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Discounted gift schemes

Over the past few years there has been a multitude of UK anti-avoidance legislation introduced, specifically the Disclosure of Tax Avoidance Schemes 2006

This legislation has proved to be quite successful for HMRC as it requires those promoting and using various tax avoidance strategies to tell HMRC all about it, or risk being hit with penalties when HMRC become aware of it.


The primary purpose of this ‘rolling’ legislation is to enable HMRC to immediately counter any strategy they perceive as damaging to the public purse or at the very least, ensure that where appropriate, suitable provisions are contained in subsequent Taxes Acts to make sure it does not work. As such, many tax strategies now have a finite operational lifetime.


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 often overlooked when considering Inheritance Tax planning is using a Discounted Gift Scheme. The good news is that HMRC know all about them, have specific web pages on the subject and even produce guidance notes which clarify how a scheme must work for them to accept any IHT saving being suggested. So whilst no current tax planning is guaranteed to ever work ‘ad infinitum’, I think it’s fair to say that HMRC are pretty comfortable with the idea at this present moment in time.


What do they do?

Some of you may already be quite familiar with the concept. However, for those of you that are not (and a refresher for those that are), Discounted Gift Schemes 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.


There are various ways of setting them up. However, more often than not they are 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.


Usually, where an individual gifts an asset into Trust and subsequently retains access or obtains a benefit from it, it is considered by HMRC to be a Gift with Reservation of Benefit (GROB). However, HMRC do accept that properly structured trusts, such as Discounted Gift Schemes, which carve out rights before a gift is made are not subject GROB.


An important point here is that the income being paid to the Settlor is fixed at outset and cannot be varied. Furthermore, the Settlor must spend these payments otherwise they will be increasing the value of their estate.


Example

John is aged 65, his home is worth £400,000 and he has a liquid estate of £500,000. John is looking to minimise 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 (£325,000) Nil Rate Band Net Estate Value of £575,000 X 40% = IHT liability of £230,000


The thought of his estate paying this amount of 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


Home £400,000 Discounted Gift Trust £244,903 Less current (£325,000) Nil Rate Band Net Estate Value of £319,903 X 40% = IHT liability of £127,961


Using a Discounted Gift Trust could save his estate over £102,000 if he were to die in the next 7 years. However, providing he survived this period of time, the entire amount placed in the trust would be exempt.


So those are the positives. You do, however, need to be mindful of certain issues which may take the shine off the benefits in years to come.


Discount chasing

Where similar products are being considered, it may be tempting to simply recommend the provider who is suggesting the largest discount. It should be remembered that the discount is only of significance should the client die within the next 7 years and furthermore, only HMRC can agree it.


The amounts suggested by all insurers should be there or thereabouts if they are working to the HMRC guidance notes and, as such, should not really be a distinguishing factor. If one provider’s estimation is significantly higher than the rest, then unless you are confident that it is being produced on the correct basis, the personal representatives of a deceased client could be in for a series of protracted negotiations with HMRC. An insurer can only ever suggest a potential discount - it cannot guarantee it, irrespective of how it is portrayed in its documentation.


Underwriting

HMRC make it absolutely clear that for any discount to stand a chance of being accepted, the client must have been 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 client had to apply for insurance to cover their life, only that their state of health was such that obtaining cover would have been possible.


Where this cannot be demonstrated, HMRC are likely to disregard the insurer’s suggested discount and, at best, replace it with something very nominal indeed. Thorough underwriting is vitally important otherwise potential problems are brewing for personal representatives dealing with the deceased’s estate should they die within 7 years of creating the trust.


For this reason, it is remarkable that some clients still choose to take advantage of a ‘sealed envelope’ underwriting service whereby the client is only underwritten where they die within 7 years of creating the trust, rather than at outset. Whilst this may enable a client to obtain the maximum suggested discount, it also creates the problem of retrospective underwriting in that the deceased’s personal representatives will have to provide HMRC with evidence that the client was insurable.


Unlike underwriting at outset, if questions are raised once the envelope is opened, being brutally honest, the only medical assessment a client is likely to have undertaken recently is a post mortem. Therefore, justifying any decision in respect of insurability is not going to be easy. Where sealed envelope underwriting is to be used it would be prudent to ensure that a client had comprehensive medical records and, where possible, undertaken a full medical assessment prior to undertaking the planning. You can see that insurability may be difficult to argue.


Trust Features

The schemes currently on the market fall in to two camps in that they are either trust based, or product based. Trust based schemes are far more flexible in that, whilst an insurance bond may be the initial trust property, the terms of the trust afford the trustees the ability to replace the bond with other property should they feel the need to do so. Product based schemes usually restrict the trust property to the provider’s bond only, and can contain restrictions as to the earliest the bond can be surrendered.


Other important differentiators are the options as to whether other property can be held alongside the insurance bond, whether additional transfers can be made, the ability to defer taking income and finally, whether there is any option to create a separate trust fund that can be used solely by the Settlor.


So, although Discounted Gift Schemes do offer significant IHT benefits which are acknowledged by HMRC, all of the factors discussed in this article do need to be taken into consideration to ensure that the planning is as robust as possible.


Key points:


° This planning can be particularly successful for clients who want to make IHT-effective gifts but require an income


° Income payments must be spent


° On death within 7 years, the value of the failed transfer is the discounted amount, not the original value


° Schemes should not be selected on discount factors alone


° Quality underwriting is paramount to the success of the planning


° Trust based schemes offer more flexibility.


Important notes

Please note, the information contained in this article is based on our current understanding of Her Majesty’s Revenue and Customs law and practice as at April 2010.