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JOHN WOOLLEY LLB, FCII, FTII warns of the liabilities that can lurk in some pension tax traps. APPROVED PENSION SCHEMES have a number of tax advantages, one of which is that lump sum death benefits are free of inheritance tax. However, this is subject to the satisfaction of certain conditions and there are some tax traps to be wary of. This article looks at the relevant issues as far as personal and stakeholder pension arrangements are concerned, and references to a personal pension plan include a stakeholder plan.
JOHN WOOLLEY LLB, FCII, FTII warns of the liabilities that can lurk in some pension tax traps. APPROVED PENSION SCHEMES have a number of tax advantages, one of which is that lump sum death benefits are free of inheritance tax. However, this is subject to the satisfaction of certain conditions and there are some tax traps to be wary of. This article looks at the relevant issues as far as personal and stakeholder pension arrangements are concerned, and references to a personal pension plan include a stakeholder plan.
Advantages of a trust
Many personal pension plans (aside from being established by a master trust/deed poll and rules) will incorporate a trust determining how the benefits will be paid. Sometimes this trust is declared separately to the governing documents and sometimes it is, in effect, incorporated within them. In some cases the rules operate as a quasi trust by virtue of their terms. This is particularly true of the model rules provided by the Inland Revenue. The type of trust used with personal pension plans will typically mean that any death benefits can be paid by the trustees to any of a wide range of potential beneficiaries (spouse, children, grandchildren, etc.) with the retirement benefits being held absolutely for the benefit of the planholder. Writing a pension plan in such a way that death benefits are held under trust gives rise to two distinct advantages:
The two-year rule
Technically, when an individual declares a trust or transfers to or pays a contribution to a plan under which the death benefits are held subject to a trust, there is a transfer of value. In general, this will be a consideration when: Fortunately, the Inland Revenue takes the view that the amount of this transfer of value is negligible unless the individual is in serious ill health when he makes the transfer. This is on the basis that the person entitled to the pension benefits ('the member') is likely to survive to take his/her retirement benefits - in which case, of course, the death benefits lapse. The Capital Taxes Office would not expect a return to be made in these circumstances although, in the event of the policyholder's death within two years of the event, an appropriate entry in the inheritance tax 200 form would be required. Therefore, if a person is in good health at the time of the gift of the death benefits, the Inland Revenue will not seek to argue that the gift should be liable to inheritance tax. The general rule is that a person who survives for two years is treated as having been in good health at the time of the gift, although the Revenue reserves the right to look behind this if there was clear evidence of serious ill health at the time of the gift. Generally, if a person made a gift of death benefits at a time when ill health had not been diagnosed, the Revenue would not then argue with the benefit of hindsight that the gift of the death benefits was other than for normal pension provision. However, the Revenue reserves the right to look at each case on its merits.
Transfers of plans
What is the situation where a plan not subject to trust is transferred to a plan where death benefits are held under trust? Here, the Revenue view is that the transfer of any pension policy from one plan to another (e.g. from a retirement annuity contract to a personal pension plan or from one personal pension plan to another) would be a disposition of the death benefits of the plan being transferred. Consequently, if this were done whilst a person was in serious ill health, the Revenue would look closely at the arrangement to determine whether a claim to tax under section 3(3), Inheritance Tax Act 1984 had arisen. This is on the footing that the transfer effectively reduces the value of the rights acquired under the original scheme to nil and results in the acquisition of new rights under the transferee scheme. Such a transfer results in a new death benefit and will give rise either to a disposal of that benefit on the transfer taking effect, or to a right to subsequently dispose of it as the member thinks fit - depending on the rules of the new scheme.
The effect of being caught by the two-year rule is that the individual will be treated as having made a substantial transfer at the time the plan was effected or placed in trust. In most cases, because the trust used is a discretionary trust, this will be a chargeable transfer.
An omission to exercise a right
Inheritance tax may also be an issue if an individual is able to draw retirement benefits, but chooses not to do so because of serious ill health. He may take the view that if he leaves the plan undrawn, lump sum death benefits will be paid out under the trust, free of inheritance tax. In this situation, the Revenue could argue that section 3(3) applies on the basis that the individual has deliberately omitted to exercise a right (i.e. drawing retirement benefits) with a view to increasing the estate of another.
The Revenue view
The Inland Revenue view on this (which was published in the Tax Bulletin of February 1992) is as follows.
'Any claims that do arise are likely to be limited to retirement annuity contracts or personal pension schemes. Only exceptionally would claims involve occupational pension schemes.
'There is no question of a claim being raised in cases of genuine pensions arrangements, i.e. where it is clear that the policyholder's primary intention is to provide for his own retirement benefits.
'Capital Taxes Office would consider raising a claim in such cases as remain only where there was prima facie evidence that the policyholder's intention in failing to take up retirement benefits was to increase the estate of somebody else (the beneficiaries of the death benefit) rather than benefit himself.
'To this end, the Capital Taxes Office would look closely at pensions arrangements where the policyholder became aware that he was suffering from a terminal illness or was in such poor health that his life was uninsurable and at or after that time the policyholder:
- took out a new policy and assigned the death benefit on trust; or
- assigned on trust the death benefit of an existing policy; or
- paid further contributions to a single premium policy or enhanced contributions to a regular premium policy where the death benefit had been previously assigned on trust; or
- deferred the date for taking retirement benefits.
'In these circumstances it would be difficult to argue that the actions of the policyholder were intended to make provision for his own retirement given the prospect of an early death. Even then the Capital Taxes Office would not pursue the claim where the death benefit was paid to the policyholder's spouse and/or dependants.'
It is the firm view of the Capital Taxes Office that this approach will give rise to only a small number of section 3(3) claims; the overwhelming majority of pensions arrangements will be unaffected. Importantly, it was specifically confirmed that, regardless of any of the above, the Revenue will not raise a claim under section 3(3) if death benefits were paid to the dependants of the policyholder or the member's spouse. The Revenue also confirmed it would adopt a similar approach in relation to personal pensions as in relation to retirement annuity policies. Section 3(3) can also be an issue in relation to income drawdown personal pensions where the individual is in deferred retirement having drawn his tax free cash.
Death and 'drawdown'
On the death of a member whilst in income drawdown, death benefits will generally be free of inheritance tax and they will either pass to the 'survivor' (widow or financial dependant) or be payable at the trustees' discretion. The lump sum will, however, be liable to income tax at 35 per cent under section 648B, Taxes Act 1988.
The Revenue will review the position of the 'survivor' who can either continue in drawdown, purchase an annuity or elect for the lump sum. The 'survivor' can elect for the lump sum within two years of the death of the policyholder. A possible claim on the survivor's estate under section 5(2), Inheritance Tax Act 1984 and section 151(4), Inheritance Tax Act 1984 would be made if the 'survivor' died within two years of the death of the policyholder on the basis that the 'survivor' had a general power of disposal or alternatively under section 3(3), Inheritance Tax Act 1984 on the basis that he had omitted to take up an annuity for reasons other than pension provision.
The Revenue takes the view that, where there has been a deferral of the taking of an annuity by the original policyholder or the 'survivor', there is the possibility of a section 3(3) claim if the failure to take the annuity is deliberate in the sense of being made so as to enable the lump sum to pass free of inheritance tax to the beneficiaries of any trust of the death benefits established by the policyholder and/or the 'survivor'.
The Revenue also considers that if the established pattern of income drawdown which commenced prior to intervening ill health continues unchanged then no claim under section 3(3) would arise. However, it reserves the right to make a section 3(3) claim if the rate of income drawdown is changed after intervening ill health becomes known, and in this case there is the possibility of a section 648B, Taxes Act 1988 income tax charge at 35 per cent with the balance then liable to inheritance tax at a potential rate of 40 per cent. The Revenue will apply an actuarial valuation in arriving at the value to be brought into charge to inheritance tax (the open market value of an annuity guaranteed for ten years, payable in advance, capable of being produced by the residual fund).
General power of appointment
Another potential inheritance tax trap came to light in 1995 when the Capital Taxes Office sought to assess to tax death benefits under a pension plan issued under a 'deed poll' arrangement. The scheme had adopted rules that were slightly different from the Revenue model rules. Also, the pension plan had not been made subject to a trust by the member before his death and as a consequence the Capital Taxes Office considered the benefits formed part of the deceased member's estate on death. The reasoning behind this approach was outlined in a letter from the Capital Taxes Office to the Law Society in May 1987 (now in the form of 1988 Capital Taxes Office guidance notes) which deals with the member having a general power to nominate a benefit. The view of the Capital Taxes Office, was that if the deceased member had a general power to nominate a benefit to anyone he wished, and had not irrevocably exercised that power during his lifetime, the benefit would form part of the member's estate at his death. This would be subject to an exemption, for example the spouse exemption. In this connection, the Capital Taxes Office relied on section 5(1), Inheritance Tax Act 1984, as modified by section 151(4). This provides that when an individual has a 'general power which enables him ... to dispose of any property', he is treated as beneficially entitled to such property and any such property to which he is beneficially entitled is part of his estate on death. The point is that the member can, up until his death, appoint to anybody he wishes, including himself. Therefore that benefit remains in his estate. The problem arises in relation to arrangements where the personal pension member has the freedom to dispose of personal pension scheme death benefits immediately before his death by, for example, declaring a personal trust of the death benefits. The specific problem in 1995 had arisen because of one particular personal pension scheme that was largely based on the Inland Revenue model rules. In general, the problem would seem to have primarily applied to schemes constituted by deed poll, where the member had the power to declare a personal trust of death benefits under which he could benefit but had not done so before death. It could also apply where the trust has been declared but, under that trust, the member can appoint benefits to anyone, including himself. Happily, in 1995 amendments to the integrated model rules and the Revenue model rules were agreed to remove the potential inheritance tax problem that could have arisen where the model rules permitted a personal trust to be declared, but no such trust was declared. The amendments to the integrated model rules and the Revenue model rules mean that if the scheme administrator wishes to pay death benefits to a trust declared by the member, this can only be done where the trust is one under which no beneficial interest in a benefit can be payable to the member, the member's estate or his legal personal representatives. The Capital Taxes Office has further confirmed that, for these purposes, it would not take account of the member's entitlement to retirement benefits under such trusts.
Personal trusts
So the problem will not exist where the new model rules are used and no personal trust declared. But what if a personal trust has been declared - perhaps on the basis of other than the model rules? Here one has to exercise care, because if the trust that is declared includes the member or his estate as a beneficiary or potential beneficiary, and the member has power to appoint benefits either directly or indirectly to himself, the Capital Taxes Office could claim that he has a general power of appointment under section 5(2) and the value of the property should therefore form part of his estate. It would appear that one pension provider's individual trust has been caught by this view because it gives the member the power to nominate additional people to be beneficiaries within the discretionary class. As the trust wording did not prevent the member from adding himself to the discretionary class and then appointing the benefits to himself, this represents a 'general power' under section 5(2). As a result of this, the value of the death benefits will form part of the member's taxable estate and could result in an inheritance tax liability if the member dies before drawing retirement benefits. The provider in question is dealing with the issue by making available a deed of release for completion by the member of an affected plan as a means of solving the 'general power' problem. Once this is completed, the member will no longer be able to appoint benefits to the persons named in the discretionary class. However, the trustees will still have a power to appoint benefits to any one or more of those people in the discretionary class within the 24 months following the member's death. Completion of the deed of release should not result in adverse inheritance tax implications provided the scheme member is not in ill health when the deed is executed.
The right to transfer
Finally, it should be noted that the Revenue does not take the point that the right to transfer per se gives the policyholder or member a general power under section 5(2). This could be the case, for example, with a personal pension plan, a retirement annuity contract or an occupational scheme. Accordingly, the mere existence of the right to transfer, for example, from a retirement annuity contract to a personal pension plan, would not cause the Revenue to question the effectiveness of a trust of the death benefit under a retirement annuity contract. The Revenue accepts that the death benefit had ceased to be a part of the policyholder's estate. The wording of non-model rules and trusts should therefore be carefully structured to avoid this problem arising. In summary, pensions can offer significant inheritance tax advantages. But be aware of the important tax traps and make sure that suitable provision is made to avoid them. John Woolley is a partner in Technical Connection; tel: 020 7405 1600.
