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So-called ‘discounted gift schemes’ have been used in Inheritance Tax (IHT) planning for many years. The basic idea behind them is that a gift is made by a person whose estate is likely to be subject to IHT and the gift is so structured (usually using an insurance product) that the value of the gift for IHT purposes is much less than the practical value of the assets passing out of the estate.
One of the most common ways of undertaking a discounted gift scheme has traditionally been to use an insurance-backed investment bond, which is put in a trust that allows the bondholder the right to withdraw a proportion of the capital over a period of time.
Needless to say, HM Revenue and Customs (HMRC) are not fond of such schemes.
The value of the bond for IHT purposes is based on the price paid for the bond less the value of the right of the bondholder to withdraw capital, on an ‘open market value’ basis. This in turn is dependent on the bondholder’s life expectancy when the bond was taken out.
When a wealthy woman aged 89 invested £340,000 in such a scheme and died less than three years later, HMRC took the opportunity to attack the arrangement. At the date she took out the bond, she had a life expectancy of a little more than three years. She died two years after making the investment, so what had been a potentially exempt transfer for IHT purposes then became a chargeable transfer.
HMRC claimed that the ‘discount’ relating to the bond should be £4,250, leaving a chargeable transfer of more than £335,000. They argued that because of the woman’s very limited life expectancy, there would be no possibility of finding a buyer of the residual right to income in the open market unless there was the security of life cover to mitigate a loss. Her executors argued that the amount of discount applicable should be £49,000 as other security could have been given.
The Upper Tribunal accepted that, in principle, various forms of security could be given that would make the applicable discount greater – but in the real world, no open market for the rights retained by the woman existed.
Although these products have been revamped in recent years, following another similar case, the essential point is that, in circumstances like this, HMRC will adhere to the principle of applying ‘real world’ valuations, not hypothetical ones.