The current Finance Bill, now undergoing Parliamentary scrutiny, contains page upon page of draft legislation required to implement the pension changes announced in 2010. Tucked away in Schedule 16 is the following:
“Where a person who is a member of a registered pension scheme, a qualifying non-UK pension scheme or a section 615(3) scheme omits to exercise pension rights under the pension scheme, section 3(3) above does not apply in relation to the omission.” Section 3(3) is a reference to the Inheritance Tax Act 1984.
What does this actually mean?
It provides that the inheritance tax charges for “omissions” for example, deliberate failure to buy an annuity in relation to registered pension schemes, qualifying non-UK pensions (Qnups) and section 615(3) superannuation schemes will no longer apply.
Deliberate omissions to exercise a right where the wealth of another individual is increased as a result will, in non-pension situations, continue to be regarded as transfers of value.
This legislative change effectively reverses the Tax Tribunal’s decision in the Fryer case (Fryer & Ors v HMRC  UKFTT 87). In that case, a widow, suffering from advanced cancer, decided not to vest a section 32 buyout plan. She died shortly afterwards never having taken the retirement benefits available. The judge held that she had a valuable right the right to a pension commencement lump sum and an annuity and by failing to exercise it, the value of her estate on death had fallen. That fall in value had to be “added back” in, determining the amount on which IHT was levied.
Arguably, the decision in the Fryer case had some unsatisfactory aspects but is important because it gave judicial support to the long-held HMRC view that deferring pension benefits while in serious ill-health was an IHT transfer.
The decision in the Fryer case was published in March 2010. Why the quick volte-face by HMRC? Could it possibly have anything to do with the 55 per cent income tax charge on all lump-sum death benefits paid from pension schemes for deaths after age 75? Death benefits for those who die before age 75 without having taken a pension will be tax-free.
Registered pension schemes do not enjoy a general exemption from IHT. However, there are specific provisions which grant relief in many situations.
Most pension schemes would be “settled property” for IHT purposes. This means that without relieving legislation they would fall into the discretionary trust tax regime with potential entry charges, 10 yearly charges and exit charges. However, specific exemptions provide the following:
1: Contributions by individuals or close company employers are not regarded as chargeable transfers and so are not subject to IHT
2: Scheme funds are not subject to the IHT charge which would otherwise arise every 10 years on the then current market value of the fund
3: IHT will not apply to distributions of capital from a scheme if paid within two years of notification of death. This exempts payment of a lump sum on a member’s retirement or payment of a death benefit to a member’s surviving spouse or civil partner
4: On the death of a scheme pensioner or annuitant, the IHT estate would not be regarded as including any part of the scheme funds relating to that pension or annuity except in respect of future payments due under a guarantee.
Given all these benefits, a logical approach to IHT planning would have been to finance all living expenses from non-pension assets at least until age 75 had been attained. These assets are “IHT-able”, so consuming them would potentially lessen exposure.
However, until now, there has been a significant drawback to such a strategy. The UK inheritance tax code contains an anti-avoidance provision Inheritance Tax 1984 section 3 (3). As outlined above, this basically provides that an omission to exercise a right can be a transfer of value for inheritance tax purposes if that omission has the effect of diminishing an individual’s estate and increasing another’s estate.
The changes set out in Finance Bill 2011 mean that section 3(3) will no longer be an issue in relation to registered pension schemes, assuming that they become law. It should now be possible to develop planning approaches as follows:
- Draw on non-pension income and capital to fund living costs until age 75 and leave pension funds untouched, safe in the knowledge that with effect from April 6, 2011 section 3 (3) will not apply. Taxable assets will be diminished. The pension funds will not form part of the client’s IHT estate
- Individual savings account investments will have an important role in meeting spending needs in a tax-efficient manner. Investment bonds will also have a part to play.
- When the client reaches the age of 75, it would seem logical to vest pension benefits; why risk the 55 per cent fund tax charge on what would otherwise be tax-free cash?
- Post-75 years old, conventional IHT planning can be used. Consideration could be given to using flexible or capped drawdown to create surplus income from which exempt gifts could be made. Strategies aiming to avail of the “normal expenditure from income” exemption could become popular.
- The pension commencement lump sum (“tax-free cash”) could finance a discounted gift trust to provide income supplements in retirement and offer a degree of IHT protection.
Alternatively, the pension commencement lump sum could be used to establish a loan trust again with the objective of providing income supplements in retirement.
The repeal of section 3(3) in relation to pension funds has widened the spectrum of potential planning strategies. These will offer advisers an opportunity to connect with their clients, solicitors and accountants and demonstrate a sophisticated approach to planning issues.