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Figure out a formula for discounts

Paul Kennedy, director of trusts & tax planning solutions at FundsNetwork, sets out the calculations that need to be made on discounted gift trusts

HM Revenue and Customs’ recent notices on calculating discounts within discounted gift trusts are significant for advisers and clients. In May, we were guided on how to calculate discounts and how to treat joint trusts, and since Sep-tember 1, there is a revision to the rate of interest.

Here is a brief introduction of how these popular trust schemes work. The DGT is distinctive in that it allows you to give away assets from your estate to cut IHT but still draw a regular income.

For example, a client – in trust terminology a settlor – might gift £200,000 to the trust and decide to retain a regular annual income of £10,000. The settlor gets the income for life and, on his death, his beneficiaries receive what is left. The settlor is free to choose how the money is invested.

Because the settlor retains the right to an income, he is not treated for tax purposes as having made a gift of £200,000 but of a lesser figure. This is because we must deduct from the gift, the theoretical value of the settlor’s future right to income. This is the discount.

For example, if the discount is valued at £80,000, the gift – for tax purposes – is £120,000, resulting in an immediate saving of £32,000 in IHT – £80,000 x 40 per cent tax rate.

The gifted amount of £120,000 is treated as a chargeable transfer if a discretionary DGT or a potentially exempt transfer if a bare DGT and so subject to the normal seven-year rules.

How is the discount figure calculated? Well, the figure must represent the current market value of the settlor’s retained right to income, in effect, how much he could sell it for in the open market. There is no active market so a hypothetical calculation is used. There are a number of highly complex formulae that can be used. The Jellicoe formula is a common method and is the formula believed to be used by HMRC.

The technical note in May provided guidance on the variables to be input into discount formulae. HMRC stated that it was not prescribing an approach that must be taken but did deliver a rather salutary warning that alternative approaches should arrive at broadly similar results.

The discount calculation involves many considerations including interest rates. HMRC now recommends what interest rate to use in calculations and, in September, following upward trends in interest rates, HMRC is increasing its rate, from 6 per cent to 6.75 per cent.

What does this mean and how will it affect you and your clients? From September 1, when the new rate comes into effect, the amount that is immediately exempt from IHT – the discount – will be lower.

Broadly, the reduction will be greater the younger the client. Typically, the overall discount figure will reduce by around 8 per cent for someone aged 50, around 6 per cent at age 65 and around 3 per cent for people in their mid-80s.

The fact that we have seen initial guidance, updated as interest rates have moved, might be seen as a strong indication that HMRC is taking seriously the need for consistency in the calculation of discounts. If the discount is calculated incorrectly – if HMRC does not agree it is fair – it could cause a headache for the adviser and client.

If the discount is too high, then the gift figure will be too low. This has some potentially profound implications not only for the DGT but also for other aspects of IHT planning for that client.

First, the client will have been given a wrong indication of the savings in IHT.

Second, for discretionary DGTs, it is really important that gift values and what tax might have to be paid is known – or, more likely, the client will want to ensure that no tax is payable.

Third, IHT planning works on a cumulative basis so you need to know what gifts have been made during rolling seven-year periods.

May’s technical note also made clear the treatment of individuals where more than one person has gifted assets to the same trust.

Joint DGTs are used typically by husband and wife making joint IHT plans. A simple 50-50 split of the discount was originally applied. After looking at some cases, however, HMRC found that this could be “unfair treatment”. Life expectancy influences the amount of the discount, so where a couple has a big age gap, HMRC did not consider the 50-50 approach to achieve a reasonable result.

The technical note states that each individual should be treated separately and it sets down the methodology for calculating the individual discounts. Simplistically, the total joint discount is calculated in its entirety and then apportioned between the two in accordance with their relative ages.

For example, with an arrangement of £200,000 for a male aged 79 and female aged 49, the overall discount is approximately £127,000. The split is then £41,500 male and £85,500 female.

The point here is that, with a joint DGT, there are three discount figures at play, get the main one wrong and the apportionment will be wrong as well.

It is to be hoped that HMRC guidance will start to ensure continuity among DGT providers in discount figures. Ask providers what methodology is being used and, if it is not the HMRC methodology, whether it provides similar discount rates.

Advisers are urged to ensure that any figures illustrated are in line with the HMRC guidance and not to search around for the highest discounts which ultimately may be detrimental to their clients.


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