Both arrangements put an investment bond into trust so that value builds up outside the investor’s estate while the investor keeps access to money. In a loan trust the investor lends cash interest free, repayable on demand, so there is no gift and the loan stays in the estate but all growth belongs to the trust from the start. In a discounted gift trust the investor gives the bond away but keeps a fixed stream of withdrawals, and the gift is valued at the premium less the market value of those retained rights.

How does a loan trust work?

HMRC’s Inheritance Tax Manual describes the typical steps at IHTM20511 and IHTM44113. The settlor makes a small gift to create a trust for others, often within the annual exemptions, and is excluded from benefit. The settlor then lends the trustees a much larger sum, interest free and repayable on demand. The trustees invest the loan, usually in an investment bond, and each year make partial surrenders to repay part of the loan to the settlor.

Because the loan is repayable on demand, IHTM20511 explains that the settlor’s estate is not reduced and there is no transfer of value when the money is lent. The settlor’s estate now holds a debt owed by the trustees instead of cash.

What is the Inheritance Tax result of a loan trust?

For the standard arrangement, IHTM20503 limits the Inheritance Tax claim on death to the original gift by the settlor plus the balance of the loan still outstanding at death, which is part of the estate. Any growth on the invested loan has accrued to the trust and is outside the estate from day one. The arrangement freezes the value of the estate rather than reducing it, and it only reduces it to the extent that loan repayments are spent or given away.

IHTM44113 confirms that the arrangement is not a gift with reservation: the settlor is not a beneficiary of the trust and the making of the loan is not a settlement for Inheritance Tax. No pre owned assets charge arises either, because the settlor benefits as a creditor and not under the trust.

How does a discounted gift trust work?

IHTM20424 describes a discounted gift scheme as a single premium investment, given away through a bare trust or a settlement, with certain rights kept by the donor. The retained rights are usually either:

  • a right to future capital payments if the settlor is alive on each payment date, typically 5% a year of the original investment; or
  • a series of single premium policies maturing on successive anniversaries, payable to the settlor if alive on the maturity date.

Provided the retained rights are sufficiently clearly defined, HMRC accepts that the settlor is not benefiting from the gifted property and the gift with reservation rules in section 102 of the Finance Act 1986 do not apply. HMRC’s Revenue and Customs Brief 22 (2013) treats the retained rights as normally held on bare trust for the settlor, and describes what the trust holds as the right to the whole bond after the settlor’s death. IHTM44112 adds that in the straightforward case no pre owned assets charge arises, because a bare trust is not a settlement for Inheritance Tax.

How is the discount worked out?

IHTM20425 sets the value transferred as the loss to the estate under section 3(1) of the Inheritance Tax Act 1984: the amount invested less the open market value of the retained rights under section 160. That value depends on the settlor’s age, health and insurability at the date of the gift (IHTM20653). If the settlor was uninsurable, the retained rights have only a nominal value and almost the whole premium is a gift.

IHTM20656 sets out HMRC’s basis. The net annual amount of the retained rights is multiplied by a purchase factor of (1 minus p) divided by (p plus i), where p is the annual whole of life premium rate and i is the purchaser’s required return, and 97% of the result is taken to allow for purchaser’s costs. The interest rate used has been 5.25% since 1 February 2009. Brief 22 (2013) explains that gender could no longer be used in pricing from 21 December 2012, so the valuation basis was changed. HMRC’s preference is full medical underwriting at the outset; IHTM20655 says that if no evidence of health was obtained and none can be produced later, a discount is not justified. For joint settlors, IHTM20654 values each settlor’s rights separately and applies the related property rules for spouses and civil partners.

Is the gift a potentially exempt transfer or a chargeable transfer?

IHTM20421 notes that before 22 March 2006 these gifts were normally potentially exempt transfers, but many are now immediately chargeable transfers because they are made into discretionary trusts. A gift into a bare trust version can still be potentially exempt, because section 3A(2) treats a transfer as a gift to another individual where the property becomes part of that individual’s estate, and HMRC’s guidance treats bare trust assets as part of the beneficiary’s estate. For a chargeable transfer, HMRC’s guidance says tax is due at 20% on transfers into trust above the £325,000 threshold, after adding the settlor’s chargeable transfers in the previous seven years, with more tax if the settlor dies within seven years; see the seven year rule.

A discretionary trust holding either kind of bond is a relevant property trust and is subject to the ten year charge. For a discounted gift trust, Brief 22 (2013) says the value charged excludes the settlor’s retained rights, and HMRC accepts a valuation using the settlor’s rated age at the outset plus ten years for each anniversary. The same value is used to test the 80% limit in the excepted settlements regulations.

How are withdrawals and bond gains taxed?

Withdrawals used to repay a loan or to pay the settlor’s discounted gift income are part surrenders of the bond. Under the rule explained at IPTM7615, up to 5% of each premium can be withdrawn each insurance year, cumulatively for 20 years, without an immediate chargeable event gain, but this defers tax rather than removing it; see the 5% withdrawal rule.

When a gain does arise, section 465 of the Income Tax (Trading and Other Income) Act 2005 taxes the settlor, if UK resident, where the bond is held on non charitable trusts they created. Under section 467, once the settlor has died or become non UK resident, UK resident trustees are taxed instead and the gain is treated as trust income, so it is charged at the trust rates for a discretionary trust.

How might the figures look?

Illustration only. Ann lends £100,000 to a loan trust and takes £5,000 a year back for ten years, spending it. At her death the bond is worth £110,000 and £50,000 of the loan is still owed. Her estate includes the £50,000 debt; the remaining £60,000 of bond value belongs to the trust beneficiaries and is outside her estate.

Bob, by contrast, invests £200,000 in a discounted gift trust and keeps withdrawals of £10,000 a year. Suppose the provider’s underwritten valuation of his retained rights is £90,000. The gift is £110,000. If it goes into a discretionary trust and Bob has made no other chargeable transfers in the previous seven years, it is within the £325,000 threshold and no entry charge is due. If he survives seven years, nothing from the scheme is in his estate except unspent withdrawals; if he dies sooner, the £110,000 gift is brought back into account, but the £90,000 discount is not.

What mistakes come up most often?

  • Setting up a discounted gift trust without underwriting, so that HMRC later refuses the discount.
  • Assuming a loan trust removes the loan from the estate. Only growth and repayments that are spent leave the estate.
  • Letting the settlor become a beneficiary of the loan trust, which risks a gift with reservation.
  • Forgetting that discretionary versions need ten year valuations and possibly IHT100 reporting.
  • Taking withdrawals above the cumulative 5% allowance and triggering a chargeable event gain for the settlor.
  • Letting unspent withdrawals accumulate, which rebuilds the estate the scheme was meant to reduce.

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Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 8 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.