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Tony Wickenden: Discounted gift trusts rules remain intact

Tony Wickenden Tax Planning Technical Area

The new GAAR guidance notes were published recently.

In the examples on inheritance tax was confirmation that Discounted Gift Trusts will not be attacked under the GAAR.

That DGTs were used as a specific example is, as it has turned out, a very good thing. HMRC stated at the beginning of the example on DGTs that “This example illustrates the scope of the gift with reservation of benefit rules as the same have been approved in case law and accepted by long-established practice.”

Well, that’s what we all thought – but it’s nice to see it in (official) writing.

The gift with reservation rules were designed to combat – for IHT – an arrangement where an individual gives assets away but continues to use or enjoy the assets or otherwise benefits from them. In that case, generally speaking, by operation of the GWR provisions the assets are treated as if they are still owned by the donor and are subject to IHT on the death of the donor under the reservation of benefit provisions. These provisions were introduced in 1986 and (subject to certain statutory let-outs) generally prevent the taxpayer from enjoying property after they have given it away. The aim is to stop what are termed “have your cake and eat it” arrangements.

Under a DGT the settlor makes a gift of an insurance bond into settlement but retains certain rights in the insurance bond. Typically, the rights retained may be in a series of single premium policies maturing on successive anniversaries of the creation of the settlement or to future capital payments if the settlor is alive at the prospective payment date.

The arrangement is viewed as a “carve-out” or “shearing arrangement” so that provided the rights in the bond retained by the settlor are sufficiently clearly defined they are not taxed on the value of the gifted property. The rights are therefore split into a retained fund for the settlor, which is effectively held on a bare trust, and a settled fund from which they are excluded and which is held for other beneficiaries such as their children. The retained fund comprises the right of the settlor to withdraw a certain fixed amount – usually 5 per cent from capital each year for the next 20 years if alive. The transfer of value they are treated as making for inheritance tax purposes is the value of the settled fund that they give away and is substantially discounted as a result of their retained rights.

Within the arrangement, the settlor has precisely defined the interest they have retained and the interest they have given away. They cannot benefit in any way from the gifted interest and so there is no reservation of benefit.

HMRC has confirmed in guidance that the retained fund is held on bare trust for the settlor. Hence the para 8 Sch 15 Finance Act 2004 pre-owned assets income tax charge does not apply to this fund, nor does it apply to the settled fund given that the settlor is excluded from this.

But how, if at all, will the GAAR apply?

Broadly speaking, there are three main questions to ask to test if an arrangement is caught under the GAAR provisions – if we accept that tax saving is one of the main objectives of the exercise and that a tax “reduction” is secured by the arrangement.

The first is this: “Are the substantive results of the arrangements consistent with any principles on which the relevant tax provisions are based (whether express or implied) and the policy objectives of those provisions?

In the Ingram case, the House of Lords held that the policy of the legislation was to identify precisely what property had been given away by the donor and what (if anything) was retained. They noted that there is nothing in principle behind the “gifts with reservation” provisions that stops the donor carefully dividing up their cake, giving away a slice and retaining the remaining cake. Continued enjoyment of the latter does not amount to a reservation in the former. Arrangements of the type adopted are known as “shearing” operations.

Sections 102 A–C Finance Act 1986 were introduced to stop shearing arrangements in relation to certain carve-out schemes over land. Hence the policy on such arrangements has clearly been altered by legislation and the effect of the GAAR in relation to such tax schemes must be considered in this light.

However, this does not mean that all carve-out arrangements have been stopped. The House of Lords has indicated that such arrangements are not necessarily against the principles behind the legislation and no legislative action has been taken in relation to other types of asset to stop such arrangements. The discounted gift scheme can be seen as a classic shearing operation on property other than land.

The second is this: “Do the means of achieving the substantive tax results involve one or more contrived or abnormal steps?”

Creating two distinct funds or a carve out may be considered contrived.

But there’s an important third question: “Do the tax arrangements accord with established practice and has HMRC indicated its acceptance of that practice?”

Well, common or garden DGTs accord with established practice. HMRC’s manuals do not suggest that the reservation of benefit provisions should apply in the settlor’s situation and confirm that the pre-owned assets tax regime does not apply. HMRC’s Technical Note of May 2007 provides guidance on how the value transferred should be calculated and HMRC will challenge cases where this methodology is not adopted.

HMRC concludes that, arguably, the settlor’s scheme contains a contrived step. It may be argued that it is outside the “spirit” of the reservation of benefit rules in allowing the taxpayer to give away property but still benefit from it. However, the House of Lords has held that carve-out arrangements where the taxpayer has carefully defined what they have given away are not caught by the reservation of benefit rules and HMRC has not sought to disturb this ruling in relation to assets other than land. In addition, the arrangements accord with established practice and so are not within the scope of the GAAR.

The reassurance is no doubt welcome.

Tony Wickenden is joint managing director at Technical Connection

Through Techlink Professional, you can access CII and IFP-accredited CPD, a full and up-to-date technical library, technical updates, business generation ideas and, through our additional ASKservice, case-related technical support. Techlink Communicator delivers content for regular client and professional adviser communication. Go to www.techlink.co.uk and click the Free Trial link. Go to www.technicalconnection.co.uk for more details on our services or call 020 7405 1600.

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