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Failure to exercise could bring a fat IHT demand

Last month, HM Revenue & Customs published a discussion paper on inheritance tax and pension simplification. The stated purpose is “to seek a consensus on the detailed application of IHT law to the new situations arising under the simplified pension regime”.

The paper also looks at how cases which are chargeable to IHT should be identified and any charge quantified.

IHT is encroaching into all areas of financial planning. As part of the advice process, you may find yourself recommending clients to exercise some of the flexibility offered by their pension plans, such as income withdrawal.

However, if you accept the approach suggested by the Revenue, your clients could suffer an unexpected IHT bill – but then again, they may not. It is this doubt which will concern many of you.

The paper states that “mini- sters are committed to tax-relieved pension saving but the generous tax reliefs granted are to encourage people to provide a secure income in retirement, not to permit the accumulation of capital sums for passing to heirs”.

In principle, the Revenue expects to see few claims in this area. However, pension planning has progressed in recent times. Drawdown is a direct alternative to buying an annuity. As you will also be aware, from April 6, 2006, clients who have not committed to an annuity can continue in drawdown after 75 in the form of an alternatively secured pension. Logically, if your client elects to take drawdown, this should have the same IHT implications as buying an annuity. That would be too easy and, as we know, logic and tax do not go together.

A claim to IHT may arise on schemes under S3(3) or S5(2), as extended by S151(4), Inheritance Tax Act 1984.

A claim under S3(3) – omission to exercise a right – may arise where a personal pension or retirement annuity client elects to defer taking their benefits before they die.

Section 5(2), as extended, applies where the member has a general power to dispose of benefits. An example of a general power would be the choice of the survivor to take a lump sum within two years of the member’s death during drawdown.

If your client elects to take drawdown, IHT can be payable where they make decisions with the intent to benefit others instead of their own retirement. If the client makes an election for sound commercial and retirement reasons, a claim under S3(3) should not arise. A generally accepted rule is that if the member is in poor health, any such actions to defer benefits can be challenged. The discussion paper extends this position to all clients who elect to use ASP.

But is this right? Is it not your role to continue to review all choices open to clients? For example, long-term care planning enables a client to decide which investments they should use to support an immediate need for care. A fully-funded LTC scheme might mean there is no need to draw further pension benefits. Your client could leave these funds to grow further and, hopefully, avoid any IHT. However, as suggested by the discussion paper, this might not be the case.

You have to ask why a client, who has a clearly settled plan for his pension funds, should draw down further cash when it is not needed. However, it will be up to clients and their advisers to prove their case.

The discussion paper suggests each case will be determined by its own facts. This is a recipe for even more confusion than has existed since the introduction of drawdown and should be opposed.

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