of potential beneficiaries outlined in the trust deed.
Flexible (Interest in Possession) Trust: This trust names specific beneficiaries who are entitled to any trust income. However, if the trust is invested in an investment bond generating no income, the trust includes an overriding power of appointment, allowing the trustees, often including the settlor, to modify the beneficiaries or their respective shares. This flexibility is valuable for situations where the settlor anticipates changes in beneficiaries, such as the birth of grandchildren or shifting preferences.
Absolute Trust: Under an absolute trust, beneficiaries are fixed at the outset and cannot be changed by the trustees later. The beneficiary of an absolute trust only gains access to the capital and income from the trust after the retained payments cease upon the settlor’s demise. This trust type is suitable for individuals who are certain about their chosen beneficiaries.
Inheritance Tax at Inception
The creation of a discounted gift trust (DGT) constitutes a transfer of value for Inheritance Tax (IHT) purposes, with the IHT treatment dependent on the type of trust used:
- Flexible & Discretionary Trusts: These are considered chargeable lifetime transfers (CLT).
- Absolute/Bare Trusts: These are categorized as potentially exempt transfers (PET).
The value of the transfer for IHT can be reduced by the value of the settlor’s retained payments. In cases where a flexible or discretionary DGT is established, IHT may be due if the value of the CLT, net of any discount, surpasses the available nil rate band, considering any other chargeable transfers made by the settlor in the previous seven years. If the settlor survives for seven years after making the transfer, no additional IHT is payable upon their death.
In the case of an absolute trust DGT, there is no IHT payable at the time of creation. As long as the settlor survives for seven years following the transfer date, there will be no IHT due.
DGTs are not subject to the IHT gift with reservation rules or the pre-owned asset tax charge. HMRC has also clarified that they do not fall within the scope of the general anti-abuse rule (GAAR).
Inheritance Tax (IHT) Periodic and Exit Charges in Discounted Gift Trusts (DGTs)
Discounted Gift Trusts (DGTs) falling under the relevant property regime, mainly comprising discretionary and flexible trusts established after March 22, 2006, may incur IHT charges at ten-year intervals and exit (or “proportionate”) charges when capital is distributed from the trust.
Ten-Yearly Charge
A ten-yearly charge occurs every ten years from the establishment of the trust. If the settlor is alive at the ten-year anniversary, the value of the trust at that point is reduced by a discount. This discount is calculated based on:
- The expected number of income payments the trustees will make during the settlor’s lifetime.
- The value that a buyer would pay for a fund at the ten-year anniversary, considering that they cannot access it until an unspecified future date (the settlor’s death).
These factors can lead to substantial discounts at the ten-year anniversary, and providers of DGTs typically assist with calculating this discount. It is important to note that the calculation method differs from the one used at the trust’s outset, such as utilizing a quotation system and the settlor’s age at the next birthday.
To ascertain the settlor’s life expectancy, HMRC does not require full underwriting at each ten-year anniversary. Instead, they accept a practical approach based on the settlor’s age at their next birthday and any underwriting rating assigned when the trust was created. Changes in health since the trust’s inception are disregarded.
Discounts can also be applied even when the settlor is 90 years old or older. In cases where two settlors established a DGT but only one is alive at the ten-year anniversary, the trust is treated as two separate settlements, and both usually receive a discount.
Exit Charge
Regular withdrawals made to the settlor as part of their retained payments are not considered exits because these payments are held under a bare trust for the settlor and are not classified as relevant property.
However, when capital is distributed to a trust beneficiary, typically after the settlor’s death or when trust provisions allow for advances to the beneficiary during the settlor’s lifetime, an exit charge may apply.
The IHT on the exit charge is calculated as a proportion of the effective rate that was applied at the last ten-yearly charge or 30% of the effective rate at the trust’s creation. In cases where the effective rate was 0% at the last review date (e.g. when the original transfer fell below the available nil rate band), no charge is imposed when capital leaves the trust.
Death of the Settlor
Upon the settlor’s death, the regular payments made to them cease. Any remaining funds become available to the trustees, who may choose to distribute them to beneficiaries or continue holding them in the trust.
In a joint settlor DGT, the predetermined level of withdrawal payments selected at the outset continues to be paid until the survivor’s death.
IHT on the Death of the Settlor
The value of the DGT fund is not included in the settlor’s estate for IHT upon their death. The settlor’s right to capital payments terminates upon death, making it devoid of value for IHT purposes. Consequently, as long as the settlor survives for seven years after creating the DGT, no IHT is payable.
If the settlor passes away within seven years of establishing the DGT, IHT may be levied on any potentially exempt transfer (PET) for an absolute trust or a chargeable lifetime transfer (CLT) for a discretionary or flexible trust. The value of the transfer for IHT may be reduced by the value of the settlor’s retained payments, and the IHT liability is calculated using the available nil rate band in the year of death.
If the cumulative PET or CLT, combined with any chargeable transfers within the preceding seven years, surpasses the nil rate band, IHT is imposed at a rate of 40%. Taper relief may reduce the IHT payable when death occurs between three and seven years from establishing the DGT. Any 20% tax paid on a CLT at the time of creating the DGT can be offset against the IHT payable upon death.
If the cumulative PET or CLT, along with other chargeable transfers within the past seven years, remains below the nil rate band, no additional tax is imposed on the PET or CLT. Nevertheless, this reduces the settlor’s available nil rate band, which could result in IHT being due on a corresponding portion of the settlor’s remaining estate at a 40% rate.
Chargeable Gains Following the Settlor’s Death
If the trustees opt to surrender the bond and distribute the proceeds to beneficiaries, there may be a chargeable gain. The assessable party depends on the type of underlying trust and when the chargeable event occurs.
All chargeable gains on absolute trusts are assessed on beneficiaries after the settlor’s death.
For flexible and discretionary trusts, if the bond is surrendered before the end of the tax year of the settlor’s death, any gains are taxable to the settlor. The settlor’s personal representatives are responsible for paying any tax to HMRC, with the option to reclaim it from the trustees. If the bond is surrendered in a subsequent tax year, any gain is assessed on the trustees at the trust rate of 45%.
Alternatively, the trustees may assign the bond (or segments of it) to beneficiaries, and any future gains are assessed on the beneficiary at their own marginal tax rates with the benefit of top slicing.
Death of a Beneficiary While the Settlor is Still Alive
If a beneficiary passes away before the settlor, this has no IHT consequences for the beneficiary in the case of a discretionary or post-March 22, 2006, flexible trust.
However, for an absolute DGT, if a beneficiary predeceases the settlor, the value of their share of the DGT becomes relevant. This value is included in the beneficiary’s estate, even though the estate will not receive any proceeds until after the settlor’s death. The valuation of the deceased beneficiary’s share considers the present value of their rights in the trust, accounting for the fact that the settlor continues to receive payments, and nothing is payable to the beneficiary’s estate until after the settlor’s death.
Summary
Trusts can be a way to structure your estate so that assets are protected, mitigates IHT and allows you to pass on any wealth you have created. It depends on what assets you have and how they are best structured for your situation.
If you have any questions please email me using the button below and if you would like some more information, here are some blogs and videos I have written and recorded:
- Guide to Inheritance Tax for British Expats
- Mitigating Inheritance Tax: Strategies for British Expats
- U.K Inheritance Tax (IHT) as an Expat
