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Avoiding the pension IHT traps

Passing on any residual pension scheme benefits particularly when the scheme member is aware they are seriously ill, is an area littered with potential inheritance tax pitfalls. John Woolley points out some of the ways to avoid the tax traps.

The increased size of death benefit payouts from pension plans means that HMRC is taking a greater interest in any relevant inheritance tax liability that may arise on the payment of such death benefits.

The IHT rules that apply to pension plans can be complex and are littered with traps for the unwary. It is therefore vital that practitioners, who advise on pensions (particularly pension transfers), are familiar with these possible IHT implications. 

In particular, if a pension scheme member is aware that he is in serious ill health, extreme care should be taken when considering the following:

  • paying a substantial pension contribution
  • placing the death benefits of a pension plan under trust
  • transferring pension rights from one provider to another – say, to a self-invested or another personal pension
  • changing the profile of income drawdown/phased retirement benefits in a way that has the effect of enhancing the value of the fund.

In the event of death within two years of any of these events (and depending on the precise facts of the case) there could be an IHT charge because the individual will be treated as making a transfer of value under section 3(1) IHT Act 1984.

Up until recently, as well as claiming that there was a transfer of value for IHT purposes, in cases where the pension scheme member was aged over 50 (now 55), and so able to draw benefits, HMRC could also claim that a transfer of value had arisen because the individual had deliberately failed to exercise a right.

Therefore, on his death he would also be treated as making a gift of the value of the pension benefits he could have taken but did not.

Fortunately, since 6 April 2011, there is no longer a need to worry about an IHT charge arising because an individual fails to exercise a right. This potential charge (under section 3(3) IHT Act 1984) has now been withdrawn as part of the legislation that imposes a 55 per cent tax charge on lump sum death benefits paid when somebody dies either with crystallised pension benefits or is aged 75 or over – irrespective of whether the benefits are crystallised.

However, the risk of a transfer of value still exists for people who make the transactions described above whilst in serious ill health. This means that anybody who knows that they are in serious ill health and has a pension plan with substantial death benefits should exercise care before making any changes to it.

TRANSFER WHILST IN ILL-HEALTH

The starting point in considering this issue is to appreciate the circumstances in which an IHT charge can apply to death benefits under a pension plan. 

Declaration of integrated trust 

 One such circumstance is where a member declares a private integrated trust of death benefits under a pension plan. In such cases, typically the pension scheme rules will provide that in the event of the member’s death, then if the member has declared a personal trust of death benefits, the scheme administrator must pay those death benefits to the trustees of that personal trust.

Where an individual sets up an integrated trust for their pension death benefits a transfer of value will be deemed to have occurred under s3(1) IHTA 1984. However, if the member dies within two years of making such a transfer then the deceased member’s personal representatives will need to tell HMRC of the transfer when they make the IHT return to HMRC (by completing the form IHT 409).

Where the individual was in good health when he made the personal trust, the transfer of value is deemed to be nominal because it is very likely the individual will live to retirement age and draw his benefits.

On the other hand if the member was in serious ill health when he made the transfer and knew this, here will be a measurable loss to his estate and a consequent measurable transfer of value will arise. This would be based on the amount of the death benefit and the member’s mortality at the time of transfer.

Advisers therefore need to be careful in placing a retirement annuity, section 32 or, depending upon circumstances, the death benefits of a personal pension into trust where health and life expectancy of a client is an issue.

Pension transfer

Whilst the analysis above may be logical, unfortunately, that cannot be said in the case of a pension transfer.

Here the pension scheme member will frequently be moving from one pension provider to another for commercial reasons, for example to pay lower charges, to access more investment options (ie. via a Sipp) or as part of a pensions consolidation exercise. Moreover, both the current pension scheme and the new pension scheme will often be subject to a trust under which the trustees/scheme administrator have a discretion to pay death benefits to a range of beneficiaries – excluding the member and possibly his estate.

So one would assume there would be no IHT implications in transferring from one pension scheme to another – the member will normally be in exactly the same position as far as the payment of death benefits is concerned and obtains no additional IHT benefit over the current position. 

Unfortunately, that is not the way HMRC views such a situation.

In such cases, HMRC takes the view that, when the transfer is made the individual has, in effect, surrendered his rights under his old pension plan in return for rights under the new pension plan.

Whilst the funds do not physically rejoin the member’s estate during transit, what does form part of the member’s estate is the right to determine the terms of the payment of death benefits in the new scheme. In HMRC’s view this right has a value because the member could direct that death benefits under the new scheme are paid to his estate. Consequently, there could be a loss to the estate if the arrangement for the payment of the lump sum death benefits under the new pension plan means that his estate will not benefit.

In this respect HMRC takes no account of the reality of how the receiving scheme can actually deal with death benefits – it simply assumes that when he makes the decision to transfer, the member had the option to choose a scheme under which he could direct that death benefits would be paid to the estate.

In such circumstances, again, we are looking at a transfer of value under S3(1) IHTA 1984 which, as above, would need to be reported in the IHT 409 if the individual were to die within two years of the transfer. HMRC takes the view that an IHT charge could result if the individual knew he was in serious ill health when he made the transfer.

HMRC analysis

In more detail, HMRC’s reasons for the application of section 3(1) IHT Act runs as follows: 

●            The death benefits of the member’s previous pension plans were subject to discretionary trusts 

●            These trusts were subject tothe member’s statutory right to transfer to a new scheme

●            When the member chooses to transfer his pension benefits, he surrenders all rights under the previous scheme in return for completely new rights under the chosen transferee scheme. He is able to do this even if he had irrevocably assigned his death benefits under the previous scheme on discretionary trusts. That direction would not, of course, apply to the payment of equivalent benefits under the transferee scheme

●            When making the transfer, the member could therefore have transferred to a new scheme and directed that the death benefits should be paid to anyone that he wished – including, of course, his own estate

●            The member chose the new pension scheme and, on his instructions, the new death benefits were written on discretionary trusts outside his estate

●            The “right” to determine the terms of payment of the new death benefits was an asset of the member’s estate for IHT purposes. That “right” is “property” itself in terms of the definition in section 272 IHT Act 1984 and has a value in the open market envisaged by section 160 IHT Act 1984

●            So when the member exercised that “right” by choosing to give away the new death benefits there was a loss to his estate for IHT purposes

●            This loss to the estate has to be valued on the normal “before and after” basis i.e. what the member had before (i.e. effectively the “right” to all the benefits the transfer payments would provide) less what he was left with after the transfer (ie. the right to take retirement benefits). Hence actuarial calculations are normally required. 

Fortunately, the position is not as bad as it used to be. For deaths prior to 6 April 2011, where a person in serious ill health made a pension transfer and did not survive two years, there could have also been a charge under section 3(3) IHT Act 1984 on the basis that the member had the right to take tax free cash and pension but failed to exercise that right and so the value of these benefits would be part of the member’s taxable estate on death. This would only be where the member was at an age where he could draw retirement benefits.

As mentioned earlier, this charge (under section 3(3)) has now been removed and so, for those aged 55 or over, in calculating the transfer of value under section 3(1), the value of the pension benefits that the member could have taken immediately before he died can be deducted in determining the transfer of value under section 3(1).

Conclusions

Whilst HMRC’s view on this is not wholly satisfactory, it is the definite view they take. Advisers must therefore be very careful if they are advising a client in serious ill health to transfer pension rights to another pension provider.

The moral of the story is to be very careful with any pension transfer for any client who is in serious ill health as the IHT consequences on death may be serious.

For those in serious ill health who, because of these issues, decide not to transfer their pension rights, they should still think carefully about taking action while still alive to mitigate the impact of an IHT charge on the later death of one of their relatives – say their spouse.

One of the most effective solutions here is the spousal by-pass trust. Indeed, in certain cases there could be an argument to say that if an adviser has not mentioned such a trust to his client, he has not given him appropriate advice.

John Woolley is joint managing director of Technical Connection

Further information on the background and technicalities on this article are given in John Woolley’s book “Financial Planning using Trusts 2013/14”, which is available from Claritax Books on 01244 342179 (www.claritaxbooks.com).

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