Preparing for the (next) Budget: urgent action required

Inheritance tax charge on pension funds

An emotive subject

Inheritance Tax is often described as the ‘most hated’ tax, even though only about one estate in 25 actually suffers it.  The new charge on pension funds upsets the plans of those who may have saved for many years, and who may have ‘underspent’ so as to be sure to have enough to cover care costs, if ever needed.   

Will the change succeed in raising revenue?

It looks like a clever tax-raising move.  An elderly member of a registered pension scheme (the ‘Member’), who has not hit his or her fund too hard, is a ‘sitting target’ and cannot easily avoid the tax.  However, as we know from the fairly low yield of CGT after the rates were raised recently, taxpayer behaviour can change, such that the tax yield suffers. 

The message in several newspapers is that, despite evidence that we do not, as a nation, save enough for our old age, people will now be discouraged by the tax change from saving into pensions.  That has two negative effects.  Some will reduce saving.  Others are now drawing heavily on their pension funds, maybe too heavily.

The ownership issue

At the heart of the proposals is a fundamental ownership issue.  Draft s150A Inheritance Act 1984 (all references in this note to draft sections are to those to be inserted into the 1984 Act) tells us that the Member is treated as beneficially entitled, immediately before death, to as much of the pension fund as, at the date of death, must or may be used to pay a ‘relevant death benefit’.

Most interests in pension funds are discretionary, such that no Member can, for example, give away an interest during lifetime.  The court may, in matrimonial proceedings, make a pensions sharing order; but that is not within the power of the average Member.  This seems unfair: if the value is part of the Member’s estate, that person should have power of disposition over it. 

For example: a life interest in a trust is also treated as if it were part of the estate of the life tenant; but that person can give up the interest so that it can, in lifetime, pass to the next person entitled.  In most cases, all that the Member can do is send the trustees of the pension scheme a letter of wishes, so that, for example, if the next main beneficiary is the surviving spouse, see draft s150A(3), the usual spouse exemption will apply.

What should people do?

The first rule, as always, is not to panic.  Some Members have been drawing huge sums from their pension pots, running themselves into Income Tax (‘IT’) charges at high rates.  It makes no sense to pay IT at 45% to save IHT at 40%. 

The first advice is to change behaviour.  For many years it was accepted advice that one should draw on the pension fund last, after exhausting other funds, because the ‘unspent’ fund would not suffer IHT.  Clearly, that no longer works, so it now makes sense to draw as much by way of income as the fund will comfortably stand.  A Member to whom Capped Drawdown applies will be familiar with the annual review and the maximum that can be drawn – which may seem more than adequate.

Increasing drawdown will, gradually, cure the problem of the ownership issue.  Thus it might make sense to pay IT, even at 40%, in order to gain control over assets.

First, this could, over time, lead to a lower IHT burden by using property reliefs, see below.

Second, the Member will have control over funds, net of IT, with which to make lifetime gifts, see below.

In particular, where possible a Member should take advantage of UFPLS.  This was described in my Article ‘Beating the (next) Budget’ but to summarise: this can apply where the Member has not already drawn the maximum tax-free lump sum upon first retiring and beginning to draw the pension.  If there remains a substantial undrawn lump sum, and, for example, the Member draws £20,000, £15,000 can be treated as income subject to tax and £5,000 can be drawn free of IT.

A Member can solve the ‘unspent’ problem immediately by using the whole fund to buy an annuity that is exhausted on death.  Depending on the circumstances, that may be a drastic measure.

A Member should review any Letter of Wishes previously sent to the pension administrator to check that it still meets their needs.  Take advantage of the new s150A(3) IHTA 1984 (spouse exemption) where appropriate.

The lifetime gifts rules (again)

So far, we have heard nothing official to suggest that the rules will change, but this is a clear possibility.  I described the rules in my Article ‘Beating the (next) Budget’, showing how large gifts, and smaller, regular gifts are treated.  It is vital to keep good records: the executors will need them.

Of these, the most useful, for as long as it lasts, is s21 IHTA 1984 ‘Normal expenditure out of income’.  A Member who has decided to increase drawings, so as to reduce the fund left at time of death, may as a result have surplus income which can be given away.  However, there should be a pattern of gifts, and the Member should still be left with enough to live on.

Apart from these exemptions there is still, at present, the ‘seven year’ rule: once that time has fully elapsed since the making of an outright gift, from which no ‘kick-back’ or benefit has been reserved, the gift falls out of account.  Keep good records: the executors will need them later.

Is there an immediate double tax charge on the pension fund?

One point that has vexed commentors and has even now only partly been explained, is quite how the new tax will work.  Suppose that the Member has already drawn all the tax-free lump sum, such that anything now drawn is treated as income.  Under the old rules, in the event that the Member had lived beyond the age of 75, and then died, what was later drawn by later beneficiaries, such as children, would be treated as income in their hands and taxed on them.  That seemed fair enough, since tax relief had been given to the Member when building up the fund in the first place.

Suppose that:

the Member has left his estate to his son;

the fund left over at death is £500,000; and that

the other estate of the Member has used up the available nil-rate band(s).

There is a 40% IHT charge on the pension fund: £200,000.  Originally it seemed that the son, in drawing the money to pay the IHT, would be treated as having received income of £200,000 (on money that he had not enjoyed), so would get a further tax bill.

IT on pension income is taxed under ss566-568 Income Tax (Earnings and Pensions) Act 2003.  Where s567 ITEPAdefines the income to be taxed, a deduction is to be allowed ‘where IHT is paid in respect of relevant death benefit’.  The Guidance Notes on this important provision state merely that a deduction for IHT payable ‘is considered when calculating the amount charged to tax.’ 

That could have been clearer, but in layman’s terms, it will probably be alright: no double charge.

Pension fund investments: agricultural and business property, and the ‘tax fund’

One point is now clear.  S150A(4) IHTA 1984, as drafted, excludes claims for relief in respect of assets, such as unquoted shares, held in a pension fund.  That is harsh, since suitable assets may have been placed in the fund long ago and may be hard to realise or even to value.  Like other measures, it might discourage future enterprise, though that would be hard to prove. 

For taxpayers the remedy is hard to achieve and will take time.  The Member wishing, partly for tax reasons, to hold unquoted shares and similar investments will have to hold them personally, instead of in the pension fund.  He or she will have to establish the usual two-year holding period afresh, to secure even the limited relief now available.  There will be transaction costs.

Another serious issue is funding the tax.  Since 40% of the fund may be needed very soon after the death (see below), it must from now on make sense, if the Member is old, to consider having a goodly proportion of the fund in readily realisable assets such as short-dated gilts and other fixed-income bonds. 

Jobs for the executors: establishing and paying the tax

Here we have some much-needed clarity.  Liability for IHT on pension funds rests, first, on personal representatives (executors or administrators): see new s210 IHTA 1984.  It will be their job to establish all the taxable values, including the pension fund.  There is a secondary obligation, in certain circumstances, on the administrators of the pension scheme.

Where IHT is due, the person for whom the unspent pension fund comes to be held, called in draft s226A IHTA 1984 the ‘beneficiary’, can ask the fund administrator to pay the tax.  S226A IHTA 1984 sets out the procedure and the (quite short) time limits.  There is alternative provision under changes to s211 IHTA 1984 where the tax on the pension is actually paid by the personal representatives from other funds.  The person enjoying the pension fund must reimburse the personal representative.

Get on with it.

My suspicion is still that, despite her protestations to the contrary, the Chancellor may need to impose another substantial raid on the funds of private individuals.  The increases in NICs have caused businesses to curtail employment.  The mood among entrepreneurs is downbeat.  Farmers continue to protest.  Investors are selling UK shares and placing their money elsewhere.  A few are leaving the country.  There is some evidence that the Chancellor is aware that her measures may discourage the investment that the country needs.  She has few options open to her.

If I am right, it must make sense to use the exemptions and reliefs from IHT and from CGT that currently exist, before they are removed or cut down even more.  Failure to plan leaves the family open to the risk of a big and nasty surprise.