BN 26 - Inheritance Tax & Pensions Simplification

Who is likely to be affected?

1. The beneficiaries of members of registered pension schemes.

General description of the measure

2. This measure clarifies how inheritance tax (IHT) will apply to choices made under the new pension scheme rules, which come into effect on 6 April 2006. It legislates an existing IHT concessionary practice for scheme members who die under the age of 75 and sets out how IHT is to be charged on death on or after age 75 where funds are held in an alternatively secured pension.

Operative date

3. Effective on the death of a scheme member on and after 6 April 2006.

Current law and proposed revisions

Death of scheme member before age 75

4. The present IHT rules will continue to apply to registered pension schemes in much the same way as they do currently. This measure will legislate the IHT concessionary practice dating from 1992 in relation to pension choices by scheme members. The practice was first published in Inland Revenue Tax Bulletin 2 (February 1992) and was subsequently updated in 1999 to take account of the introduction of income withdrawal under pension schemes.

5. An IHT charge can arise in a scheme member’s lifetime under section 3(3) Inheritance Tax Act 1984 if they do not exercise their right to take pension benefits. The charge applies at the latest time when the right could be exercised i.e. immediately before death. For example, if a scheme member did not take their pension when their life expectancy was seriously impaired, and this resulted in an enhanced death benefit being paid to their beneficiaries, then IHT could apply. Currently, by concession, IHT is not charged in respect of these enhanced death benefits where the beneficiary is a spouse, civil partner or person who is financially dependant on the scheme member. Nor is IHT applied where a scheme member chooses not to exercise a right at a time when this choice does not trigger a charge (for example, choosing not to take a pension when they are in good health) and does not subsequently vary that choice, even when a reduction in their life expectancy would in strictness trigger an IHT charge.

6. This concessionary treatment will be legislated in the Finance Bill. In addition, payments arising in these circumstances which are made to charity will also be exempted from IHT.

Death of scheme member on or after age 75 – Alternatively Secured Pension

7. The Government provides generous tax relief on pensions on the basis that pension funds are used to secure an income in retirement. The pensions tax simplification rules provide that an individual must secure an income before they reach the age of 75. For most people an annuity or scheme pension is the best means by which they can do this. The new pensions tax regime introduces an additional option for securing their retirement income – an Alternatively Secured Pension (ASP).

8. The Government made clear throughout the development of the new pensions tax regime that ASPs are specifically designed for those who have a principled religious objection to annuitisation. It has become clear that some individuals and their advisors are intending instead to use the ASP provisions for a much wider purpose to enable individuals to pass on tax-privileged retirement savings to their dependants rather than to provide a pension in retirement. In order to prevent this the Government is examining how best to restrict ASPs to their original limited purpose.

9. Following a consultation by HMRC, legislation will be introduced in the Finance Bill to ensure that appropriate IHT charges will apply on left-over ASP funds. The Government will apply an IHT charge on left-over ASP funds on death (or later) as follows:

• any funds paid as a “transfer lump sum death benefit” (i.e. where the funds remain within the scheme for the benefit of other scheme members) or refunded to an employer or used to provide benefits for a dependant in the pension scheme context who is not a spouse, civil partner or person who is financially dependant will be subject to an IHT charge on the death of the original scheme member as if the funds were part of the scheme member’s own taxable estate on death;
• any funds paid on the death of the scheme member to charity will be exempt from IHT, as will funds expended for the scheme member’s spouse, civil partner or person who is financially dependant on the scheme member;
• any left-over funds, once use by the spouse, civil partner or person who is financially dependant (the beneficiary) has come to an end, will be chargeable to IHT on the earlier of the cessation of those benefits and the death of the beneficiary. These remaining funds will be treated as if they were an addition to the original scheme member’s estate. However, any left-over funds that are paid to charity will be exempt from IHT;
• in certain circumstances, an IHT charge on ASP funds will fall on the estate of a dependant (rather than that of the original scheme member). This will apply where a dependant – within the meaning of the pension scheme rules – opts for an ASP derived from “benefits” inherited from a scheme member who died before age 75. Here, any left-over funds on the dependant’s death will be charged to IHT as if they were part of the dependant’s taxable estate on death.

The IHT charge

10. IHT will be payable on the value of the taxable property at the time the charge arises, and calculated by reference to the tax-free threshold and rate of tax in place at that time. The pension scheme administrator will be responsible for accounting for and paying any IHT due on the ASP funds.

11. There are two instances where the tax charges on ASP funds overlap. One is where the funds are paid to an employer and the other is where on the death of a dependant under age 75 any remaining funds are paid out as a lump sum other than to a charity. The IHT charge takes priority over the pension scheme tax charge which is then applied to the net fund after deduction of IHT.
Impact

12. HMRC will work closely with the pensions industry on the necessary processes to help minimise any regulatory impact on pension schemes. Personal representatives of estates will be required to provide information in the estate account about the ASP. This will include an estimate of the value of the left-over ASP funds at the date of death together with details of the name and address of the scheme administrator (who will be liable for any IHT payable).

Further advice

13. These IHT aspects are reflected in the updated full regulatory impact assessment “Simplifying the taxation of pensions” which is also published today.

14. If you have any questions about this change, please contact the IHT Pensions Helpline on 0131 777 4296.