Inheritance Tax and Pensions

• Contributions to a pension scheme can be a lifetime transfer of value if the member is in ill health or the contributions are made to someone else’s pension.
• Death benefits can be subject to inheritance tax if the estate has a legal right to the payment, there is a lifetime transfer of the death benefit or the member can dictate to whom any benefit is paid.
• Usually pensions are exempt from IHT charges which would apply to settled property. However, there are circumstances when these charges would apply.
• IHT can apply to payments from annuities if the estate is entitled to a guaranteed payment or if value protection applied.
• Previously omission to act was an issue in relation to pensions but legislation changed this. 

It is often quoted that inheritance tax (IHT) does not apply to pensions. But there are instances where it can and does apply. So this article looks at the IHT issues surrounding approved pensions arrangements.

Information on IHT for unapproved arrangements is available from HMRC.

For pension planning strategies linked to IHT, see the Pensions and Inheritance Tax Planning article

Contributions to a pension scheme are not usually lifetime transfers of value for the purposes of IHT, and will be immediately excluded from the member's estate.

There are however two caveats to this.

1. Where the death benefits from the pension are outside of the estate and the payor is in ill health

If the contributions are made while the member is in good health there will be no transfer of value. But if made while the member is in ill health, there may be a transfer of value.

The underlying principle is that where the member is likely to survive to take their retirement benefits then the payments are for their benefit so are not transfers of value.

It is accepted practice that contributions made more than two years prior to death are not transfers of value.

IHT Manual - IHTM17042 & IHTM17043 

2. Where a contribution is made to someone else's pension, as the benefit will be for another

These would be a lifetime transfer of value. IHT wise they would either be exempt, possibly under the annual exemption or normal expenditure out of income rules, or potentially exempt.

Further information on transfers of value are in the IHT articles.

IHT Manual - IHTM17044 

There are three 'death' related areas where pension funds could be subject to IHT.

1. Payments forming part of death estate

• where the member's estate has a legal entitlement to have the value of the death benefit paid to it then the death benefit would form part of the member's estate. This would arise, for example, where a retirement annuity contract was held where the death benefits had not been assigned into a trust.
• any outstanding guaranteed payments from an annuity that are payable to the estate or paid at the annuitants direction are included in the estate for IHT purposes (see IHT and annuities below).
• any arrears of annuity payable to the member on death would also form part of their estate.

IHT Manual 17051 to 17056

 2. Lifetime transfers of death benefits

This can occur when death benefits are assigned into trust and potentially where there is a transfer between pension schemes.

Assignment

Where the member is likely to survive to take their retirement benefits ie the death benefit will lapse, then the transfer of value would be nominal. However, if a transfer is made whilst in poor health then the value could be more substantial.

Like contributions, in the absence of any evidence to the contrary HMRC would assume that the transfer happened whilst in good health if the period until death was greater than two years.

This principle could also apply where a transfer of benefits is made from a scheme with no discretion / payable to the estate, to one that did have discretion.

Transfers

HMRC consider transfer of benefits from one scheme to another to be transfers of value. This is down to the fact that the member could direct that the transfer is made to an arrangement where the estate would be entitled to the death benefit.

Like most other things the good health / two-year rule applies. There is a grey area / absence of case law to give an idea of what any transfer of value would be. HMRC will review each case individually taking into account its specific circumstances. The transfer of value may be nominal, or even exempt, but could be substantial. The case study below gives an example of how a transfer might be dealt with.

The basis for calculation is the loss to the transferor’s estate by virtue of section 3(1) IHTA 1984. As such we need to calculate the transfer of value from the transferor’s estate as it is this transfer of value that will drive the IHT consequences.  In broad terms, it is the difference in value of the death benefits and retirement benefits in the receiving scheme.

Finally, whilst the member retains the right to retirement benefits there are no 'gift with reservation' issues that would otherwise normally arise where gifts are made and entitlement to benefit from the gift remains.

IHT Manual 17070 to 17074

The IHT manual doesn’t give any guidance. HMRC have however given an indication of how the calculation does take place.

Rights “before” the transfer

This is the open market value of the death benefits which could have been directed towards the member’s estate. This is slightly confusing as it isn’t the rights which there would have been if the member had stayed in the ceding scheme.  Instead it is the transfer value ie the death benefit in the receiving scheme. Growth is applied to the death benefit amount and a deduction is made for the period that the member is likely to survive and this then gives the open market value. So, the deduction is calculated using both a growth rate and a discount rate.

“After” the transfer

This is the open market value of the pension rights available after the transfer, again, in the receiving scheme. This has traditionally been calculated using PCLS plus a 10-year guaranteed annuity. However, this valuation basis will be impacted with the introduction of pension freedoms and the change to full access. In principle, this amount should now be the amount of a full withdrawal less what the income tax payable and LTA charges that would have applied on that withdrawal. HMRC have indicated this is the case, however, a case will need brought to tribunal to test the valuation basis.

Hypothetical case study

Simone completes a pension transfer from her DB scheme to a PP. The transfer value is £800,000. She is terminally ill and she dies within six months. Given the reasonable proximity of death it is likely the open market value would be reasonably high. Let’s assume the “before” value is calculated to be £760,000.

The “after” figure could be calculated by looking at a full UFPLS payment.

Let’s assume there is a 25% tax free portion of £200,000 and the remaining fund of £600,000  is taxed using PAYE.  If we assume Simone had other taxable income on her death of £150,000, and using UK tax rates (Scottish rates of income tax will give different results) there would be £270,000 income tax to pay.

This is the loss to the estate. As it is a transfer of value to a pension scheme, there is no spousal exemption available.

In the case study above the value is less than the nil rate band so there would be no IHT payable from the transfer on the members death. However, there is a knock on IHT impact. The transfer will use up the nil rate band available for the rest of the deceased estate which could cause an increased IHT liability. There is another potential impact, the NRB used up by the transfer of value will not be available for transferring to the spouse for use on second death.

3. Claim on general power to dispose of death benefits

This applies where the member had an unfettered right to bind the trustees or administrators or had a power of nomination to pay the death benefits to a specific person or to their estate.

This would apply even where the benefits were ordinarily held under discretionary trusts if the member could direct at any time where the death benefit was to be paid.

Whether or not this would apply would be entirely down to an individual scheme's documentation.

It may be possible to make a binding nomination, without IHT consequences, where it is irrevocable and happens in good health / two years prior to death or where the trustees are bound to pay to a restricted class of dependants, broadly spouses / civil partners and dependants other than through mutual interdependence.

Finally, many schemes have nomination forms - these should not be confused with a power of nomination as they are normally non-binding expressions of wish.

IHT Manual - IHTM17052 

Section 43(2) of the 1984 Inheritance Act means that amongst other things pension and annuity arrangements are settlements for IHT purposes.

As settled property, this would ordinarily result in the normal IHT charges at the point of settlement, each 10 years and on exit. However, there are specific exemptions within the act so that these IHT charges do not apply to pension or annuity arrangements.

On the member's death the scheme / trustees have two years from the date they were reasonably aware of the member's death on which to pay out any death benefits. After this period the exemptions enjoyed by pension arrangements cease to apply and periodic and exit charges may apply.

As noted, death benefits paid as a lump sum are usually not liable to inheritance tax on the death of a member / pension holder. However, in the past, they could have been liable to IHT on the subsequent death of the beneficiary of the member / pension holder's death benefit. As such it was common for a discretionary trust to be set up and a letter of wishes made to the scheme / trustees that any lump sum death benefits are paid to that trust, especially where the death benefit amount could cause IHT issues for the recipient. This was usually called a "spousal bypass trust", although it should have strictly just been called a bypass trust as the recipient may not always have been a spouse.

However, legislation introduced by the Taxation of Pensions Act 2014 meant that, in the vast majority of cases, the benefits are able to be retained within a pension arrangement (dependant flexi-access drawdown or nominee flexi-access drawdown) and pass down through generations (successor’s flexi-access drawdown) free of IHT. As such many have said that spousal bypass trusts are no longer required. However, it's important to note that on the death of the dependant / nominee, the funds pass to the successor of the dependant / nominee, and not the original member / pension holder's line of succession. It may be that some members / pension holder's may prefer to have a greater degree of control of the ongoing beneficiaries of their pension funds, and as such spousal by-pass trusts may still have a role to play, especially as recent legislation has confirmed that payment of tax on entry to a bypass trust is reclaimable by a subsequent beneficiary of the trust (see our Pensions and Inheritance tax planning and Spousal Bypass Trust article.

When using a bypass trust, the trust is subject to the normal discretionary trust taxation regime and periodic and exit charges may apply.

The ten-year periodic charge anniversary applies from the date of the settlements. The determining factor is whether or not the trust-based / contract-based scheme has discretionary disposal powers. Typically the relevant date would be the date the member first joined the pension scheme for a trust-based scheme and for a contract-based scheme (e.g. retirement annuity contract / S226 plan), it would be the date of payment to the bypass trust or the date any benefits had been assigned to a trust.

The general principles are:

• where there are multiple schemes / contracts, for the purposes of IHT, there are multiple settlements each starting on the date the pension membership started for a trust-based scheme or where a contract-based scheme was placed under trust
• where there are no contributions to a scheme that scheme would not be counted as a settlement unless it accepted a transfer from a contract-based scheme
• where there is a transfer from a contract-based scheme into a trust-based scheme that also accepts contributions there would only be one settlement
• the bypass trust would count as a settlement as well
• each individual settlement would have its own nil rate band

The examples below show the theory: 

There are three settlements, A C and D:

A – 10-year anniversaries on June 1998, 2008, 2018, etc.
B – as this is contract-based there is yet to be a settlement
C – 10-year anniversaries on February 2008, 2018, 2028 (generated by the transfer in from B), etc.
D – 10-year anniversaries on March 2009, 2019, 2029, etc.

The charges would start to apply on the anniversaries after death where the money has been paid into the discretionary trust.

Taking the above scenario if there was a subsequent transfer into a trust based scheme 'E' in August 2012 and contributions were made to this scheme: 

There are now four settlements, A C, D and E:

A – 10-year anniversaries on June 1998, 2008, 2018, etc.
B – as this is contract-based there is yet to be a settlement
C – 10-year anniversaries on February 2008, 2018, 2028 (generated by the transfer in from B), etc.
D – 10-year anniversaries on March 2009, 2019, 2029, etc.
E – 10-year anniversaries on August 2022, 2032, 2042, etc.

This is a complex area of trust and IHT law and expert advice should be sought if in doubt.

For further information on periodic and exit charges see the IHT articles.

IHT Manual 17121 to 17126

There are two areas where IHT applies to annuities.

1. Where there are continuing guarantee payments under an annuity, payable to the estate as of right or at the annuitants direction, the market value of the remaining payments is included in the estate.

HMRC have a calculator which can assist on valuing the open market value. This only works for certain 'standard' annuities, other types of annuities would need to have a value agreed with HMRC at the time.

2. For IHT purposes if a lump sum is paid from a value protected pension, then if that amount is paid to the estate as of right, or at the member's direction, then the net of tax amount would be included in the estate for IHT purposes.

More information on annuity death benefits can be found in the Death benefits and annuities article.

IHT Manual 17320 to 17321

Finance Act 2011 has this clause in Schedule 16, para 47:

Section 3(3) is a reference to Inheritance Tax Act 1984.

As it has been enacted, it provides that the inheritance tax (IHT) charges for 'omissions' in relation to registered pension schemes, qualifying non-UK pensions (QNUPS) and 'section 615(3)' superannuation schemes will no longer apply.

Prior to 6 April 2012 section 3(3) claims to IHT on pension funds could occur where, for example:

• retirement was deferred
• phased retirement was undertaken
• income withdrawal was entered instead of annuity purchase

These involved omission to take retirement benefits, so, if this was done whilst in ill-health (2 year rule as described above) HMRC considered there to have been a transfer of value and would seek to add an amount to the estate for IHT purposes.

Deliberate omissions to exercise a right (where the wealth of another individual is increased as a result) will, in non-pension situations, continue to be regarded as transfers of value.

This legislative change effectively reversed the Tax Tribunal's decision in the Fryer case (Fryer & Ors v HMRC [2010] UKFTT 87). In that case a widow, suffering from advanced cancer, decided not to vest a section 32 buy-out plan. She died shortly afterwards, never having taken the retirement benefits available. The judge held that she had a valuable right – the right to a pension commencement lump sum and an annuity – and by failing to exercise it the value of her estate on death had fallen. That fall in value had to be 'added back' in determining the amount on which IHT was levied.

This change has however, brought about what could be an interesting planning angle. For an explanation see Fryer planning in our Pensions and Inheritance Tax planning article.

As stated above, section 3 (3) IHT Act 1984 has not applied to a member’s entitlement to tax-free cash and pension payments under a registered pension scheme due to the amendment in section 12(2) IHT Act 1994. HMRC confirmed the exemption, to the omission to act rules, also applies for a beneficiary's entitlement to flexi-access drawdown death benefits on that beneficiary's death, and a change was made in Finance Act 2016 backdated to 6 April 2011. HMRC have confirmed that the nomination of a dependant, nominee, or successor by a pension scheme member or beneficiary will not cause them to be treated as making a transfer of value for inheritance tax purposes on death as long as:

• the member / beneficiary does not have power under the scheme's rules to irrevocably choose the beneficiary who should be entitled to death benefits on his / her death; and
• the scheme trustee or administrator has a discretionary power to choose who should receive death benefits.

The main IHT return is the form IHT400.

Question 36 asks if the deceased had any retirement provision other than the state pension. Where the deceased had a pension the IHT409, a supplementary form, has to be completed.

This form essentially asks the questions which allow HMRC to identify if any IHT is payable in respect of the pension funds in the scenarios described above.

Overview HMRC v Staveley and Piney [2017] UKUT 0004 (TCC)

This is a really interesting case and well worth a read but we are only going to consider a few of the essential points. As with any case, the judgement was based on the facts of this particular case and refers to some parts of legislation that have changed since 2006. However, interesting comments were made by the Upper Tier Tribunal (UTT). 

The facts

This involved the case of Mrs Staveley and was in respect of two alleged lifetime transfers of value.  Mrs Staveley died on 18 December 2006. In November 2006 Mrs Staveley transferred funds from a section 32 policy into an AXA PP. The alleged transfers of value were the fact that the transfer took place but then also the omission to take any retirement benefits during her lifetime. The move from the s32 to the PP meant that the money was moving from a return of fund to her estate, to a return of fund to discretionary beneficiaries.

Question 1 - was there a transfer of value?

The main reason for the transfer in 2006, which was accepted by both sides was the fact that Mrs Staveley wanted the transfer to take place so that her ex-husband could not receive any of the money. As the s32 derived from an EPP, any surplus in the s32 would be returned to the employer, which to her meant, her husband. 

The UTT confirmed that this was a transfer of value. There was a power of disposal before but not after the transfer. Section 3 of the Inheritance Tax Act 1984 (IHTA) determines that a "transfer of value is a disposition made by a person (the transferor) as a result of which the value of his estate immediately after the disposition is less than it would have been but for the disposition". However, s3 is subject to s10 which deals with dispositions which are not intended to confer gratuitous benefit. 

The UTT stated that the First Tier Tribunal was entitled to find that the transfer was not intended to confer gratuitous benefit on any person. In considering this, the UTT stated that a transfer from one PP to another, without a change in beneficiaries, was unlikely to result in a transfer of value but also that the “presence of commercial reasons (and no other reasons) would enable s10 to apply".

Question 2 - was the omission to take lifetime pension benefits treated as a transfer of value?

The second part of the case focussed on whether or not the omission to exercise the right to take lifetime pension benefits was properly treated as a transfer of value. This is not as much of an issue now since the Fryer case and the change to section 3(3) which specifically allows someone to leave their pension benefits. In addition, the Finance Act 2016 added section 12A to IHTA which clarified that funds designated to drawdown, but not taken as income, were usually safe from IHT as it was not a deemed disposition. This was backdated to 6 April 2011. 

However, the death in this case was prior to section 3(3) change in law. Essentially in this case, HMRC argued that the omission to take benefits meant that the estates of Mrs Staveley's sons were increased. However, the UTT found that in reality it was the exercise of discretion by the scheme administrator that increased the estates of her sons and not the omission to take benefits. This meant that the omission could not be treated as a disposition or as a transfer of value within section 3(1).

The final Supreme Court decision Commissioners for Her Majesty’s Revenue & Customs (Respondent) v Parry and others (Appellants) Case ID: UKSC 2018/0208

The Court of Appeal had found in favour of HMRC but this ended up in the Supreme Court, and on 19 August 2020 to give final clarity on the situation.

It was confirmed that there was omission to take benefits based on the law at the time of the transfer (2006), since this transfer the law was amended in 2011 which means that omitting to take benefits from an uncrystallised pension from that date is permitted. This was further enhanced in 2015 when omitting to take benefits from crystallised funds were also exempt from this.

However on the issue of the transfer, it was deemed not to have been made to confer a gratuitous benefit and as such was the transfer was exempt from IHT. 

What does this case mean now?

Pensions and IHT on transfers has been a hot topic since pension freedoms came along. The flexibility changes have meant more transfers are taking place and often these are when people are terminally ill or a key driver is 'death benefits'. The potential for IHT has to be a discussion point and should almost certainly be covered in any suitability report.

However, this case had very specific issue as although the transfer did provide better benefits for her sons, Mrs Staveley’s sole intention in transferring the funds was to eliminate any risk that any part of the funds might be returned to her ex-husband. The mere fact that the sons’ inheritance was intended to be enjoyed in a different legal form after the transfer did not mean that Mrs Staveley intended to confer a gratuitous benefit her sons.

It’s worth noting that not many transfers will have happened in such circumstances.