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UK Inheritance Tax Planning - Discounted Gift Scheme

Every year, the UK Government introduces new anti-avoidance legislation making it harder to mitigate UK taxes.

Now I must stress that whilst tax mitigation is perfectly legal, it isn't something which is wholeheartedly embraced by Her Majesty's Revenue and Customs (HMRC) and woe betide anyone who intends to deprive George Osborne of another 'ivory back-scratcher'.


Joking aside, the difficulty of course with ever changing legislation is that it makes planning for the future a difficult thing to do and for this reason, many advisers and clients are reluctant to get involved in anything remotely 'racy', preferring instead to stick to tried and tested methods of mitigating tax liabilities


One such method when considering UK Inheritance Tax Planning (IHT) is the Discounted Gift Scheme. This planning opportunity has been around for many years, HMRC know all about them, have specific web pages on the planning opportunity and even produce guidance notes which clarify how a scheme must work in order for them to accept any IHT saving being suggested. There have also been many test cases through the courts over the years reinforcing the principals/features that the planning must adhere to, in order for it to be successful.


So, whilst no tax planning is guaranteed to ever work 'ad infinitum', I think it's fair to say that HMRC are pretty comfortable with the of Discounted Gift Schemes at this point in time.


Now, many of you may not currently be UK resident and will quite rightly be wondering how this type of planning is of relevance. If you are UK resident for tax purposes, you are liable for UK Income and Capital Gains Taxes. If you are not UK resident, then you are generally only liable to UK Income Tax on any UK source income. However, if you are UK domiciled you are liable to UK IHT on your worldwide assets where those assets exceed £325,000 (referred to as the Nil Rate Band) at 40%. As such, whilst it can be relatively straightforward to be non-UK resident, it's far more difficult to become non-UK domiciled, especially if you plan to live in the UK at some point and/or were born in the UK and maintain significant ties to it.


So what do Discounted Gift Schemes do?

They can:

  • Provide an immediate IHT saving on the value of an amount transferred should the transferor die within 7 years of making a gift into trust.
  • Exempt the entire value of a gift from IHT where the transferor survives for 7 years or more.
  • Provide an income for life or until such time as the trust fund is exhausted.

So how do they work?

They are usually used in conjunction with an Insurance Bond which is then assigned to a suitable trust.

Prior to the establishment of the bond/ trust, the bond applicant (and Settlor of the trust) is underwritten by the product provider to determine whether or not they would be insurable

(HMRC's principal requirement).


Once insurability has been determined, an actuarial calculation is performed which takes into account the applicant's life expectancy and their income requirements to arrive at a present day value for the amount of payments the Settlor of the trust is likely to receive during their lifetime.

These payments are usually referred to as the 'Settlors Rights' and when deducted from the amount transferred result in the initial gift being 'discounted' hence the name.


Why is Underwriting required?

HMRC make it absolutely clear that for any discount to stand a chance of being accepted, the applicant must be deemed to be insurable under a whole of life assurance contract at the time the trust was created. Now HMRC are not saying that a person has to actually apply for insurance to cover their life, only that their state of health is such that obtaining cover would have been possible. The rationale behind this requirement is that for the income stream to have any value, it must be capable of being sold in the open market and any prospective purchaser would only buy the income stream if they could insure the life on which it is being paid.


Example

John is aged 65, his home is worth £400,000 and he has a liquid estate of £500,000. John is looking to minimize the value of his estate which will be assessable to IHT upon his death. He arranges to meet his financial adviser to look at his current position and discuss the options available to him.


Current IHT Position

Home £400,000
Liquid Assets £500,000
Less current Nil Rate Band (£325,000)

Net Estate Value of £575,000 X 40% = IHT liability of £230,000


The thought of his estate paying this amount of UK IHT nearly sends John to meet the grim reaper there and then however, his adviser suggests that he replaces his liquid assets with a Discounted Gift Scheme.


John is underwritten and found to be in good health deemed to be insurable by the product provider; he has requested annual payments of £25,000 to supplement his pension income. After taking into account various factors, the product provider estimates that the value of John's £500,000 gift to the trust could be reduced to £244,903 if he were to die within 7 years, whilst at the same time providing him with an annual income of £25,000.


Potential IHT Position with Discounted Gift Scheme

Home £400,000
Discounted Gift Trust £244,903
Less current Nil Rate Band (£325,000)

Net Estate Value of £319,903 X 40% = IHT liability of £127,961


Using a Discounted Gift Scheme could save his estate over £102,000 if he were to die in the next 7 years however, providing he survived the full 7 years, the entire amount placed in the trust would be exempt whilst at the same time providing an ongoing income.


Discounted Gift Scheme key points

  • This planning can be particularly successful for those who want to make IHT effective gifts but require an income.
  • Income payments must be spent otherwise all you are doing is increasing the value of your estate.
  • On death within 7 years, the value of the failed transfer is the discounted amount not the original value.
  • Quality underwriting is paramount to the success of the planning.