The Finance Act 2006 contained radical changes to the taxation of trusts for inheritance tax purposes. In particular, most types of non-bare trust used for discounted gift schemes created after 21 March 2006 became relevant property trusts and therefore subject, among other things, to a potential charge to IHT on the value of the relevant property held in the trust every 10 years. We have now reached the stage when these post-2006 trusts are starting to hit the first 10-year periodic charge and appropriate valuations will be required to ascertain any inheritance tax payable.
The value of the relevant property for IHT purposes is its open market value as required by s.160 IHTA 1984, but it does not include the value of the rights retained by the settlor. In essence, we must ask what a hypothetical purchaser would be prepared to pay for the trust fund at the 10-year anniversary. While we assume hypothetical sale of the trust fund in a real market there is no full-scale day-to-day market in the sale of DGT trust funds, so valuations must largely be guided by actuarial principles. There are a number of approaches that could be adopted but I shall cover the method outlined within the brief from HM Revenue and Customs.
The open market purchaser of the trust fund would be purchasing the right to receive the whole value of the underlying trust fund following the death of the settlor. In determining what to pay, they will need to take account of the expected withdrawals to be received by the settlor between their purchase date and the settlor’s death, and the expected delay between their purchase date and the eventual death of the settlor.
With a DGT, it is possible for the amount that must be paid to the settlor each year to exceed the growth generated by the fund itself. Therefore, the fund may be overly depleted over time. Conversely, the growth of the fund may exceed the sums due to the settlor so that the fund is less depleted over time. HMRC takes the view the purchaser would adopt a prudent approach and would not allow for any growth in the trust fund value, but simply would discount the current value to account for the delay until the fund will be available, being on the death of the settlor.
Therefore, the calculation requires two actuarial discounting factors to be built into the price. Starting with the value of the trust fund at the 10-year anniversary date, the purchaser will first discount the price they will pay to allow for the expected delay between the purchase and the eventual death of the settlor. They will then include a further discounting factor to allow for the settlor’s expected withdrawals between the purchase date and the date of the settlor’s death. The actuarial formulae and calculations are complex but, in essence, the longer the settlor is expected to live, the longer the purchaser will have to wait for their trust fund, the more the settlor will take out year-by-year and so the less the purchaser will pay.
The settlor’s state of health could be important in determining what the purchaser would pay. If life expectancy were significantly below expected norms they will die earlier and theoretically a purchaser might pay more. However, to prevent onerous burdens on trustees in obtaining assessments of medical evidence HMRC has provided a practical approach. That is, provided underwriting was completed on the initial set-up, the valuation at the 10-year anniversary can follow the settlor’s rated age next birthday when the DGT was effected, plus an addition of 10 years for each 10-year anniversary.
As an example, assume a settlor with rated age 75 established a discretionary DGT in 2006, putting £500,000 into trust while retaining a right to periodic payments of £25,000 per annum for life. At the 10-year anniversary the fund stands at £1m. Calculations are based on an 85-year-old. If application of the discounting factors produced a value of £534,250, this is the value of the relevant property for IHT purposes and to which the trust’s available nil-rate band is then applied.
With the calculation of the initial “discount” it is considered essential the purchaser of the settlor’s life interest take out life insurance on the settlor to protect their capital outlay. With the 10-year valuation, the purchaser of the trust fund would not need to insure the life of the settlor and would actually benefit from an early demise of the settlor. It follows that, because life insurance is not required, the methodology should apply irrespective of the age of the settlor at the 10-year anniversary and whether or not life insurance would be available on them.
Paul Kennedy is head of tax and trust planning at FundsNetwork