Discounted gift trusts may not always be so tightly wrapped

A recent tribunal judgment on the disputed value of a PET has highlighted the pitfalls of wrapping inheritance tax planning in a discounted gift trust.

Discounted gift trusts (DGTs) are popular arrangements for inheritance tax (IHT) planning. A major attraction to many users and advisers is the ‘discount’. This discount reflects the fact that payments from the trustees to the settlor fall back into the latter’s estate. Without the discount there would potentially be double taxation, on the original gift and on the payments made to the settlor.

The availability of a discount for an elderly client has always been a bone of contention. It was thought that the Bower case (heard by the High Court in 2008) had settled most of the doubts around the calculation of the discount. However, some advisers thought that the HM Revenue & Customs (HMRC) approach had elements of unfairness. A second case, heard by the Tax Tribunal late in 2011, considered an alternative approach to the valuation issue.

This case in point concerned Kathleen Watkins, who died on 18 March 2006, aged 91 years and one day. On 21 December 2004 (when aged 89 years and nine months) she established a discounted gift trust using a Royal Skandia capital redemption bond as the underpinning asset. She had made an inheritance tax potentially exempt transfer (PET) which ‘failed’ on her death and became a chargeable transfer. The issue in this case was the value to be placed on the PET.

Watkins’ two sons, David and Keith, were the trustees of the trust, which divided into two funds: the first called ‘the settlor’s fund’ for the absolute benefit of the settlor, and the second a residual fund for the named beneficiaries, namely David and Keith.

Clause six of the trust deed provided that ‘the trustees will pay or transfer capital of the settlor’s fund to the settlor… of the amount and at the frequencies stated in the third schedule’.

Establishing value

The third schedule specified level payments of 10% per annum of the single premium for the trust property (the Skandia bond), payable quarterly for the life of the settlor.

This was quantified at £4,250 per quarter, or £53,273 over the actuarially reckoned life expectancy of Watkins of 3.1337 years. A medical report on Watkins dated 20 October 2004 was taken into account when making the actuarial projection.

The value of her interest (ie the ‘discount’) was assessed (by Royal Skandia) to be £53,273. The HMRC view was that the appropriate discount was £4,250 (ie one quarter’s payment).

The value of the PET was the amount transferred to the trustees (the premium) minus the value of the settlor’s interest.

So, what was the value of the payment stream to which Watkins was entitled? The executors’ approach was to establish whether buyers of the type of interest retained by Watkins would be interested in purchasing her rights and how they would value them.

In so doing, they paid particular regard to the mortality risk: the factor that the risk of her death before her actuarially estimated lifespan would terminate the income stream.

Mortality risk

The executors argued that the mortality risk could be secured on physical or financial assets, rather than needing to be covered by a life policy. To support their argument, they put forward six different scenarios in which the mortality risk would be effectively eliminated:

(a) Security for the risk of early death could be given by a charge on assets, either of the settlor or the beneficiaries.

(b) The price for the income stream could be paid by phased payments, matching the release of income.

(c) The beneficiaries could underwrite the purchaser’s mortality risk.

(d) The ‘remaindermen’ under the trust (the beneficiaries in this case) could purchase the settlor’s rights on their own account, thus advancing the retained income.

(e) The remaindermen could take the opportunity of the income stream being sold to sell with it all, or the relevant part of, their interest in the trust, thus acquiring capital early.

(f) The purchase price of the payment stream could be deposited in an escrow account. Amounts would be released to the purchaser as payments were received from the life office. In the event of the settlor’s early death, the balance in the escrow account would be returned to the purchaser.

HMRC’s argument

HMRC deployed an actuary as an expert witness. Although there was no market in the sale of income streams from discounted gift trusts, there was an established approach for valuing interests, such as life interests, absolute reversionary interests and contingent reversionary interests, derived from a trust.

There was evidence that purchasers were not willing to take a mortality risk without life cover on the life tenant. It was not possible to obtain life assurance on the life of a woman who was over 89 with a life expectancy of only slightly more than 3.1 years.

HMRC’s expert witness had analysed transactions arranged through Foster & Cranfield (auctioneers and valuers of financial rights and interests) and the results supported the life cover argument.

The judge said the executors’ views were ‘speculations on what would be possible or even probable; they are no doubt well informed on the matters on which they opine, but there is cited no factual foundation in previous or similar transactions to refer to’.

However he also said: ‘It is true that the evidence adduced by the Crown is limited, and not entirely on all fours with the facts of this case, but it shows a consistent pattern of behaviour over a significant period of time in regard to rights which are very similar to those in this appeal.’

That clinched the case in favour of HMRC. ‘Ingenious though the appellants’ [the executors] formulations may seem, they do not pass the test that they are identifiable with any type of open market that exists,’ said the judge.

It is rumoured that the executors will appeal. However it will be difficult to overturn the tribunal’s decision.