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Rights and wrongs

Why advisers need to be aware of the incidence of inheritance tax and customers taking pension rights

Gerry Brown, Tax and trust, manager, Prudential
Gerry Brown, Tax and trust, manager, Prudential

The basic principles of inheritance tax are well known. The tax is levied on “transfers of value”. What is less well known but equally important is that an omission to exercise a right can also be treated as a transfer.

This, of course, is logical – it is clearly possible to benefit another person by refraining from doing something. The legislation, however, restricts the inheritance tax charge to situations where there has been a deliberate omission to exercise a right. Mrs Patricia Arnold was born in
September 1942. In November 1995, she declared a discretionary trust (for the benefit of her children) of a pension policy. In April 2002, she was diagnosed with cancer.

The provider issued a “maturity pack” at the end of May 2002 shortly before Mrs Arnold’s 60th birthday. A few days thereafter, she confirmed that no pension was to be taken at 60.

Mrs Arnold died in July 2003, never having taken benefits from her pension.

HMRC Capital Taxes formed the view that she had made a transfer of value by deferring her retirement benefits under the plan. The HMRC argument was that by failing to take pension benefits (tax-free cash and an annuity) Mrs Arnold had increased the value of assets in the discretionary trust (the death benefit). The discretionary trust was not for her benefit, it was for the benefit of her children.

The matter was referred to the First Tier Tax Tribunal which addressed four questions:

a: Was there a transfer of value?
“Did Mrs Arnold omit to exercise her rights under the pension? At no stage during her lifetime did she elect to take her retirement benefits, as she was entitled to do under the scheme rules. She omitted throughout her lifetime to exercise her right to take the benefits. That omission continued to the date of her death. That date was the latest point at which she could have exercised the right. The transfer of value flowing from the omission must be treated as made on that date.”

b: Was the omission deliberate?
If there is to be an inheritance tax charge, the omission to exercise a right must be deliberate. On the basis of the available evidence, the judge was satisfied that when Mrs Arnold received the maturity pack in June 2002, she took, or had already taken, a conscious decision not to take her pension benefits at her 60th birthday. The circumstantial evidence suggests that, if she gave it any further thought, she must have decided to continue as she was without taking the pension benefits.

c: Did the omission to take benefitsreduce Mrs Arnold’s estate?
The judge stated that Mrs Arnold had a valuable right. By not exercising it, she allowed the whole of its value to disappear from her estate. Her estate was therefore diminished by her omission to exercise that right.

d: What was the value transferred?
For inheritance tax purposes, was the valued transferred the open market value of the deferred pension benefits?

Actuarial evidence was as given follows:

As at July 30, 2003, the value of Mrs Arnold’s pension fund was £147,342. If she had opted to take retirement benefits on that date, the maximum lump sum which she could have taken was about £51,800.

If she had then opted to buy a lifetime annuity with the balance of the fund, she would have obtained a gross income for life of about £9,554 guaranteed to be payable for at least 10 years. The market value of such a guaranteed income stream as at July 30, 2003 would have fallen in the range £61,500 to £68,000.

The judge used the higher capitalised annuity value £68,000 Added the tax-free cash £51,800 £119,800.

Applied a discount of 25% £29,950 and arrived at a value of £96,850

There is an assumption that pensions are treated favourably for inheritance tax purposes (as they are for income and capital gains tax purposes) but it should be appreciated that there are a number of situations in which pension contributions and/or pension benefits can be subject to a tax charge. This is one of them.

In 1992, HMRC issued a tax bulletin on this topic which said it would consider raising an IHT claim only where there was evidence that the individual’s intention in failing to take up retirement benefits was to increase the estate of someone else. HMRC will look closely at pension arrangements where the member became aware that he or she was suffering from a terminal illness.

Advisers need to be aware of the incidence of inheritance tax in such situations. However, it should be appreciated that even after inheritance tax had been paid, Mrs Arnold’s children received a significant sum from the death benefits which would not have been available had she vested her pension rights.

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