Transfers into these trusts are chargeable lifetime transfers (to the extent that they are not otherwise exempt). Tax is payable at one half of the death rate (20%). Where the settlor pays the tax, the transfer of value is grossed-up (divided by 80% if over nil-rate band) to reflect the overall loss to the settlor's estate.

For example, if a client created a discretionary trust in 2010/11 for £342,000 and no exemptions were available, tax of (£342,000 ¬£325,000) x 20% = £3,400 would be payable by the trustees. If the settlor paid the tax, the transfer of value would be grossed-up to £4,250 (tax at 80% = £4,250).

The table below shows the tax payable if the settlor were to die within seven years. The tax is recalculated at 40% using the nil-rate band (NRB) applicable at death (in these examples, the NRB assumed is £325,000). Tax already paid by the trustees is credited (up to the extent of the liability) and taper relief may reduce the liability after three years.

Note that despite tax paid being greater than the total tax payable in the later years, there is no tax refund available. After seven years, the settlor’s NRB will be available again.

Where a discretionary trust is created by two settlors, for IHT purposes each settlor is treated as making a settlement and will be separately assessed for initial, periodic and exit charges. For example Mr and Mrs Jones created a discretionary trust for £676,000, each contributing £325,000, therefore initial charges if paid by trustees £338,000 - £325,000 (NRB) x 20% = £2,600 for each settlor.

Assets and cash (property) which are held in an IIP trust created on or after 22 March 2006 or are held in a discretionary trust are defined as relevant property. Where any property ceases to be relevant property (the property is distributed to beneficiaries), it will be subject to an exit charge based on the time that has elapsed since the commencement of the settlement or from the date of the last 10-year anniversary, if later.

The rate of tax chargeable before the first 10-year anniversary will be an appropriate fraction of the 'effective rate'. For this purpose, the appropriate fraction will be 3/10ths multiplied by 1/40th for each successive quarter since the commencement of the settlement. Any quarter expiring before the day on which property became comprised in the settlement will be ignored. Please note: the 'effective rate' is the average rate that would be charged if an individual had made a chargeable lifetime transfer (CLT) equal to:

i. the value of property comprised in the settlement or related settlements (ie created on the same day by the same settlor) immediately after it commenced, and
ii. the value of property subsequently added to the settlement immediately after its addition.

In determining the rate of tax applicable to the above mentioned transfers, any chargeable transfers made by the individual during the seven years immediately before the transfers will be taken into account – but not potentially exempt transfers (PETs) unless they later become chargeable by reason of death within seven years.

In many cases, particularly where the settlor had made no chargeable transfers in the seven years preceding the settlement, there would be very little, if any, tax payable on property ceasing to be relevant before the first 10-year anniversary. Indeed, a settlor, having made no previous CLT, may deliberately settle assets within his NRB knowing that there would be no exit charge before the first 10-year anniversary.

Initial Charge

Mr Green settles £213,000 into a discretionary trust on 1 May 2010, having made no previous gifts (other than his annual exemptions which have been used elsewhere).

Exit Charge

The trustees distribute £10,000 to Miss Green and £15,000 to Master Green on 1 May 2013.

Hypothetical CLT

Where a distribution is made in the first 10 years, the IHT payable is calculated by taking into account the settlor's chargeable transfers in the seven years before he settled the discretionary trust plus the initial value of the trust fund.

Initial Charge

Mr Hill settles £425,000 into a discretionary trust on 15 May 2010, having made no previous gifts (other than his annual exemptions which have been used elsewhere).

Exit Charge

The trustees distribute £50,000 to Miss Hill on 15 May 2013 (assuming tax was payable out of the £50,000 so that no grossing up was necessary).

Hypothetical CLTs

Where a distribution is made in the first 10 years, the IHT payable is calculated by taking into account the settlor's chargeable transfers before he settled the discretionary trust plus the initial value of the trust fund.

Initial charge

Mrs White made a CLT of £325,000 to a discretionary trust in January 2010. She is creating a further discretionary trust for £50,000 in February 2010 by transferring a further £50,000 to the trustees of this trust.

Since her cumulative total of previous transfers has used up Mrs White’s NRB, the transfer into the second trust will be immediately chargeable at 20% (one half of death rate). 

Assuming the settlor pays the tax, it is necessary to gross up the value of the gift by 20% to reflect the total loss to Mrs White's estate.

Thus her gift becomes:

Exit Charge

If the trustees distributed £15,000 from the additional discretionary trust in February 2013 (assuming the tax payable is out of £15,000 so no grossing up was necessary).