Pensions: other provisions: ABI guidance note
In June 1999 the Association of British insurers (ABI) (after discussion with HMRC Inheritance Tax) issued a guidance note setting out the basis on which a claim to Inheritance Tax might arise. The text of the guidance note is as follows:
1.1 This paper sets out the conclusions reached in discussions and correspondence between ABI and the Capital Taxes Office on the Inheritance Tax position regarding the deferral of annuity purchase/income withdrawal facility under personal pensions.
1.2 While there will be cases where there is an Inheritance Tax liability, these are likely to be relatively few. The circumstances in which a claim might arise are described in the following sections of this note. Some brief comments are also included in section 5 on the Inheritance Tax position in other circumstances, i.e. where an earmarking order has been made on divorce or dissolution of a civil partnership, under the proposed AVC flexibility arrangements, where there are benefits under an approved scheme, where a death benefit is assigned while the member is in ill health and in respect of phased retirement.
2.1 The legislation covering Inheritance Tax is contained in the Inheritance Tax Act 1984 (‘the Act’). There are two sections of the Act under which claims might arise in respect of retirement benefits: IHTA84/S5 (2) , as extended by IHTA84/S151 (4) , and IHTA84/S3 (3).
2.2 Section 5(2), as amended, applies where the member has a ‘general power’ to dispose of the benefits. (‘General power’ means a power enabling the person by whom it is exercisable to dispose as he/she thinks fit). Paragraph 4.1 sets out an example of how a general power can arise in relation to income withdrawal.
2.3 A claim may arise under section 3(3) where holders of personal pensions or retirement annuities (or exceptionally occupational scheme members) do not elect to take their benefits before they die (but after they are able to take retirement benefits, e.g. the holder has attained age 50). In certain limited circumstances we might take the view that the failure to exercise the right before death gives rise to a lifetime charge to Inheritance Tax under section 3(3). These circumstances were described in an article in HMRC’s Tax Bulletin of February 1992, following discussions between ABI and this office, but the point was also made that we expected to see very few cases where a claim would even be considered. A copy of the article is annexed to this paper.
2.4 During the recent discussions ABI argued that income withdrawal was a direct alternative to annuity purchase and so electing the income withdrawal option should not carry any Inheritance Tax implications which do not apply where an annuity has been bought. We do not accept this argument. They point out that after the death of a member who had elected for income withdrawal, the lump sum is paid subject to a 35% tax charge. That is therefore an indication that at that time the money has ceased to be what was previously a tax approved pension scheme. The protection under IHTA84/S151 of the Act would not apply and there is therefore nothing to prevent an Inheritance Tax liability arising where this is appropriate. (Section 151 provides, broadly, that an interest in a pension or annuity under an exempt approved occupational scheme, an approved personal pension or an approved retirement annuity contract will not be taken into account in determining the value of an individual’s estate immediately before his death.)
Application to income withdrawal
2.5 Parts 3 and 4 of this paper describe the application of IHTA84/S3 (3) and IHTA84/S5 (2) of the Act to income withdrawal under personal pensions, and the circumstances in which claims might arise.
The application of Section 3(3) to income withdrawal
3.1 The circumstances in which an Inheritance Tax charge might be considered under section 3(3) are where decisions have been made prima facie with the aim of benefiting others on death rather than to make provision for the member’s retirement. If having elected to take income withdrawal it can be shown that the member (or survivor, where applicable) was in normal health and that the option was elected for commercial and retirement planning reasons, a section 3(3) claim would not arise. As a rule of thumb, if the member makes a decision, unless it was known the member is in ill health, and lives for two years, that is evidence that he was not suffering from ill-health when he made the decision (‘ill-health’ in this context means terminal ill-health or such ill health that the member’s life is uninsurable). We acknowledge that income withdrawal will usually be elected for commercial and retirement planning rather than donative reasons.
Valuation of a Section 3(3) Claim
3.2 When a section 3(3) claim does arise the claim is on the failure to take up the retirement benefits available to the member at the instant before death, i.e. on the loss to the estate at that date. At that point the member had the right to use the whole remaining fund for the purchase of an annuity.
3.3 The section 3(3) claim is therefore based on the value of an annuity guaranteed for 10 years payable monthly in advance calculated by HMRC, which the balance of the whole fund would have purchased. The annuity value for this purpose will be based upon the drawdown provider’s single life rates, without increases or provision for dependants except to the extent that this is specified in the scheme rules. (Any lump sum payment would have to have been taken at the outset of drawdown and so would not feature in the calculation.)
3.4 We stress that no claim under section 3(3) will normally arise where there is no change in the established pattern of income withdrawal i.e. where what was clearly initially a commercial transaction or ‘plan’ continues without change despite intervening ill health. In addition the concessions given in the Tax Bulletin of February 1992 will continue to apply and the result should be that very few claims will arise.
The importance of planning within the advice process: the implications for Inheritance Tax
3.5 It is essential that, as part of the advice process, an adviser discusses death during income withdrawal and the Inheritance Tax position. General advice about death and Inheritance Tax on the plan will not prejudice the position as regards a claim. However, this would not be the case if the advice dealt with, say, a scenario whereby the holder became ill and the drawdown was altered because of the ill-health of the holder.
3.6 If a clear commercial plan of action is agreed and documented while the individual is in good health, and is then acted upon, much greater certainty then exists regarding Inheritance Tax. The plan would set out the level of income to be taken for each year and might include other parameters, such as when an annuity is to be bought. If this member later becomes terminally ill, or so ill as to be uninsurable, this does not of itself give rise to an Inheritance Tax charge. If he then decides to reduce any payments received under drawdown this will give rise to a potential Inheritance Tax charge as this is a decision driven by being ill. The charge will arise on the annuity capable of being produced by the whole of the remaining residual fund.
4. The application of Section 5(2) to income withdrawal
4.1 As noted above, section 5(2) (as amended) applies where the member has a ‘general power’ to dispose of the benefits. An example of a general power is the option of the survivor to take a lump sum within two years of the member’s death during income withdrawal. If the survivor dies within those two years the value of the lump sum would form part of the survivor’s estate for Inheritance Tax purposes unless the survivor gives up the right to take the lump sum, at a time when he/she could reasonably have expected to live to enjoy the benefits, by effecting an irrevocable disclaimer of that right.
4.2 We have confirmed that a potential Inheritance Tax liability is unlikely where the member had a power of nomination in relation to a lump sum death benefit, revocable in life but binding on death, to select from a limited class of survivors. There would be a claim, of course, if the effect of a revocation is that the lump sum is paid to the legal personal representatives as of right.
5. Other issues
5.1 The following issues were also covered briefly in the discussions with us
(i) Earmarking Orders on Divorce or dissolution of a civil partnership
5.2 The Inheritance Tax position depends upon the precise terms of the court order. If the court makes a clear direction in the order there should be no Inheritance Tax liability; but problems could arise if the order directs that the position be reviewed at the time of retirement.
5.3 If the wording of the order suggests that the ex-spouse or civil partner has an interest in possession during the interim period, a claim might arise on these grounds if the ex-spouse or civil partner dies before the member’s retirement. The precise wording of the order is crucial in this respect
[An Inland Revenue Press Release dated 12 February 1976 contained the following definition of interest in possession:-
“…… an interest in possession in settled property exists where the person having the interest has the immediate entitlement (subject to any prior claim by the trustees for expenses or other outgoings properly payable out of income) to any income produced by that property as the income arises; but … a discretion or power in whatever form, which can be exercised after income arises to withhold it from that person negatives the existence of an interest in possession. For this purpose a power to accumulate income is regarded as power to withhold it, unless any accumulations must be held solely for the person having the interest or his personal representatives.”]
5.4 We consider that the overriding by an earmarking order of the discretionary disposal of a death benefit would not normally give rise to an Inheritance Tax liability as this situation would be covered by the exemptions in sections 10 and/or 11 of the Act.
(ii) Flexible Use of Additional Voluntary Contributions
5.5 At the time of these discussions proposals had been published by the Inland Revenue to allow benefits from AVCs to be paid earlier or later than the main scheme benefits, but final details were not yet available.
5.6 We commented that, subject to the final provisions, they would expect the position to be very similar to that outlined in paragraph 2.3 of this article from the Tax Bulletin of February 1992, which is annexed to this note. The scope for a section 3(3) claim would therefore be as described in the article.
(iii) Unapproved Schemes
5.7 Unapproved schemes usually contain far greater powers of disposition for members than approved schemes. As a result of this section 5(2) is much more likely to feature with regard to benefits. The gifts with reservation provisions may also apply to benefits under unapproved schemes, but will not apply to approved schemes, which are excluded by virtue of Statement of Practice 10/86
(iv) Assignment of Death in Service Benefits: Section 3(1) Claims
5.8 A claim might arise under section 3(1) of the Act where the death benefit is assigned whilst the member is in ill health. Although the death benefit and the pension rights are mutually exclusive, at the date of assignment both remain potentially available. The section 3(1) claim is on the loss to the estate, i.e:
the open market value of the whole plan, i.e. the death benefits, less
the value of the pension rights retained at that date, i.e. the maximum commutable lump sum plus the value of the 10 year guaranteed annuity payable monthly in advance which the remainder of the fund would purchase.
5.9 Where any existing ‘bolt-on’ term assurance exists (e.g. under IHTA84/S226A) and is assigned in similar circumstances a claim may also arise. The claim would be based on the open market value of the term assurance, which would be dependant inter alia on the individual’s state of health.
(v) Phased retirement
5.10 Paragraphs 3.5 and 3.6 comment on the importance of planning within the advice process for income withdrawal, and the Inheritance Tax implications of this. The position is in some respects similar for phased retirement, and the following example may be helpful:-
the member has 100 arrangements, each worth £2,000.
while in good health, the member agrees to plan with his adviser for using phased retirement.
in years 2 and 3, the member wants £12,000 and £15,000 respectively and arrangements are vested accordingly.
in year 4 the member becomes terminally ill or uninsurable. The plan provides for £18,000 to be taken in this year but the member decides to reduce this because of his ill health.
5.11 The Inheritance Tax liability would extend to the annuity capable of being produced by the whole of the residual fund.