Many inheritance tax planning strategies involve making significant capital payments to trustees to reduce the taxable estate. A trust is used to retain control over the ultimate destination and timing of benefits.
What planning opportunities can be utilised where significant lump sums are not available? How can the asset-rich, cash-poor undertake IHT planning? One option is to use the tax advantages offered by contributions to registered pension schemes either for “self” or for “others”.
Pension contributions reduce an individual’s IHT estate the contributor’s bank balance falls. However, the fund grows in an IHT-exempt environment and when it is converted into an annuity, the only potential IHT liability is in respect of the discounted value of the remaining payments in any guarantee period. Even when in income drawdown, the residual fund has protection from IHT.
The downside is that the unvested fund is subject to an income tax charge of 55 per cent if the member dies after reaching 75 years old or dies having commenced drawdown before that age.
Where an individual makes cont-ributions to a pension fund, there is not usually a transfer of value as a result. However, there are two situations where payment of contributions may result in a lifetime transfer:
l The transferor contributes to his/her own pension scheme, retains the retirement benefits but has assigned the death benefits, usually to trustees
l The transferor contributes to a pension scheme for someone else and the benefits are solely for other persons.
In cases where a person contri-butes to their own pension scheme and the death benefits have been transferred to trustees, the contributions may be transfers of value. Whether or not there have been transfers of value depends on the health of the member at the time the contributions were made.
Generally speaking, where contributions are made more than two years before the member’s death, HMRC will assume unless there is clear evidence to the contrary that the member was in normal health at the time, so that the transfer is of negligible value.
This treatment applies whether the contribution is direct or indirect, for example, by a reduction in the remuneration which the scheme member would otherwise have received. The rationale for this approach is that, provided the member is in good health at the time and so likely to survive to eventually take retirement, that is, (pension) benefits (when the death benefits will lapse), the contribution is providing a benefit for the member and so there is no loss to his or her estate.
Conversely, if the member is in ill health when the contribution is made so much so that he or she is unlikely to survive to take the retirement benefits then, if the death benefits have been assigned, there is likely to be a transfer of value.
The fact that the “omission to act” rule will no longer apply to pension arrangements is a further aid to planning. The decision of the tax tribunal in “Fryer” has effectively been reversed. A second strategy is to make pension contributions for “others” usually for children and/or grandchildren.
This strategy has many appealing features:
- The contribution reduces the donor’s estate for IHT purposes.
- A govern-ment subsidy in the form of basic-rate tax relief is available. The contribution for tax purposes is treated as if made by the recipient so that he/she will get the relief. If the recipient has no relevant earnings, tax relief is still possible. The maximum contribution in such a situation is £2,880, which will be “grossed up” to £3,600. Otherwise, the size of the maximum possible contribution is governed by the recipient’s relevant earnings and the available annual allowance.
- The recipient has no access to the fund until he/she attains age 55. This is achieved without the need for a trust.
- There is no commitment to further payments. Payments can be made as and when desired.l The fund enjoys tax-advantaged growth it suffers no income tax or capital gains tax charges
- Payments can be varied between children/grandchildren, as deemed suitable by the donor
- It can be used to relieve children and/or grandchildren of the need to fund pensions in early life when resources are stretched but when benefits of pension contributions are the greatest.
There is no doubt that contribu-tions for “others” are transfers for IHT purposes. The donor’s estate is reduced. What IHT status do they have? Is it possible that they could be exempt transfers?
There are several exemptions potentially available:
(i) Normal expenditure from income: this exemption applies where gifts are unconditional and the donor can show that the gifts:
- Formed part of his/her (normal) usual expenditure
- Were made out of income, and
- Left the donor with sufficient income to maintain his/her normal standard of living.
The advantage of this exemption is that there is no limit to the value that can be gifted. It is important to be able to demonstrate an intention to make a series of gifts. It is also important to maintain adequate documentation to support a later claim for the relief.
(ii) Annual exemption: gifts of up to £3,000 per year are exempt. Any exemption that is not used can be carried forward for one year only
(iii) Small gifts of up to £250 per recipient. This is unlikely to be of significant use to the serious tax planner
(iv) Gifts on the occasion of a wedding or civil partnership ceremony are exempt from IHT, subject to certain limits:
- parents can each give gifts worth £5,000
- grandparents and great grandparents can each give gifts worth £2,500
- anyone else can give gifts worth £1,000
While a pension contribution might not be the most romantic wedding gift, it could well be the most tax-efficient
(v) Spouse exemption: payments for the benefit of a spouse (or civil partner) will be exempt, or
(vi) A potentially exempt transfer: provided that the donor survives seven years from the gift, it will become exempt. Death within the seven-year period will result in the potentially exempt transfer becoming chargeable. Taper relief might be available to reduce any tax payable.
It is worth pointing out that contributions to schemes entered into by an employee of the person making such contributions are not transfers of value, so the question of exemption does not even arise.
This will be of use when family members are employed by the donor.
When compared with conventional bond-trust arrangements, pension contribution strategies take time to implement. However, they offer a considerable degree of flexibility and can be switched on or off as circumstances dictate. They can be operated on a relatively informal basis no trust documentation is required and the member, that is, the beneficiary of the planning) is responsible for investment decisions.
There is no reservation of benefit issue. The HMRC view is as follows: “The board confirms that their previous practice of not charging capital transfer tax on death benefits that are payable from tax-approved occupational and retirement annuity schemes under discretionary trusts also applies to inheritance tax.
“The practice extends to tax under the gift with reservation rules as well as to tax under the ordinary inheritance rules.”
It follows that in an approved scheme where the death benefit is held on discretionary trusts under the scheme rules, the gift with reservation provisions will not apply where the deceased or the deceased’s estate or the deceased’s personal representatives are potential beneficiaries. The icing on the cake is, of course, the availability of income tax relief. What other strategy offers such a subsidy?
It is, of course, possible to combine a pension contribution strategy with a bond trust strategy the two approaches are not mutually exclusive. Consider the opportunities offered when trustees of loan trusts make pension contributions for beneficiaries.
Pension contributions should be considered as part of every IHT planning exercise.