Two of the biggest challenges to effective inheritance tax (IHT) planning are the donor’s desire for continuing control over the assets being considered for gifting and/or access to those assets.
The control bit can be relatively easily overcome with appropriate trusts. The access bit is a bit trickier. Legislation in the shape of the gift with reservation and pre-owned asset tax provisions sees to that.
Of course, IHT doesn’t represent a huge challenge in relation to a pension fund or an interest in a trading business owned for two years. Control and access both delivered.
Any planning with a main residence is always going to be difficult from an IHT standpoint and potentially challenging on emotional grounds too.
From 1 May, the rate of interest used when valuing the retained rights under DGTs increased from 4.5% per annum to 6.75% per annum
That said, the industry has been pretty successful in designing plans founded on financial products and trusts to overcome the stated challenges and not be caught by the anti-avoidance legislation.
Most notable well-used solutions are the loan trust and the discounted gift trust (DGT).
Both are tried and tested, avoid the Disclosure of Tax Avoidance Schemes (DOTAS) provisions (in the case of the DGT, provided the scheme used was established practice before 1 April 2018) and need to be registered under the Trust Registration Scheme – a relatively simple process.
I am not going to go over how these innovative and relatively long-standing solutions work in granular detail. I fully expect anyone who’s got this far into the article to know that. Suffice to say the loan trust delivers a way to give away the future growth on the investment (a UK or offshore investment bond). Effectively a kind of “freezer trust”. The lender retains access to the original capital.
The change was a long time coming and suggests HMRC had just forgotten about DGT
With a DGT, the donor retains the right to a flow of regular payments throughout their life – but no access to capital. The “discount” comes from the fact the value of what is given into trust is diminished by the value of the retained right to the “income” payments from the trust.
Of course, this discount is only relevant if the settlor dies within seven years of making the gift. But it is relevant and a really big selling point for the DGT.
So, for those for whom this kind of planning might be appropriate, there is a degree of importance attached to any change that affects the level of the discount.
From 1 May, the rate of interest used when valuing the retained rights under DGTs increased from 4.5% per annum to 6.75% per annum, in accordance with a policy paper from HM Revenue & Customs.
As stated, broadly, when someone sets up a DGT, there is a transfer of value for IHT purposes. This transfer is quantified as the difference between the amount invested and the open market value of the retained rights. The retained rights are effectively payable to the settlor(s) for the remainder of their lifetime.
So, what affect does an increase in the interest rate have on the discount applied to the value of the amount transferred by way of gift when a DGT is established?
The HMRC interest rate basis is unclear
The answer is that the rise in interest rate from 4.5% to 6.75% will reduce the value of the retained benefit (think of it as a higher interest rate making an annuity cheaper per £1 of income). The corollary is that the discount used to calculate the value of the gift also falls.
We do not have a copy of the mortality tables used for the valuation basis, but it’s possible to work backwards from existing discounts to get an idea of what the new rate would be.
For example, if, for a 65-year-old with 5% withdrawals, the current discount was 66.88%, that would go down to about 56%. For a couple aged 65, the difference would be between about 77% and 61%. The discount reduction shrinks as age increases.
The change in interest rate was a long time coming and suggests HMRC had just forgotten about DGT.
The HMRC interest rate basis is unclear. Its latest paper says, “Yields on medium to long-term gilts have increased over the last year” but also adds, “In addition, the Bank of England has increased interest rates to 4.25% now”.
To muddy the waters more, the only other reference to a basis we can find goes back to the original technical note in 2007, which refers to “a 1% differential over short-term gilts”.
Tony Wickenden is managing director of Technical Connection
Comments