The discounted trust as an inheritance tax planning tool explained

When we are planning to mitigate inheritance tax, we know that it is usually only exceptionally wealthy clients who can give away assets, expecting to survive seven years.

A tested way to allow clients to place money outside their estates and continue to receive income withdrawals is by setting up a discounted gift trust.

A discounted gift trust will usually be an investment bond together with a suitable trust. The investment bond can be either onshore (held in the  UK) or administered offshore, for example the Isle of Man, which offers tax advantages and higher investor protection limits than in the UK.
The discount is an actuarial calculation, taking into account life expectancy and the level of income withdrawals taken from the bond. All capital growth on the investment is free of inheritance tax from day one, and the balance of the investment, not immediately discounted, is free of inheritance tax after seven years with taper relief applying from year three onwards.

At the same time the clients can receive tax efficient income, without infringing reservation of benefit rules.

When these arrangements first appeared they were supported by counsel’s opinion. They have now been tested and the Capital Taxes Office has agreed discounts. In fact, the discounts are calculated in accordance with tables produced by HMRC.

Where the bond is administered on the Isle of Man, income and gains accumulate free of UK taxes, even where the settlors and trustees are UK resident. There is no withholding tax on the Isle of Man.

The underlying investments can be managed on an advisory or a discretionary basis, but to gain maximum tax advantage, investment must be in collective investment funds such as unit trusts or investment trusts rather than directly in equities. Investments can be made in cash, fixed interest, corporate bonds, property funds and UK or international equities. Investment strategy should be tailored to meet each client’s requirements, including attitude towards investment risk.

Withdrawals and discounts

Income is taken in the form of regular withdrawals. Where these are up to 5% per annum of the initial investment, these are payable back to the settlor without personal tax liability over a 20 year period. At the end of 20 years, the withdrawal becomes taxable.

If we look at some examples of discounts, where the clients are taking a 5% withdrawal the amount placed outside the estate immediately would be as follows:

Age 60 – 62%
Age 65 – 60%
Age 70 – 50%
Age 75 – 42%

For example, a couple aged 65 investing £300,000 would place £180,000 outside their estate immediately, with £120,000 being a gift.

It is important to remember that the discounted fund is not regarded as a gift, so amounts well in excess of the £325,000 threshold for discretionary trusts can be placed into discounted gift trusts. For example, a couple aged 65 would be able to invest up to approximately £1,080,000 in a discounted gift trust without triggering the 20% entry charge above the nil rate band to discretionary trusts.

Usually, for the bond, I would recommend a capital redemption bond rather than a capital investment bond. Capital redemption bonds have been available since 1988 and are known to and understood by HMRC. These have owners rather than lives assured, so there is no question of a chargeable event on the death of a life assured or a trustee. The capital redemption bond has a lifetime of up to 99 years, so offers a highly tax efficient way of passing money from one generation to the next.

When the investments from the trust are finally encashed, an income tax charge can arise on the profits. Provided that the bond is set up correctly, dividing it into a large number of segments, and the encashment is managed properly, the income tax charge can be minimised. Tax efficient income can continue for successors after death.

The best way to assess the suitability of this type of arrangement, and other tax efficient investments, is to consult a specialist independent adviser.

The Author
Michael Stokes is senior partner, Michael Stokes Financial Planning 
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