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Matthew Hutton MA, CTA (fellow), AIIT, TEP reports on the IHT implications where pension policies are held in flexible interest in possession or on discretionary trusts.

Context

Many pension policies are held under flexible interest in possession trusts provided by insurance companies, although some insurance company trusts are true discretionary arrangements.

The death benefits under the pension policy are held for the benefit of the trust’s beneficiaries whilst the other benefits under the policy, the pension annuity and demutualisation benefits for example, are held for the absolute benefit of the settlor (the member of the pension scheme).

It should be noted that for pensions law purposes the member of the pension scheme always retains the right to a transfer value under the policy over which the trustees have no control; this can cause some trustees concern if they are asked to approve a transfer.

Existing rules for discretionary trusts

Assets held under the pension scheme itself are not relevant property (IHTA 1984 s58(i)(d)), provided they are payable at the discretion of the pension scheme trustees.

Furthermore, IHTM 17123 allows the assets to be held within the scheme for two years after death, during which time they can be distributed free of IHT. (Incidentally, the growth in value of the fund during this time, or income arising to it, is not subject to income tax.) 

Whilst the pension scheme trust deed is likely to give the pension scheme trustees wide-ranging discretion over who they can pay the death benefits to, it is not unusual for members to establish their own trust to receive these benefits. If they do, then the two year period from the date of death extends to the recipient trust.

However, where the pension scheme trustees transfer the death benefits to a receiving trust at their discretion, there might be a charge when that trust distributes its assets to the beneficiaries. These rules are found in IHTM 17124.

What is the commencement date for purposes of the ten year anniversary charge?  It is the date on which the individual joined the pension scheme.

Existing rules – interest in possession trusts

Where the death benefits are currently held under a flexible interest in possession trust, IHT is based on the life tenant’s tax position following transfers of death benefits into the trust after death. Generally, they will then be transferred to the trust’s beneficiaries and problems will arise only if the life tenant dies before the distribution is made, or their share is changed by the trustees so that assets are appointed away to other beneficiaries.

Pensions after the changes

The rules for discretionary trusts remain the same and new interest in possession trusts will be treated in the same way going forward, as will most existing trusts if there are changes in life tenants after 5.4.08.

By way of reminder, where death benefits are transferred from a pension scheme trust to a receiving trust at the discretion of the pension scheme trustees, they are treated as relevant property immediately they enter the second trust and as a result there may be a charge when they are distributed from that trust. 

To determine whether there is a charge, it will be necessary to recalculate the periodic charge for the receiving trust at the last ten year anniversary assuming that the death benefits formed part of the trust at that time.
 
This rate of charge will be applied to the death benefits when they are paid out of the receiving trust, although it will be pro-rated depending upon the number of quarters that have elapsed between the time that the death benefits were paid into the trust and the time that they were distributed from it (IHTA 1984 s69(4)). Whilst this might happen in the first quarter, it is still treated as though one quarter has elapsed as you ignore only quarters since the last ten year anniversary which have expired before the property became relevant property (s68(3)(b)).

(Lexis Nexis conference on Trusts and Inheritance Planning 22.2.07 lecture by Paul Garwood of Smith & Williamson)

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