Avoiding Inheritance Tax with Discounted Gift Schemes

Inheritance tax (IHT) is payable at 40 per cent on the net value of a person’s estate above (2010/11 rates) £325,000 (the current nil rate band). It affects an increasing number of people owing to the rise in house prices in recent years. One straightforward method of avoiding IHT is through discounted gifts.

Discounted gifts can be made by a donor setting up a discretionary trust (this is usually done with a single premium investment bond) with a flexible power of appointment.

For IHT purposes, the valuation of assets gifted is based on the ‘loss to the estate’ as a result of the transfer of the property and is calculated on the value when the assets are transferred into the trust. HM Revenue and Customs (HMRC) will estimate the amount that is likely to be returned to the donor through the income they draw, based on their age and health. With discounted gift schemes, the valuation HMRC then place on the transfer will be less than the amount actually invested, creating a discount. This discounted amount is the valuation of the transfer of assets for IHT purposes, creating an immediate potential tax saving.

Discounted gifts are Potentially Exempt Transfers (PETs), meaning that if the donor survives seven years after making the gift, the trust property normally drops out of the estate altogether and becomes exempt from IHT. Any growth in value is also exempt from IHT liability.

As well as the IHT saving, this type of arrangement has the advantage of providing regular income payments for the donor during his or her lifetime. Also, because the assets are no longer within the estate, the trust beneficiaries can receive the trust funds on the testator’s death and will not need to wait for probate.

The downside, however, is that such schemes are not very flexible. The donor will lose all rights to the capital invested once the trust has been drawn up and will not benefit from any investment growth, although they will be able to receive a regular income.

Discounted gift schemes are best suited to people who have some certainty about their financial status. They are also more advantageous where the donor is confident of surviving seven years, in order to utilise fully the tax saving. As with any tax planning device, especially where trusts are being created, it is important to seek professional advice as to whether it is the best option, given your individual circumstances.

At least one major insurer is offering such schemes which, according to counsel’s opinion, will not fall foul of the IHT charges introduced on some trusts in the Finance Act 2006.