Discounted gift trusts provide withdrawals for life in return for a ‘discount’ from a lifetime gift but what happens if the withdrawals are no longer needed?
Discounted gift trust
Under a discounted gift trust (DGT) the settlor makes a lifetime gift to trustees (usually in the form of an investment bond) but they carve out the right to receive withdrawals for life or until the trust fund is exhausted (usually up to 5% to benefit from the bond’s tax-deferred allowance). The withdrawals are based on life expectancy of the settlor and actuarial calculations, which provide a market value, i.e. what someone might expect to pay for the right to receive withdrawals. This figure is then used to establish a reduced value of the gift for IHT purposes.
The result of the discount is that an instant IHT saving can be achieved (as the discount is immediately outside the estate) and it allows for a more substantial investment to be made using a discretionary trust, above the level of the nil rate band (NRB).
It is important to note that the discount quoted by an insurer is not guaranteed and HMRC can challenge the underwriting opinion and therefore figures quoted. However, a prudent approach by the insurer, i.e. underwriting in advance for all cases and use of the HMRC-prescribed interest rate in the discount calculations, should help to minimise the likelihood of any challenge.
What options are available if withdrawals are no longer required?
The question of ‘how do I stop my withdrawals?’ and ‘what are the implications?’ arises more often than you would think. If the deed allows for withdrawals to be waived, it can be stopped or reduced. However, the loss to the estate must be valued and therefore a new gift for IHT purposes has been made.
Withdrawals are often waived in three ways:
- Waive for a short period of time, i.e. settlor waives for six months.
- Waive indefinitely, i.e. settlor never wants any withdrawals again.
- Waive until further notice.
So what is the open market value of the asset in the transferor's hands before the action of waiving?
For the first option this can be as simple as the value of the waived payments, inflation/future value of money is not really a factor. E.g Waiver of monthly payments for 6 months in total, the gift may be valued as 6 x £monthly withdrawal amount.
For the second option the loss will be the open market value of the right to receive withdrawals at the date of transfer. This is similar to estimating the initial discount, but using the revised parameters such as the age and health of the settlor at the time of the waiver. Most insurers will not undertake this process due to the costs involved with re-underwriting the individual for a second time. It is therefore down to the settlor to seek appropriate advice and record the value of the gift as it will need to be disclosed should they die within seven years of giving up their right to withdrawals, or to assess whether an entry charge applies (where the DGT is a structured as a flexible or discretionary trust).
The third option is difficult as ‘until further notice’ is an unknown period. The question is what value would an open market purchaser place on the settlor’s rights to withdrawals in these circumstances? It is unlikely that anyone would buy such an income stream because it is unclear when it will start. Therefore, the settlor’s retained rights under the trust, after the waiver, has no market value. With this in mind the same approach as option two should be used i.e. the settlor is treated as if they had waived all rights to withdrawals indefinitely.
Will the waiver affect the initial discount?
No. S160 IHTA 1984 confirms the ‘market value’ used for valuing assets is the value at that time, this means the gift cannot be retrospectively valued Instead the settlor is making an additional gift of the market value of the rights waived on the date the waiver is executed.
Conclusion
Funds that are within the settlor’s estate are potentially liable to 40% IHT on death whereas the future right to withdrawals, prior to any decision to waive, is immediately outside the estate on death. Assuming the trust deed allows for the withdrawals established by a DGT to be waived, it might be worth seeing if these withdrawals can be used in other ways before recommending such action. This will avoid a new gift and seven-year clock.
If the ‘withdrawals’ from the DGT are not required and are just being accumulated within the estate, other options might be available. The withdrawals are classed as capital from an investment bond, so the settlor will not be able to use the ‘gifts out of income’ exemption. Other exemptions might be available, including annual exemption, small gifts and charitable donations.
For financial advisers only. Not to be relied on by consumers.