For high-net-worth expats, transferring assets to beneficiaries without subjecting them to a substantial inheritance tax (IHT) bill is a significant concern.
While establishing a trust can be an effective strategy to reduce potential IHT liabilities, it requires you to relinquish control over those assets permanently, which may not align with your financial goals.
A discounted gift trust (DGT) can address these issues by reducing your estate’s value while granting you controlled access to the capital within the trust. This guide will explore how a discounted gift trust works, what its benefits and restrictions are, and what tax implications you should be aware of.
What You Will Learn
- What is a discounted gift trust, and who is it suitable for?
- How is the value of the discount determined?
- What steps are involved in setting up a DGT?
- What are the tax implications of a DGT arrangement?
- What are the advantages and drawbacks of using DGTs for expats?
What Is a Discounted Gift Trust?
A discounted gift trust is an arrangement that allows the settlor to transfer a portion of their assets into a trust to reduce the inheritance tax for their beneficiaries while retaining the right to receive predefined capital payments for the rest of their life or until the trust is depleted.
With a traditional gift trust, once the assets are settled into the trust, you are no longer permitted to access them. Failing to relinquish all rights to the assets in the trust, the settlement is considered a gift with reservation, diminishing the trust’s effectiveness as an IHT-reduction tool.
Discounted gift trusts allow you to alleviate future inheritance tax bills and draw predetermined amounts of capital at regular intervals. Your beneficiaries are entitled to receive the remainder of the trust fund when you die. The value of the gift transferred into the trust is discounted by the value of the retained benefits, mitigating the future inheritance tax.
How Do Discounted Gift Trusts Work?
DGTs are usually funded using investment bonds because they offer:
- Medium to long-term growth potential
- Tax-deferred withdrawals within the legal limit
- The ability to be assigned to a trust, individual, or different fund without triggering capital gains tax
In addition, bonds don’t produce regular income, such as dividends and interest, which means that income tax is not imposed on investment growth.
Whether you are investing the capital in an onshore or offshore investment bond, the DGT provider will need to calculate the value of the payments you will likely draw from the fund.
The estimated value of the future withdrawals is referred to as the discount or settlor’s fund, while the value of the invested capital, less the discount, is known as the discounted gift or residual fund.
How Is the Discount Calculated?
The discount is calculated based on the hypothetical price a buyer would pay to purchase your right to future payments from the capital, taking into account several key factors, including:
- Life expectancy: Your age and health status determine whether you qualify for a discount and how long your capital payments will last. Generally, a doctor’s report is considered sufficient evidence of health, but in some cases, DGT providers may request a complete medical examination.
- Level of capital payments: The more withdrawals you are likely to take during your lifetime, the larger the discount you will receive. You can set the date you want to start taking withdrawals, choosing the payment frequency that suits your needs—monthly, bi-monthly, quarterly, half-yearly, or yearly. You can also defer the withdrawal start date for up to five years.
- Potential tax exposure: You can receive regular payments of up to 5% of the capital annually without incurring an income tax charge.
His Majesty’s Revenue & Customs (HMRC) prohibits settlors with poor health or those aged 90 or older from receiving immediate discounts.
It also reserves the right to review and readjust estimated discounts, meaning that the actual discount received may be lower. However, HMRC discount assessments only occur after the settlor’s death.
Types of Discounted Gift Trusts
There are two main types of discounted gift trusts, each offering varying degrees of flexibility, control, and inheritance tax benefits:
- Absolute discounted gift trust
- Discretionary discounted gift trust
Absolute Discounted Gift Trust
An absolute discounted gift trust, also known as a bare discounted gift trust, is a financial arrangement that cannot be altered once it is set up. You cannot remove or add new beneficiaries, and you can’t reallocate shares if circumstances change.
The discounted gift portion is considered a potentially exempt transfer (PET) for inheritance tax purposes. However, if you die within seven years of establishing the trust, and the value of the discounted gift portion exceeds the nil-rate band (NRB), which is currently £325,000, the excess amount will be liable for IHT at the rate of 40%.
If your death occurs 3–7 years after setting up the trust, a taper relief may be used to reduce the tax due, depending on your time of death:
| Years Between the Gift Establishment and the Settlor’s Death | The Percentage of the 40% IHT That Is Still Payable |
|---|---|
| 0–3 | 100% |
| 3–4 | 80% |
| 4–5 | 60% |
| 5–6 | 40% |
| 6–7 | 20% |
The retained benefits are not classified as gifts for inheritance tax purposes. While they remain part of your estate, they will have no value for IHT purposes even if you pass away within seven years of establishing the trust.
An absolute trust is the preferred method for transferring assets to minor beneficiaries or heirs who may not be able to manage their inheritance independently.
The trustees will oversee the trust fund and make appropriate distributions after you die and, in the case of minors, after they turn 18.
Discretionary Discounted Gift Trust
A discretionary discounted gift trust offers a more flexible structure for transferring assets, allowing you to name a class of beneficiaries without granting them absolute rights to the capital from the trust. Instead of specifying beneficiaries, you will designate a group of individuals, such as a surviving spouse, children, or grandchildren. Your trustees will decide how and when to distribute the benefits within the designated group, so any specific allocations you make will be treated as a non-legally binding recommendation.
Assets placed into a discretionary discounted gift trust qualify as a chargeable lifetime transfer (CLT) on which an entry charge may apply immediately if the discounted gift exceeds the NRB.
This is typically levied at 20% on the excess amount, or 25% if you choose to settle the tax yourself. The sum of other CLTs you’ve made in the preceding seven years will be subtracted from the NRB to determine your remaining tax-free allowance.
If you survive for seven years after setting up the discretionary discounted gift trust, the discounted gift will be removed from your estate, and no inheritance tax will be incurred.
Should your death occur within seven years, the gift will be reassessed. If the total IHT at the death rate (40%) exceeds the amount already paid, an additional 20% tax may be due on the portion above the NRB.
Note that for discounted gift trusts to be efficient at mitigating inheritance tax, the amount and frequency of the payments you intend to withdraw in the future must be determined at the outset.
You can structure the withdrawals as equal payments or gradually increasing sums over time, but the payment terms cannot be changed once the trust has been finalised.
Additional Taxes To Be Aware Of
On top of inheritance tax, there are additional reporting obligations and tax charges to consider when using a discounted gift trust:
| Type of Charge | Amount / Trigger | Explanation |
|---|---|---|
| Periodic charge | Up to 6% of the trust fund. | If the value of the trust fund, not including the discount, at the time of each 10-year anniversary, is above the current NRB, the excess amount will be subject to the periodic tax charge. |
| Exit charge | Up to 6% | Based on the periodic charge rate at the last 10-year anniversary, apportioned by the time since that anniversary. Applies to capital distributions made after 10 years. |
| IHT100 filing obligation | Value exceeds 80% of NRB | Trustees must submit HMRC form IHT100 at the 10-year anniversary if the trust value exceeds 80% of the NRB, even if no tax is due. |
| TRS registration | Within 90 days of trust creation. | UK-resident or UK-taxable trusts must register with HMRC’s Trust Registration Service (TRS) and update records every 10 years or upon changes. |
Income Tax Considerations
Income taxes may be incurred on any gain from a chargeable event, such as the following:
- A full surrender of the policy
- An assignment in part or whole of the policy for money or money’s worth
- The death of the last life insured under the policy
- The maturity of the policy
- Withdrawals above the 5% annual tax-free allowance
Income tax will be charged on the excess withdrawals over 5% and any gains realised from other chargeable events. However, the tax payable will depend on the party liable for it.
The beneficiary bears the tax liability for gains from an absolute discounted gift trust, irrespective of age, unless they are the settlor’s minor child. In such a case, the settlor is charged with paying tax on gains exceeding £100.
Under discretionary discounted trusts, the applicable tax rate and person responsible for paying vary according to the circumstances at the time the charge arises, as highlighted in the table below:
| Person Liable for the Tax | DGT Income Tax Rate |
|---|---|
| The settlor, if they are alive and a UK resident | Highest marginal rate |
| UK resident trustees, if the settlor is dead or a non-UK resident | 45%, less a basic rate tax credit of 20% |
| The beneficiary, when receiving a distribution from the trust | Personal income tax rate |
Who Can Benefit From a Discounted Gift Trust?
Discounted gift trusts can be an excellent estate planning solution for you if:
- You are between 18 and 75 years old and in reasonably good health, which means that you’re likely to live longer and may require access to an additional source of income
- You want to maintain your standard of living by retaining access to the capital via steady, fixed withdrawals.
- You are not comfortable with gifting away all of your disposable assets.
- You need to reduce your UK IHT immediately.
If you have investments and beneficiaries in multiple countries, a DGT allows you to minimise UK tax exposure, simplify cross-border asset management, and reduce legal complexities that can emerge under different inheritance laws.
For instance, some jurisdictions have stringent rules governing wealth distribution amongst beneficiaries, especially for expats who die intestate.
A DGT allows you to pass on assets to preferred beneficiaries based on what you deem appropriate. Compared to certain financial planning vehicles that may have geographical restrictions, a DGT can be established and used from anywhere, providing additional convenience to expats.
What Are the Drawbacks Associated With a Discounted Gift Trust?
Although a discounted gift trust is an appealing inheritance tax planning vehicle for UK expats with considerable wealth, it carries certain risks that should be carefully considered, such as:
- Strict withdrawal rules: Once the trust is set up, you cannot modify the stipulated payment amount and frequency even if your financial needs change. The withdrawals you can take annually without incurring income taxes are capped at 5% of the investment’s value.
- Use of withdrawals and IHT risk: HMRC expects the retained withdrawals to be spent for personal use. If these payments are reinvested, gifted, or allowed to accumulate within your estate, they may be deemed not effectively removed from your estate for inheritance tax purposes. This could reduce the trust’s effectiveness in mitigating IHT.
- Potential tax consequences: Income tax may become payable if you withdraw more than the 5% annual tax-deferred allowance, after 20 years of 5% withdrawals, or when the bond is surrendered.
- Ineligible discounts: When you die, there is no guarantee that HMRC will accept the estimated discount provided by the investment company. If the discount amount isn’t confirmed, it could result in a higher IHT bill than anticipated.
- Loss of control over capital: You cannot add to, reclaim, or access the invested capital outside of mandatory withdrawals after it’s placed in the trust.
Secure Your Complimentary IHT Planning Consultation
Discounted gift trusts offer powerful IHT benefits – but only when structured correctly. In a free consultation with Titan Wealth International, you will:
- Assess whether a discounted gift trust suits your estate and income needs.
- Understand the tax and legal implications across jurisdiction.
- Learn how to structure withdrawals for maximum IHT efficiency.
Key Takeaway
Mitigating inheritance tax liabilities is an important concern for expats with significant assets who want to gift a portion of their wealth while retaining access to capital during their lifetime.
In this guide, we’ve outlined the different structures you can use to set up a discounted gift trust based on your requirements and financial goals. We’ve also examined the tax implications associated with each strategy and explained the methodology used to calculate the discount that would apply to the gift placed in trust.
Given the complexity of discounted gift trusts, it is highly recommended that you seek guidance from qualified financial and tax advisers.
At Titan Wealth International, our experts can assess your financial situation to determine whether a discounted gift trust is right for you. They offer strategic advice on reducing your IHT tax liability and avoiding financial mistakes that could affect the trust’s efficacy.
