Playing it safe

Discounted gift schemes (DGSs) can be presented as a panacea for most IHT problems. They have three characteristics that appeal to many clients:

• A gift is made and part of the value of that gift (for IHT purposes) immediately disappears (the discount).
• The rest of the value disappears after seven years.
• For up to 20 years (or earlier death) the client can still receive an income.

As explained in an HMRC technical note, essentially 'a DGS involves a gift of a bond from which a set of rights are retained, typically withdrawals or a set of successively maturing reversions. The retained rights are sufficiently well defined to preclude the gift being regarded as a gift with reservation for IHT purposes.'

For example: a 75-year-old widower in good health makes a gift of £100,000 to a life assurance bond within a DGS with a chosen return of five per cent per annum reserved back to himself. Because of the reserved return five per cent per annum, the gift has an actuarial valuation for IHT purposes of £65,000.

So, the gift of £100,000 is immediately discounted to £65,000 for IHT valuation purposes and that reduced actuarial valuation of £65,000 will escape IHT if the widower survives a seven-year period. In the meantime, the widower receives £5,000 p.a. tax deferred, i.e. with no tax to pay until the widower's death and possibly none then either.

This is alluringly attractive. As a result, many are sold '“ but there are areas of difficulty which need consideration.

Hidden costs

The first problem is DGSs have costs. Not only can commission be up to seven per cent of the initial value, but there are also the provider's costs and ongoing expenses '“ not least the ubiquitous trail commission. As they say in investment advertisements, what you invest may not be what you get back.

I saw a new client last year who had been to consult a 'wealth manager'. The adviser had recommended that all of the client's spare cash and all investments within the client's ISA umbrella were liquidated '“ some £300,000 '“ and used to buy a discounted gift bond. The client had consulted her son who had become concerned at the commission figure in the key features document '“ just over £20,000. All these costs are paid from the investment so what the beneficiary will ultimately receive would be after these payments.

A mis-selling problem

The commission is a powerful incentive to sell the product. On the 19 September 2009, the Financial Times headlined an article: 'Financial advisers fear impact of new rule.' This is the proposal by the FSA to ban commission from 2013. A startling figure at the bottom of that article was that 85 per cent of IFAs are working on a pure commission basis.

Crucially, the actuarial discount of £35,000 mentioned in the example above would depend on the health of the widower at the time he makes a gift to the DGS. Mis-selling arises because some advisers use standard health assumptions and not specific medical underwriting for the client.

The bond provider will obtain medical evidence based on the specifics, but that evidence is retained in a sealed envelope until death occurs: the financial adviser will complete the application form for the DGS selecting a 'revised discount at the point of death' option. Would the widower or indeed many professional advisers appreciate the significance of that option?

As HMRC explains in its technical note: 'The gift (to the DGS) is a transfer of value for IHT purposes whose value is determined by the loss to the estate principle. This is set out in section 3(1) IHTA 1984 and quantified by the difference between the amount invested by the settlor and the open market value (OMV) '“ section 160 IHTA refers '“ of the retained rights.'

HMRC goes on to state succinctly: 'The OMV of the retained rights will depend on, inter alia, the settlor's sex, age, health and thereby insurability as at gift date. If the settlor were to be uninsurable, for any reason, as at the gift date the OMV of the retained rights would be nominal and the gift would be close to the whole amount invested by the settlor.'

If the death of the client using the DGS occurs within seven years after the purchase of the product and the sealed envelope option has been taken, the bond provider (usually an insurance company) will open the envelope and assess the position. Whoever is administering the estate will receive a letter with a technical explanation and ending with the nub of the matter: the discount is reduced, probably to nil.

The beneficiaries are very likely to be out of pocket because of the costs deducted and possibly also to (bad) investment performance as opposed to remaining in cash. The beneficiaries will take a double hit.

Not only could there be the loss within the investment, but there will also be IHT charged on the sum initially invested.

For example, if £200,000 was invested in a DGS, no discount applies and the value of the bond at death is £150,000, the loss is:

£200,000 - £150,000 = £50,000

Plus IHT on £50,000 loss = £20,000

= £70,000

If the client had taken no action, there would still be the £20,000 IHT to pay on the £50,000: but a different strategy using particularly the section 21 IHTA 1984 relief for gifts from surplus income could have a better outcome (see box).

Access to capital

The general loss of access to the capital is the second problem. I am aware of one provider that sells DGSs with the prospect of obtaining access to capital if trustees agree, but that is no guarantee. Often overlooked is that the access to capital is lost both by the investor and by the beneficiaries. This has led some advisers to question whether there is a better way.

Dennis Hall, president of the London branch of the Institute of Financial Planning, published on the Citywire website on 3 September 2009 an article entitled: 'A case study in beating inheritance tax' (https://www.citywire.co.uk/Personal/-/blogs/ money-blog/ content.aspx? ID=355690).

Hall's solution for his elderly client was to use a purchased life annuity (PLA) with a five-year capital protection period. The article shows how the figures worked out. Fundamentally, instead of £200,000 going into a DGS, £91,475 purchased the annuity (on a gross yield of 10.34 per cent '“ for life) and there was an immediate cash gift of £108,520 '“ a potentially exempt transfer (less possibly £6,000 annual exemptions if available). The gross income of £9,476 p.a. had a deemed return of capital of £6,760 and the balance of £2,716 was taxable. The article contains no mention of the client's income tax circumstances and in particular whether the age allowance trap was a relevant consideration.

Points to note

The two strategies are not mutually exclusive: a client could do both. In practice it can be the initial commission that drives a preference for a DGS. There will be specific medical underwriting undertaken to implement the DGS. It would be better to put in place the resolution to gift surplus income first '“ Bennett makes it clear that for a resolution to be effective there must be the expectation of a reasonable period during which it will remain in force. Medical examinations can sometimes reveal problems of which the client was reasonably unaware.

Equally, if a PLA is part of the solution it is sensible to explore if any health problems exist. A health problem usually reduces longevity and that will increase annuity rates. There are providers who specialise in enhanced (not too severe a problem) and impaired (a significant health problem) rates.

Keep in mind that the cost of the PLA is expenditure that immediately reduces the value of the purchaser's estate. If a capital-protected PLA fell in on death so that protected payments are due to the estate, the actuarial value of the sum of those payments is an asset of the estate for IHT purposes. An interesting innovation would be to gift the capital protected component of the policy at the time the PLA was taken out.