On 17th April 2023 HMRC announced a change which reduces the amount of discount which can be awarded to new Discounted Gift Trusts (DGT) created on or after 1st May 2023. The change is an increase in the interest rate assumption used in the calculation, jumping from 4.5% to 6.75%.
The increased rate represents the value which an individual might reasonably expect when purchasing an income on the open market. As this expectation has increased, then the open market value of the income stream from a DGT is reduced. This reduction means the settlor is making a higher value gift.
Key takeaways
- The change is not retrospective and will not impact trusts declared before 1 May 2023.
- The change affects the market valuation of the settlor’s income for the purpose of calculating their IHT liability. It does not reduce the amount which the settlor will receive from their trust.
- The change also affects discount calculations performed at the 10 yearly periodic charges which applies to relevant property trusts.
To understand the change and why it impacts the discount we need to brush up on how DGTs operate.
How do DGTs work?
The DGT is a ‘carve-out’ trust, where the settlor (the person creating the trust) gifts a new or existing investment bond to be held on trust by their trustees. Under the terms of the trust the settlor carves-out a right to receive a regular payment (referred to as an income) for the rest of their life (or until the trust fund is depleted, if sooner).
When creating the trust, the settlor is making a gift (a chargeable lifetime transfer or potentially exempt transfer). Usually, the value of the gift is the surrender value of the investment bond. However, HMRC agree that the value of the gift may be discounted based on the open market value of the settlor’s income rights. This effectively splits the gift into two parts;
- The ‘value of interest retained’ also known as the discount
This is the open market value of the settlor’s lifetime right to income from the trust and is immediately outside the settlor’s estate. - The ‘discounted value of the gift’
This is the chargeable lifetime transfer (CLT) or potentially exempt transfer (PET) made by the settlor. This part will be outside the settlor’s estate if they survive for a period of seven years.
If the settlor died within seven years of creating the trust, the CLT / PET fails and may be subject to inheritance tax. HMRC may require evidence of the discounted awarded to the settlor and may alter the value of the CLT / PET if they disagree with the discount.
How is the discount calculated?
The discount is usually calculated by the provider of the trust / investment bond and is given before the trust is declared. The provider arranges for medical underwriting of the settlor and calculates the discount based on age, medical history, the value placed into trust and the amount of income carved-out.
The formula for the calculation is dictated by a briefing note issued by HMRC. It’s complex, but it effectively considers how much an open market purchaser might pay the settlor in exchange for their lifetime income rights from the trust - similar to purchasing a second-hand annuity. If the settlor is young and in good health, the market value of their income is higher. If they’re older or in poor health, then the value of their income rights is lower. This value is purely hypothetical as the income rights are not actually for sale, but it’s this principle which tells us the IHT value of the settlor’s right to income and therefore the discounted value of the gift they’re making to trust.
Why does the rate of interest matter?
The rate of interest represents the rate of return which a person could expect when purchasing an income stream on the open market. The rate of 4.5% was originally set by HMRC in December 2013, since then the bank of England base rate has increased to 4.25% along with a rise in gilt yields. As a result, persons purchasing an income on the open market will be expecting a higher return, HMRC’s view is that would be 6.75%. If the wider market can now offer higher returns, then the market’s valuation of the settlor’s income rights is reduced - and therefore so is the discount.