SPOTLIGHT ON: PENSIONS AND INHERITANCE TAX

Transcription

1 SPOTLIGHT ON: PENSIONS AND INHERITANCE TAX

2 PENSIONS AND INHERITANCE TAX THE FUNDS HELD WITHIN A PENSION ARE USUALLY EXCLUDED FROM THE SCHEME MEMBER S INHERITANCE TAX (IHT) ESTATE. THIS IS AN INTENDED CONSEQUENCE OF THE STRUCTURE OF PENSION SCHEMES, PARTICULARLY THAT WHICH RELATES TO DEATH BENEFITS, WHICH ARE OFTEN HELD UNDER A DISCRETIONARY TRUST. UNDER THIS STRUCTURE THE MEMBER IS NOT ENTITLED TO DEATH BENEFITS AND SO THEY ARE NOT INCLUDED WITHIN THEIR ESTATE. NOR ARE THEY INCLUDED WITHIN ANY OF THE BENEFICIARIES ESTATES UNLESS AND UNTIL DEATH BENEFITS ARE PAID TO THEM E.G. A LUMP SUM DEATH BENEFIT OR A PAYMENT FROM A BENEFICIARY DRAWDOWN ARRANGEMENT. This is the usual and ideal scenario, but there may be some circumstances where the value of an individual s pension can be included within their estate. The payment of death benefits direct to the estate is the most obvious of these but, with the exception of some older plans such as some Retirement Annuity Contracts, it is unusual for death benefits to be paid out in this manner as they are being intentionally paid to the estate. Leaving the pension scheme trustees to decide who receives death benefits from a discretionary trust avoids this outcome. So, assuming the pension scheme is structured in the most IHT-efficient way, the pension fund should not be paid to or included within their estate. There are, however, three common circumstances where a value relating to a pension scheme can result in an IHT liability. These are: the payment of contributions which we will look at in turn. lifetime transfers of death benefits pension transfers 1

3 PAYMENT OF CONTRIBUTIONS Gratuitous intent A transfer of value for IHT purposes takes place if there is intent to confer gratuitous benefit: in other words, intent to make a gift for which nothing is received in return. CONTRIBUTIONS IHT is payable on the value of a person s estate on death after deducting any assets that are covered by an exemption, and adding the value of any assets (again, assuming they were not IHT exempt) that were given away in the seven years leading up to death. This is to prevent taxpayers making death bed gifts to avoid IHT. The inclusion of such amounts is notional and covers assets that were given away with the intention of reducing the value of the estate. A cash gift of 100,000 to a sibling, for example, three years before death would be added to the taxpayer s estate on death: it was made within seven years of death, there was a clear reduction in the value of the estate; and intent to make a gift. In contrast, 100,000 paid to an ex-spouse as directed by a divorce settlement three years before death is not included because the reduction in the estate s value was not intentional. More precisely and in language familiar to those acquainted with IHT legislation there was no intent to confer gratuitous benefit. The payment of contributions to a pension scheme also reduces the capital value of the estate when they are made. So, are these considered transfers of value? Should they be included in the estate if the member dies within seven years of making them? The general answer is no: there is no intent to confer gratuitous benefit, so nothing has been given away. Instead, the member is buying something with their money: entitlement to future retirement benefits. The immediate value of the estate may have reduced, but it has been replaced with something else of similar benefit a more secure retirement. As there is no loss to the estate, there are no IHT consequences. Pension contributions made during lifetime, however, can sometimes be considered transfers of value for IHT purposes. The most obvious reason being that the member made a contribution whilst in serious ill-health. The usual explanation that the contributions are generating future retirement benefits is not necessarily the case as the member is aware they may not live long enough to receive them. The contributions are more likely to enhance the death benefits available to the nominated beneficiaries, so the transfer from the member s bank account to the pension fund, within which they sit outside of the estate, could represent a loss to the estate. These contributions, to the extent that they are not covered by an exemption or allowance, may be treated as transfers of value for IHT purposes. HM Revenue & Customs (HMRC) employ an arbitrary two year cut-off point to determine which pension contributions may have IHT consequences. Generally, contributions made more than 2

4 PAYMENT OF CONTRIBUTIONS two years before death are not considered; those made within the two year period can be investigated to determine if they were made at a time when the member was aware of their ill-health. This doesn t mean that contributions made within two years will always have IHT consequences, or that more distant contributions never will, rather the former were more likely to have been made at a time when serious ill health was apparent to the member and will attract greater scrutiny. Intent to confer gratuitous benefit, however, must still be established. Examples Peter, who is terminally ill, pays 160,000 to his personal pension having paid no contributions in previous years. He dies 6 months later. His death within 6 months of making the contributions is well within the two year timeframe so HMRC will investigate the client s circumstances. His contribution history and the fact that he made the full contribution after being made aware of a terminal illness will probably lead HMRC to conclude that the contribution was a transfer of value for IHT purposes. Paul also pays a 160,000 contribution to his personal pension. A month later he is advised he has less than a year to live and dies 11 months later. His death within one year of making the contributions is well within the two year timeframe so, again, HMRC will investigate Paul s circumstances. As he made the contribution before he became aware of a terminal illness, it is unlikely HMRC will treat the contribution as a transfer of value for IHT purposes. In other cases similar to Peter, it will not always be the case that contributions made within two years of death whilst aware of a terminal illness are transfers of value. Contributions that were part of an ongoing sequence that were not amended by the member after learning of limited life expectancy may be excluded as intent could be difficult to establish. Contributions to registered pension schemes made within two years of death must be detailed on form IHT409 by the executors of the estate. 3

5 LIFETIME TRANSFERS OF DEATH BENEFITS LIFETIME TRANSFERS OF DEATH BENEFITS Where a pension scheme member who is in good health makes an assignment of their death benefits that is they set up a trust or make a binding nomination over them there are normally no IHT effects. The death benefits have no value in these circumstances, which means there is no loss to the estate when they are assigned. A member in ill-health, on the other hand, should be cautious about redirecting the death benefits, as they could have a calculable value which could add to, or create, an IHT bill. HMRC s general view is that an assignment of death benefits made at least two years before death is not considered a transfer of value for IHT purposes. Whereas, an assignment made within the two year period may be. Again, this is not a hard and fast cut-off point, rather a rule of thumb that enables assignments that are more likely to have been made during a period of ill-health to be highlighted. Any assignments that were made within two years of death must be noted on form IHT409 by the executors. This will prompt HMRC to investigate the client s circumstances to determine if the member knew of their ill-health at the time they made the assignment. If sufficient evidence is available the value of the death benefits can be included in the deceased s IHT estate, and the usual route of appeal is available to the executors. It is important to set out what types of assignment can be caught by these rules. The majority of defined contribution schemes hold death benefits within a discretionary trust, which gives the trustees the final say over the recipient of the death benefits. The member completes a nomination of beneficiary, which is a recommendation to the trustees and not a binding declaration, which the trustees should take into account. In many cases they will pay the benefits to the beneficiary nominated, however they have full discretion to pay them to someone else. During the member s lifetime, as circumstances change, the nominated beneficiary should be reviewed and, if appropriate, amended. As a discretionary trust does not have any beneficiaries with an interest in possession, such changes do not constitute a change of beneficiary and should not have IHT consequences. This is the ideal scenario, but not all pension schemes are designed with such IHT efficiency. Certain pension schemes e.g. NEST, under their current structure do not pay death benefits from a discretionary trust. This would usually mean that death benefits fall within the estate of the member when they die. A member in this position may be able to create a trust for the pension death benefits that excludes them as a beneficiary or a binding nomination to pay to a specific individual. Either represents a clear assignment of the death benefits away from the member s estate, so if at the time of the trust s creation the death benefits have a value caused by the member s ill-health this could lead to transfer of value for IHT purposes. Other events that fall into the assignment category include a member creating a binding nomination over death benefits already held under a discretionary trust. This is not recommended as the death benefits could be being brought back into the estate unnecessarily. Furthermore, little is achieved by the creation of a new trust for the death benefits. In most cases it will be preferable to simply update the nomination of beneficiary, which could if control is important to the member - recommend payment to a separately established pilot/bypass trust with suitable trustees in place to manage the funds when they are paid out. 4

6 PENSION TRANSFERS PENSION TRANSFERS The most topical aspect of pensions and IHT is pension transfers shortly before death. The recent Staveley case has brought these rules under the spotlight, in particular HMRC s treatment of pension transfers made within two years of death at a time when the member was aware of serious ill-health. The current rules can treat members as having made a transfer of value in these circumstances, which can increase the liability to IHT on their death estate. HMRC s reasoning is that when a pension is transferred, any trust holding death benefits is brought to an end, allowing the member to redirect them elsewhere. Even if the member sets up an identical arrangement to deal with the death benefits, such as transferring to a scheme with a discretionary trust and completing an identical expression of wish, they still had the choice to redirect the death benefits to their estate. Using this logic, HMRC will in some cases seek to treat the member as though they had brought the death benefits back into their estate and then disposed of them. Death within two years of this at a time when the member was aware of their ill health giving the death benefit a greater value can result in the value of death benefits being added to the estate. Many have doubted the validity of this approach as one consequence is that a member of a personal pension with death benefits subject to a discretionary trust who transfers to another personal pension provider with a very similar death benefit structure could be subject to IHT charges on the value of those death benefits, even though the before and after pictures look almost identical. The Staveley case answers some of these doubts but, as with many legal cases, there were many factors at play which make it difficult to draw broad conclusions. A brief history of this case is helpful before looking at its consequences for pension transfers. Mrs Staveley and her husband set up a company to which was attached an Executive Pension Plan (EPP). In 2000, after a bitter divorce, Mrs Staveley s benefits under the EPP were transferred to a section 32 contract, which separated her and her ex-husband s funds but, under rules in force at the time, did not fully sequester them as the overfunded section 32 could still be required to pay funds back to the employer Mrs Staveley s ex-husband. Fortunately for Mrs Staveley, the Pension Simplification changes in 2006 allowed her to transfer her section 32 benefits to a personal pension plan, which severed the link between her benefits and the employer eliminating any chance of excess benefits being returned to her ex-husband. She followed this through in November 2006, the sole motivation of which appeared to be to prevent her ex-husband (via his company) from benefiting from any part of her fund. Complicating matters was Mrs Staveley s ill health at the time of transfer: she was terminally ill with cancer, and died the following month. HMRC determined that a transfer of value for IHT purposes had occurred in November 2006: there was a lifetime transfer of death benefits from one scheme to another creating a new trust over the death benefits; the client knew of her ill-health at the time; and subsequently died within two years of the transfer. Mrs Staveley s executors and two children the recipients of the death benefits from the personal pension appealed against HMRC s decision to the first-tier tribunal. HMRC argued to include a value relating to the death 5

7 benefits in Mrs Staveley s estate on two points: a transfer of value for IHT purposes and the omission to take benefits. The second point is no longer relevant due to recent legislative changes that have effect from 6th April 2011 onwards, so we will focus on the transfer of value. An IHT bill is calculated based on transfers of value or deemed transfers of value. In this case there was a clear transfer of value: the death benefits, which were part of Mrs Staveley s estate, were transferred to the discretionary trust used to administer death benefits by the personal pension scheme. But a loss to the estate is not a transfer of value for IHT purposes if there was no intent to reduce the estate s value. Mrs Staveley s sole reason for making the transfer was to ensure there was no risk that any part of her fund would be returned to her ex-husband s company. That this might have been a perceived, rather than real, risk did not alter her intent. The transfer of value did not, therefore, have any IHT consequences because of Mrs Staveley s intentions, which were not related to reducing the value of her estate. The first tier tribunal (FTT) did not agree with HMRC and overturned their decision to include a value relating to the pension fund in her estate. HMRC s appeal on this point to the upper tax tribunal (UTT) also failed. The unique factors at play in this case clearly won t apply to every pension transfer, but a number of relevant points which will have relevance for many cases were brought out, in particular a comment by the FTT: The entire premise of s 10 is that a benefit is conferred. It presupposes that the benefit did not exist before and is newly conferred. If Miss Wilson [for HMRC] was right, a transfer from one PPP to another PPP for commercial reasons (perhaps to get a better rate of return) without any change in beneficiaries, would be caught. We do not think that this was intended by Parliament. Thus, whilst the case did not deal with one personal pension plan being transferred to another, it would appear that HMRC might have difficulty upholding a decision to attach a value to any death benefits that are transferred between these schemes for purely commercial reasons. However, other than to get a better rate of return, it is not clear what constitutes a commercial reason. Further case law will be needed to clarify this, including whether transferring to take advantage of Freedom & Choice falls into this category. Where there is a clear transfer of value, HMRC must be able to demonstrate that the transfer was intended by the scheme member to reduce the size of their estate for IHT purposes. Where they cannot do this, there should be no IHT consequences. Advisers dealing with transfers whilst in ill-health should understand the principal reason for transferring and decide whether an appeal on this basis is likely to succeed. Either way, the potential IHT liability should be explained to the client. 6

8 SUMMARY Most pension benefits will be outside of the reach of IHT during the member s lifetime and upon their death. It should not be assumed that this is the case, however, particularly for older or more specialised schemes. The scheme death benefit structure should be checked to ensure that a discretionary rule or some other IHT-efficient method for distributing the death benefits is in place. If the death benefits are to be paid to the estate and could result in an IHT liability a trust (or a binding nomination depending on the scheme) should be executed to direct them elsewhere to the spouse, say, or dependent children or other relative. Schemes that pay out death benefits under a discretionary rule should create few IHT issues for members, but the nomination a beneficiary should be kept under review, which will aid the trustees when the time comes to distribute funds. The post-death position should also be considered: a beneficiary could create an IHT liability for themselves by receiving a lump sum death benefit. An elderly widow, for example, who opts to receive a lump sum death benefit from her deceased husband s pension may be increasing the value of her own estate beyond the IHT nil-rate band. Such clients could be better advised to leave the death benefits in a beneficiary drawdown contract and only receive the funds that are needed or will be spent before death. Death benefits can be retained in a beneficiary drawdown arrangement in this manner until they are exhausted, keeping the residual funds outside of any beneficiaries estate. Contributions, assignments and transfers made whilst the member is suffering ill-health should be made with caution, but they can be made without IHT consequences if there are clear, genuine non-tax reasons for making them. A detailed record of the primary reasons for transferring will help the personal representatives in the event that HMRC attempt to include the value of death benefits in the estate. As always, the non-tax considerations may be more important than any potential IHT. Taking action that generates an IHT liability could be the best course of action if it enhances the death benefits more than the resulting increase in tax. Scottish Widows Limited. Registered in England and Wales No Registered office in the United Kingdom at 25 Gresham Street, London EC2V 7HN. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Financial Services Register number /17