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Sweet clarity

Discounted gift trusts – Phil Carroll, UK tax and estate planning manager at Skandia, welcomes teh recent HMRC guidance clearing up confusion over DGTs and also the consultation with the industry to discuss the issues.

In recent months, there has been mixed comment in the market on discounted gift trust schemes. Thankfully, a degree of clarity was added to the discussion on May 1 when HM Revenue & Customs issued a guidance note outlining its views on DGTs and the basis it uses when calculating discounts.

Understanding the value of the discount is absolutely crucial because the bigger the discount, the more of the investment is taken out of the estate and therefore the greater the potential inheritance saving. The new guidance came into effect on June 1.

HMRC’s aim in issuing this guidance was not to change its stance radically – and indeed HMRC confirmed that it did not actually make any fundamental change to its overall approach towards DGTs.

It did, however, confirm that the latest guidance is “more precise than previously” and, with different practices taking place in the market, it is a positive step towards a more uniform approach being adopted.

In summary, the guidance note clarified HMRC’s views in three areas:

– HMRC has specified the actuarial methodology that it uses in the valuation of gifts. This is crucial for determining the discount available on a DGT and therefore affects the amount of IHT payable. HMRC has confirmed that the value of the gift will be based on the settlor’s sex, age, health and insurability as at the date of the gift. It has also outlined its current assumptions on mortality and interest rates for this purpose.

– HMRC has also confirmed the technically correct methodology for valuing joint-settlor cases.

Whereas previously in joint-settlor cases (typically, husband and wife), many providers assumed that the discounted value of a gift could be shared equally between the two individuals (that is, 50-50), HMRC has confirmed that the correct approach, which some providers have been using for several years, is to value each individual’s discount based on their own sex, age, health and insurability as at the date of the gift.

In effect, this means that the correct discount will be allocated to the correct settlor. For example, consider a 70-year-old male and a 60-year-old female, both non-smokers, who together invest £200,000 in a bond held through a DGT and take 5 per cent withdrawals.

Previously, some providers would have attributed the discounted potentially exempt transfer or chargeable lifetime transfer to be split 50-50 between husband and wife. However, the guidance confirms that the right discount should be applied to the right individual, which in this case would mean a split of 43 per cent attributed to the older life and 57 per cent to the younger life.

– HMRC has confirmed that whole-life underwriting should be carried out for DGTs before the gift is made. Again, some providers have already adopted this stance although for others this will involve a change in practice.

Additionally, HMRC stated that due to market changes, it will use a higher interest rate assumption of 6 per cent in calculating discounts from June 1, reflecting the change in gilt yield returns.

This change alone will mean the discounted Pets or CLTs will be smaller than previously. As a result, more of the investment is inside the estate and therefore potentially subject to inheritance tax.

What does this mean for advisers? DGTs have been a cornerstone of IHT planning over the past few years. Available as either bare of discretionary trusts, onshore and offshore, they offer a wide range of flexibility.

The good news is that the guidance notes should give practitioners in the IHT sector clarity when advising in this market and they can put IHT strategies in place with a much clearer understanding of what HMRC expects when establishing a DGT. This clarity should also enable providers to address some of the inconsistencies associated with these arrangements.

For many clients, the new guidance means discounts will reduce, increasing the importance of starting IHT planning at a younger age.

Budget Notice 25 seems a long time ago but 16 months on from the most radical changes to the IHT arena for nearly 20 years, the extra clarity now available for this type of planning can only help advisers to develop effective strategies to reduce clients’ ever-increasing IHT liabilities.

Another point for advisers to be aware of is the issue of medical evidence. Although not specified in the guidance, it is clear from recent cases that HMRC’s view is that medical evidence should exist prior to the declaration of trust. The definition of full medical evidence will no doubt be debated in times to come, but in principal medical evidence is crucial in obtaining a discount.

Aside from the clarity provided by the guidance, it was encouraging to see the consultation process working well in practice. HMRC took the opportunity and engaged with various interested bodies within the industry.

Time was taken to consult with practitioners and the Association of British Insurers before issuing the guidance, which should be welcomed.

For some providers the practical changes are minimal, but a more standard approach to calculating discounts in the industry is to be welcomed, as it is going to make things more straightforward for advisers.

Improved confidence in this area could provide a boost to the DGT market. It is encouraging to see changes being thought through in detail before being implemented and we hope it continues.

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