Do Discounted Gift Schemes Work?

 In Finance & Investments

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DISCOUNTED GIFT SCHEMES

Inheritance Tax mitigation schemes involving the issue of life assurance bonds are worthy of a sceptical assessment, not least because the commissions paid by insurers to financial advisers who recommend such bonds can be as high as 7.5% of the capital value invested, which will be a potential motivation for self employed advisers and bank employees with targets to meet.

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One such scheme is the Discounted Gift Scheme (DGS). This type of arrangement is well understood by HMRC and they have guidelines on their website as to how they are to be treated under the IHT legislation.

What is a DGS?

In simple terms a DGS is a gift of a life assurance bond with the right to “income” retained. Income is actually a set of withdrawals and in strict terms will usually be capital withdrawals, either in the form of maturing reversions, or the 5% annual withdrawals permitted under the Chargeable Event rules that deal particularly with income tax on life assurance bond gains. Practitioners sometimes call this a “carve out” of rights.

Tax treatment

HMRC accept that if a settlor gives a bond to a trust and retains sufficiently well defined rights, the transfer of value may be determined in the normal way by measuring the loss to the estate under s.3(1) Inheritance Tax Act 1984. The gift with reservation rules do not apply and the value transferred for IHT purposes is the amount invested discounted by the open market value of the retained rights – usually a fixed income for life. So if the settlor dies while the gift is still in the estate, then the value of the gift will be less than the amount settled and there will be a potential tax saving.

From 22 March 2006 it is no longer possible to create settlements during lifetime which are PETs (unless they are for the benefit of a disabled person). Accordingly, if the discounted value transferred exceeds the Settlor’s available Nil Rate Band, IHT at 20% will be payable on the excess. The settlement will be subject to the relevant property regime.

Age is relevant

The value of the income stream clearly depends on how long the settlor can be expected to live and general actuarial principles are accepted as applicable by HMRC. In other words, the settlor’s age, sex and insurability are all relevant. HMRC will treat the value of retained rights as purely nominal if the settlor is well into their 80’s when the gift is made, or known to have a terminal illness. In fact they go so far as to state that there is no evidence to suggest that any life aged over 90 can be insured, so this is adequate evidence that an income stream for life owned by a 90 year old has no market value! This view has been accepted recently in the Executors of Mrs Marjorie Edna Bower (deceased) v HMRC [2008] EWHC 3105. (create link)

Joint settlors?

The issue of joint settlors has been reviewed very recently as different life assurance bond providers were using different methods to value the retained rights. A more age specific calculation is now required. In the view of the author, it is generally not a good idea to set up joint arrangements anyway, and experienced financial planners will almost always recommend single life DGS schemes.

Health issues

It is important that the health of the settlor is established at the time the bond is arranged and HMRC will usually take the view that if no evidence of underwriting at the point of arranging the bond is available, there is no discount. Some providers will obtain the evidence but not reveal it to the settlor (on grounds that they may be upset at a negative prediction as to their life expectancy). This so called “sealed envelope” approach is however unsatisfactory from a planning point of view, as it may be that the evidence of health was that it is very poor and yet the settlor lives on for 2 or 3 years. No discount would be allowed after death (because the retained rights had no market value at the date of gift) and the cost of setting up the plan would have been wasted, aside from which there is the opportunity cost of not having done something else.

Conclusion

In simple terms a DGS will work for a client aged under 80 where favourable medical evidence is obtained before the plan is set up. Most experienced and competent financial advisers will liaise with their client’s legal adviser when setting up a plan, so that everyone is aware of the full process and what to expect when the time comes to calculate the IHT due.

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