Discounted Gift Trust

Discounted gift trusts (DGTs) are popular inheritance tax (IHT) planning arrangements.

Why is the term discounted used?

The term 'discounted' is used because the value transferred on establishing the trust is less than the amount invested. This is the logical consequence of the fact that the settlor is entitled to a stream of capital payments. The settlor is entitled to payments on specified dates subject only to being alive on those dates. The settlor is thus 'certain' to receive payments. The settlor's transfer or gift is the bond/policy premium less the value of the payments receivable during his/her lifetime.

What is the nature of the payments received from the trustees?

Capital not income!

Payments from the trustees to the settlor in a DGT are capital, not income. Imagine the tax consequence if they were income. It would be the financial equivalent of turning gold into lead – the alchemist's nightmare rather than the alchemist's dream.

How is a DGT structured?

There are two basic types of DGT but many variations on the general DGT theme.

The two types are those based on a bare/absolute trust structure and those based on a discretionary trust structure.

Use of a bare/absolute trust structure triggers an IHT potentially exempt transfer (PET) by the settlor. The trust fund is within the beneficiary's IHT estate. (In this context the trust fund is the policy/bond value less the value of the settlor's rights to payment.)

The bare/absolute trust structure denies flexibility.

In a bare/absolute structure chargeable event gains arising on the trust bond/policy will be assessed on the beneficiary.

Use of a discretionary trust structure triggers an IHT chargeable lifetime transfer (CLT) by the settlor and the trustees are thereafter within the relevant property regime. The discretionary structure gives greater flexibility and is thus generally preferable.

In a discretionary trust structure chargeable event gains arising on the trustees' bond/policy will be assessed on the settlor while alive and UK resident and thereafter on the trustees.

Joint settlor versions of both structures are widely available.

Advantages

  • Allow an IHT effective transfer
  • Allow settlor access through preselected payment stream
  • Discount
  • Tried and tested – 'work as described'

Disadvantages

  • Relatively inflexible
  • Payment stream can't be changed
  • Payments generally capped at 5 per cent of premium
  • Access only in form of capital payments

The HMRC view

The HMRC manuals contain very little information on DGTs. Such information as is provided can be somewhat confusing!

IHTM20424 – Discounted gift schemes (DGSs): Basic scheme

DGSs are single premium investments. They essentially comprise a gift (PET in the form of a settlement with certain 'rights' being retained by the donor. The retained rights are usually of two types:

  • A series of single-premium policies maturing (usually) on successive anniversaries of the initial investment or on survival, reverting to the settlor, if they are alive on the maturity date, or
  • The settlor carves out the right to receive future capital payments if they are alive at each prospective payment date

There is considerable HMRC comment on the valuation of the 'transfer'. This is discussed at length later in this note.

It is generally acknowledged (based on comments in the Bower case) that HMRC accepts that DGTs work as intended.

Reservation of benefit

DGTs do not trigger the reservation of benefit provisions because the settlor's rights are never given away. The settlor's gift to the trustees is subject to the pre-selected payment stream, the right to which is never given away.

Would the settlor's payment stream have a value on his/her death?

The settlor's contingent (contingent on his/her survival to the selected date) will have no value on death. There is nothing to be included in his/her estate in respect of the payments. Although the deceased is treated as making a transfer of value the instant before death, the value actually transferred takes account of the fact that he/she has died. The value of the payment stream on death is thus nil.

Calculation of the discount

The HMRC view is:

“Essentially a DGS involves a gift of a bond from which a set of rights are retained, typically withdrawals or a set of successively maturing reversions. The retained rights are sufficiently well defined to preclude the gift being regarded as a gift with reservation (GWR) for IHT purposes.

The gift is a transfer of value for IHT purposes whose value is determined by the loss to the estate principle. This is set out in s.3(1) Inheritance Tax Act 1984 (IHTA) and quantified by the difference between the amount invested by the settlor and the open market value (OMV) – s.160 IHTA refers – of the retained rights.

The OMV of the retained rights will depend on, inter alia, the settlor's sex, age, health and thereby insurability, as at the gift date. If the settlor were to be uninsurable, for any reason, as at the gift date the OMV of the retained rights would be nominal and the gift would be close to the whole amount invested by the settlor. This is because s.160 IHTA 1984 provides that, in valuing the retained rights, we assume that a sale of them takes place.

The logic behind that premise is based upon sound open market evidence and fully endorsed by leading counsel from whom HMRC has taken advice. We have looked for evidence to sales of assets similar in nature to the retained rights, for example life, interests or contingent reversions which are dependent upon the survival of the relevant life to a series of predetermined dates. This indicates that such rights are not saleable unless life assurance can be effected on that life by the open market purchaser (OMP) or it comes as part of the sale. If it cannot be effected, market evidence shows that those assets will not sell.

Without life cover being in place, the OMP is at risk of anything up to the total loss of his investment should an early death of the settlor occur. We consider it to be fundamental that the OMV of the retained rights should be carried out having regard to what market evidence is available. Additionally, we have been unable to find any evidence that it is possible to effect cover on lives older than 90 next birthday. HMRC therefore regards lives older than that, true or equivalent (mortality rated), as being uninsurable with the resultant ramifications in respect of the gift value.”

What does this mean in practice?

The starting point is to estimate the settlor's life expectancy. This is done through an underwriting process which incorporates a medical report. Once the settlor's life expectancy has been established, the value of the payments receivable during his/her lifetime is calculated and reduced to current values by use of a discount factor (a reverse interest rate). An adjustment is made for various costs. The value of the settlor's entitlement is deducted from the premium to give the value transferred.

No discount is available where the settlor is, or is 'rated', over 90. The value transferred in such cases is the policy premium.

The value transferred – the view of the courts

HMRC v Bower (Exors of Estate of ME Bower) 2008 EWHC 3105 (Ch)

Mrs Marjorie Bower established a discounted gift trust in 2002 when she was nearly 91 years of age.

The premium for the bond was £73,000 and the payment stream selected was equivalent to five per cent of that premium, payable on a monthly basis. The monthly payment was £304.16.

Mrs Bower died in 2003, approximately five months after taking out the policy.

HMRC accepted that “as Mrs Bower's rights were clearly defined, there would be no question of her being treated as having made a gift with reservation of benefit for inheritance tax purposes”. So far so good.

Mrs Bower had made an IHT PET. (The trust was an interest in possession trust with the trustees having a wide-ranging power of appointment.)

The question then arose: what was the value of the transfer that she made?

This was to be calculated by taking the price paid for the bond and subtracting from it the value of her right to a monthly payment.

The life assurer had considered a report from Mrs Bower's doctor and assessed her state of health, and thus her life expectancy. It was decided that the medical information provided justified 'loading' her age, and treating her for life expectancy purposes as if she was 103. On that basis she was assumed to have a life expectancy of between two and three years.

Having calculated a life expectancy, the life assurer then worked out the value of her reserved rights to the payment stream by taking the number of monthly payments that Mrs Bower could be assumed to receive during her anticipated lifetime and discounting them to an equivalent value at the time of the transfer by applying a 4.5 per cent interest rate. The fact that a buyer of the right to a payment stream would probably reduce the price paid for it to fund the medical and legal expenses of cross-checking the life expectancy of Mrs Bower and dealing with the formal assignment of her rights under the trust was ignored. The life assurer valued the rights retained by Mrs Bower at £7,800.

HMRC valued the transfer at a nominal £250 on the basis that there would be no purchaser for Mrs Bower's payment stream and that therefore her “right” had no OMV.

The Special Commissioner came to the conclusion that the payment stream should be valued at £4,200.

HMRC appealed.

In the High Court Lewison J reviewed the statutory provisions.

The value of property for the purpose of IHT is governed by s.160 of IHTA 1984, which provides:

“Except as otherwise provided by this Act, the value at any time of any property shall for the purposes of this Act be the price which the property might reasonably be expected to fetch if sold in the open market at that time, but that price shall not be assumed to be reduced on the ground that the whole property is to be placed on the market at one and the same time.”

What does this mean? It assumes a hypothetical sale but in a real market. There must be an assumed sale (however unlikely it would be in reality). The marketplace and the potential purchasers therein must be real.

The Special Commissioner had found as fact that:

(a) Mrs Bower was uninsurable

(b) Purchasers of rights similar to Mrs Bower's would wish to 'lay off' the mortality risk by insuring her life (or by 'pooling' similar investments).

The 'pooling' approach had been correctly rejected by the Special Commissioner because it was precluded by the statutory hypothesis that he was required to value her right alone

The Special Commissioner had concluded that no buyer would be able to lay off the mortality risk by taking out term life assurance because such assurance was simply not available bearing in mind Mrs Bower's rate age of 103. He had accepted evidence from Foster & Cranfield (auctioneers and valuers of financial rights and interests) to the effect that, in valuing life interests in settled property, purchasers almost invariably wish to lay off the mortality risk by taking out life assurance.

The key question was thus whether that meant there would be no potential buyers of the relevant annuity for any figure in excess of the nominal figure that HMRC had suggested.

Lewison J agreed that the Special Commissioner had to consider all possible purchasers and that this could include 'speculators'. However:

“If in the real world an asset is worthless, the statutory hypothesis does not make it valuable.”

The HMRC value was

“…the necessary consequence of a finding of fact that an asset is not commercially, as opposed to legally, saleable coupled with the assumption that a sale must be assumed to have taken place”.

The Special Commissioner had erred in law in determining a figure based on “little more than uninformed, but hopefully realistic, guesswork”; a figure based on the existence of a hypothetical speculator whose existence and whose valuation price sensitivity had never been put forward by counsel for either party. His figure was not based on the evidence before him.

The appeal would therefore be allowed.

No further appeal having been made, this judgment is now final.

Watkins & Harvey (Exors of KM Watkins dec'd) v HMRC [2011] UKFTT 745 (TC)

Mrs Kathleen Watkins died on 18 March 2006 aged 91 years and one day.

On 21 December 2004 (when aged 89 years and nine months) she established a DGT. She had made an IHT PET which 'failed' on her death and became a chargeable transfer. The issue in this case was the value to be placed on the PET.

Mrs Watkins' sons, David and Keith, were the trustees of the trust, which divided into two funds: the first called 'the Settlor's Fund' for the absolute benefit of the settlor, and the second a Residual Fund for the named beneficiaries. David and Keith were the named beneficiaries.

Clause 6 of the trust deed provided:

“The trustees will pay or transfer capital of the Settlor's Fund to the Settlor… of the amount and at the frequencies stated in the third schedule.”

The third schedule specified level payments of 10 per cent a year of the single premium for the trust property (the Skandia bond), payable quarterly for the life of the settlor. This was quantified at £4,250 per quarter, or £53,273 over the actuarially reckoned life expectancy of Mrs Watkins of 3.1337 years. A medical report on Mrs Watkins dated 20 October 2004 was taken into account in the actuarial projection.

The value of her interest (i.e. the 'discount') was assessed as £52,273.

The HMRC view was that the appropriate discount was £4,250 (i.e. one quarter's payment).

The value of the PET was the amount transferred to the trustees (the premium) less the value of the settlor's interest.

So what was the value of the payment stream to which Mrs Watkins' was entitled?

The executors' approach was to establish whether buyers of the type of interest retained by Mrs Watkins would be interested in purchasing her rights and how they would value them. They paid particular regard to the fact that the risk of her death before her actuarially estimated lifespan would terminate the income stream – mortality risk.

The executors advanced the argument that the mortality risk could be secured on physical or financial assets (rather than being covered by a life policy).

The scenarios suggested by the executors were:

(a) Security for the risk of early death could be given by a charge on assets, either of the settlor or the beneficiaries

(b) The price for the income stream could be paid by phased payments matching the release of income

(c) The beneficiaries could underwrite the purchaser's mortality risk

(d) The remaindermen under the trust (the beneficiaries in this case) could purchase the settlor's rights on their own account, thus advancing the retained income;

(e) The remaindermen could take the opportunity of the income stream being sold to sell with it all or the relevant part of their interest in the trust, thus acquiring capital early

(f) The purchase price could be deposited in an escrow account with instalments being released as income was received, any shortfall in the purchased stream returning to the buyer in the event of the early death of the settlor.

In all these examples, the mortality risk would effectively have been eliminated.

HMRC led expert evidence – an actuary. Although there was no market in the sale of income streams from DGTs, there was an established approach for valuing interests derived from a trust such as life interests, absolute reversionary interests and contingent reversionary interests. There was evidence that purchasers were not willing to take a 'mortality risk' without life cover on the 'life tenant'. It was not possible to obtain life assurance on the life of an 89+ year-old with a life expectancy of 3.1 years. HMRC's expert witness had analysed transactions arranged through Foster & Cranfield and the results supported the 'life cover' argument.

In respect of the executors' case, the judge said: “Their views are speculations on what would be possible or even probable; they are no doubt well informed on the matters on which they opine, but there is cited no factual foundation in previous or similar transactions to refer to.”

In contrast:

“It is true that the evidence adduced by the Crown is limited, and not entirely on all fours with the facts of this case, but it shows a consistent pattern of behaviour over a significant period of time in regard to rights which are very similar to those in this appeal.”

That clinched the case in favour of HMRC:

“Ingenious though the appellants' [the executors] formulations may seem, they do not pass the test that they are identifiable with any type of open market that exists.”

Disclosure of tax avoidance schemes (DOTAS)

Users of DGTs have no reporting requirements under the DOTAS provisions.

Pre-owned asset tax (POAT)

The operation of a DGT should not trigger an income tax charge under the POAT regime.

The HMRC view on this is as follows:

Insurance policies

The settlor effects a DGS comprising a gift into settlement, with certain 'rights' being retained by them. The retained rights may, for instance, be a series of single-premium policies maturing (usually) on successive anniversaries of the initial investment or on survival, reverting to the settlor, if they are alive on the maturity date, or the settlor carves out the right to receive future capital payments if they are alive at each prospective payment date. The gift with reservation provisions do not apply.

In the straightforward case where the settlor has retained a right to an annual income or to a reversion under arrangements, that right is not property within paragraph 8 as the trustees hold it on bare trust for the settlor. A bare trust is not a settlement for IHT purposes. The settlor is excluded from other benefits under the policy and so this schedule does not apply.

There may be more complex cases where the settlor's retained rights or interests are themselves held on trust. But that would normally be construed as being a separate trust of those benefits in which the settlor had an interest in possession, and no charge to tax will arise under this schedule by virtue of paragraph 11(1).

Even if, in less common cases, the paragraph 11 provisions did not apply so as to exempt the case from charge completely, any charge under this schedule would apply by reference to the value of the rights held on trust for the settlor, not by reference to the value of the underlying life policy.

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