This is a chapter from the Bloomsbury Professional book Houseman's Law of Life Assurance, 14th edition, which is an authoritative guide for insurance practitioners and covers every aspect of life assurance law. The latest edition of this key text includes coverage of the recent changes at the European level, including the creation of the European Insurance and Occupational Pensions Authority (EIOPA) and its role in the Solvency II Directive. It examines proposed changes to UK regulation being split between the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA). Other proposed changes covered by the book are the Retail Distribution Review.
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Table of Contents
14.1 From 1894 transfers of capital on death were subject to estate duty. The Finance Act 1975 replaced estate duty with capital transfer tax (CTT) from 26 March 1974. This taxed not only transfers of capital on death but also lifetime gifts and was codified by the Capital Transfer Tax Act 1984. The Finance Act 1986 replaced CTT with inheritance tax (IHT) which applies to all transfers made on or after 18 March 1986 and renamed the codifying act the Inheritance Tax Act 1984 (IHTA 1984).
14.2 The general principle is that transfers of capital out of an individual's estate are liable to IHT. The essential features of IHT are that:
(1) it applies (subject to certain exceptions) to transfers by way of gift during lifetime, as well as to the value of an individual's estate on death;
(2) it is generally charged on the donor, not the donee, ie, the tax is applied by measuring the loss suffered by the transferor, not the benefit received by the transferee;
(3) it is cumulative, ie, it is chargeable on the cumulative total of chargeable transfers made by an individual during a seven-year period (on transfers in excess of the 'nil rate band', a threshold of £325,000 from 6 April 2011 which will stay at that level up to and including tax year 2014/15), and any transfers made more than seven years before the transfer in question will not be taken into account; and
(4) it is levied separately from any other tax, so that it is possible for a transfer to be liable to both IHT and capital gains tax (CGT), without any allowance in one for the other.
IHT is not restricted to cases where an individual actually makes a gift during lifetime or the value of his estate on death. It also applies to cases which are treated as if a transfer had occurred, eg in connection with settled property and the failure to exercise a right. IHT applies to individuals. However, special rules exist to charge individuals in respect of dispositions made by close companies and to bring trustees within the scope of the tax.
The tax applies to the whole of the United Kingdom (UK), including Northern Ireland.
14.3 Life assurance itself is linked with IHT because it plays a large part in mitigating and providing for the tax. Life assurance practitioners should, therefore, be aware of at least the basic principles of IHT for this reason and also to be able to appreciate fully the IHT consequences of movements of certain assets within the client's estate. This Chapter sketches the general scheme of the tax[1] and looks more closely at the relevant IHT provisions relating to life assurance contracts. Chapter 15 will then examine the effect of IHT on various types of life policy trust wordings and consider the role and use of life assurance in estate planning.
14.4 IHT is charged on the value transferred by a chargeable transfer[2] which, in the case of a lifetime gift, means any transfer of value made by an individual which is not exempt[3] and which is in excess of the nil rate band (£325,000 for transfers made on or after 6 April 2011). For IHT purposes, certain lifetime transfers are potentially exempt transfers (PETs)[4] which are assumed to be exempt at the time of transfer and do not enter the cumulative total until death[5]. 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 be but for the disposition and the amount by which it is less is the 'value transferred' by the transfer[6].
IHT is levied, therefore, by reference to the reduction in the transferor's estate, as a result of making the gift, not by reference to the increase in the transferee's estate. This means that if tax on the gift is paid by the transferor, the reduction in his estate includes the amount of the tax, as this forms part of his loss. To calculate the total tax payable in these circumstances it is necessary to 'gross up' the value transferred at the appropriate rate[7].
On a transfer for partial consideration, only the balance, ie the element of gift, is chargeable. Similarly, if the transferee assumes responsibility for a liability of the transferor (eg where he pays CGT arising on the gift) the value of the transfer is reduced accordingly.
14.5 There is no transfer of value, and thus no IHT, if the transfer was not intended to confer any gratuitous benefit on any person and either the transaction was at arm's length between unconnected persons, or was such as might be expected to be made in a transaction at arm's length between unconnected persons[8]. 'Connected persons' means, essentially, a spouse, registered civil partner, or relative (including uncle, aunt, nephew and niece)[9].
If the transfer was of a sale of shares or debentures in an unquoted company it is also necessary to show that the price was freely negotiated at the time of the sale or that the price was that which would have been expected had it been freely negotiated at the time[10]. (This is to avoid the possibility of avoiding IHT by imposing a fetter on the disposition of shares in the company's articles of association.)
Certain other 'transfers' are also deemed not to be transfers of value, including dispositions for the maintenance of one's family[11] and transfers of property by a close company to trustees to hold on trust for the benefit of employees (excluding any shareholder with 5% or more of the shares[12]).
14.6 This term is not defined and carries its ordinary wide meaning which includes, inter alia, the payment of money, the conveyance, transfer or assignment of property (by sale or gift), and the creation of a settlement[13], ie any transaction by which a person disposes of an interest in an asset or creates a new interest in another person in an asset. Where an individual deliberately omits to exercise a right, which as a result reduces his estate and increases another's, the omission is treated as a disposition[14]. This could, for example, cover the failure to collect a debt or to vote in respect of shares in a company. In relation to settled property a surrender of a life interest has been held to be a disposition[15].
14.7 A disposition includes one made by 'associated operation', which is where a transfer of value is made by any two or more operations of any kind by the same or different persons and whether simultaneous or not affecting the same property, or where one operation affects a further operation[16]. Note that 'operation' includes an omission.
The 'same property' means property which represents directly or indirectly the property or income (including accumulations) arising from it. Similarly, operations which in any way provide for, or facilitate, the performance of other operations will be associated with them.
Where the associated operations provision applies, the composite transfer (ie the value of the overall loss to the estate) will be treated as being made at the time of the last of the operations.
This provision is designed to counter avoidance measures whereby an individual's estate is reduced through a series of transactions or where property is transferred in stages, the aggregate value of the constituent transfers being less than the value of the property as a whole; or where a gift is made of property worth little at the time but which subsequently increases in value by reason of some other act of the donor. This matter will be raised again in connection with 'back-to-back' arrangements and certain other arrangements referred to in Chapter 15.
HMRC does not view the sharing of one spouse's or registered civil partner's estate with another, where that other makes gifts out of the money received as an associated operation, unless it is a blatant case of a gift conditional upon using it to make gifts to others[17].
14.8 IHT only arises if a disposition reduces the value of the transferor's estate[18]. Broadly, an individual's estate comprises the aggregate of all property to which he is beneficially entitled (not including excluded property)[19], less his liabilities. In addition to tangible property, equitable rights, debts and other choses in action, an individual is treated as beneficially entitled to all property, other than settled property, over which he has (or would if he were sui juris) a general power to appoint or dispose as he thinks fit or on which he can charge money. An individual beneficially entitled to an interest in possession in settled property (such as a life interest) was treated as entitled to the property in which the interest subsists[20]. However, this position was altered by the Finance Act 2006. This will only remain the case for settlements created before 22 March 2006 provided the existing beneficiaries at that date have not been changed, unless that change occurred before 6 October 2008 in which case the new beneficiaries will be treated as having been the beneficiaries in existence at 22 March 2006. For new settlements created on or after 22 March 2006, the former treatment will continue to apply only if the settlement is made for the benefit of disabled persons as defined in section 89 of the IHTA 1984 or if the trust used is an absolute or bare trust. If this is not the case, such settlements will be treated for IHT purposes as trusts without an interest in possession and will be taxed accordingly.
14.9 On the death of an individual, IHT is chargeable as if immediately before his death, the deceased had made a transfer of value equal to the value of his estate at that date[21]. In valuing the estate, any changes brought about by the death (eg the cessation of a life annuity, or the proceeds payable on a claim under a single life policy owned solely by the deceased) are to be taken into account[22]. This provision does not apply, however, to the termination on the death of any interest or the passing of any interest by survivorship[23] (eg the interest under a jointly owned, joint lives, last survivor contract) which would, therefore, be valued at the full open market value at death[24]. No grossing up is required in determining the value transferred, since the tax is payable from the estate by the personal representatives.
Any PETs within seven years prior to death become chargeable at the value of the property at the time of the PET, subject to any claim for a fall in the value of the property from the date of the gift to the date of the transferor's death or earlier sale by the transferee[25] and taper relief. If there are any available annual exemptions, they may be applied retrospectively. If a PET does become chargeable by virtue of the donor dying within seven years, it will be necessary to look back over the seven years before the PET to see whether any chargeable lifetime transfers have been made. If this is the case, account needs to be taken of such transfers in determining the amount of tax, if any, due on the failed PET.
If an individual dies within seven years of making a chargeable transfer, the IHT death rates will retrospectively apply with credit for any lifetime tax already paid and taper relief as appropriate[26]. The donee is liable for the extra IHT and so no grossing up is required.
14.10 The meaning of estate is similar to that for lifetime transfers, and is the aggregate of property to which, immediately before his death, the deceased was beneficially entitled, other than excluded property. Certain property is left out of account, however, for the purpose of the IHT charge on death. Thus, where the deceased had an interest in possession in property settled before 22 March 2006, and on his death: (1) the property reverts to the settlor during the settlor's lifetime, or (2) the settlor's spouse or registered civil partner becomes beneficially entitled to the property, then its value is excluded from the deceased's estate – unless the settlor or the settlor's spouse or registered civil partner acquired the reversionary interest for money or money's worth[27]. (Spouse includes widow or widower in cases where the settlor died less than two years before the deceased.) Also left out of account are interests in certain superannuation schemes and certain overseas pensions. The value transferred is the value representing the sum which the estate might reasonably be expected to raise if sold in the open market (less liabilities)[28].
14.11 The Finance Act 1986[29] introduced the concept of 'gifts with reservation of benefit' (a similar concept existed under the estate duty regime). Where property is disposed of by way of gift (on or after 18 March 1986) but either:
(1) possession and enjoyment of the property is not bona fide assumed by the donee at least seven years before the donor's death; or
(2) at any time within seven years of the donor's death ,the property is not enjoyed to the entire exclusion, or virtually[30] to the entire exclusion, of the donor and of any benefit to him by contract or otherwise,
the property is deemed to be 'property subject to a reservation', ie property to which the donor was beneficially entitled immediately before his death, and it will be added to and form part of his taxable estate for IHT purposes. Furthermore, no CGT uplift will be available on the donor's death.
If the reservation ceases before the donor's death, he will be treated as having made a PET at that time. If the cessation was more than seven years before the death, the PET will have fallen out of account, but if not, IHT will be assessed on normal principles[31]. Note that the value of the PET cannot be reduced by any of the available annual exemptions.
The rules relating to gifts with reservation involving land were tightened with effect from 9 March 1999 in response to the House of Lords ruling in Ingram and another v IRC[32]. Section 102A of the Finance Act 1986, as inserted by the Finance Act 1999, extends the existing provisions to prevent the avoidance of IHT on death by way of a lifetime gift where the donor or his spouse enjoy a significant right or interest or is a party to a significant arrangement in respect of land. Where this happens, the interest disposed of will be treated as a gift with reservation. A right, interest or arrangement is significant if it entitles or enables the donor or his spouse to occupy all or part of the land (or enjoy some other right) otherwise than for full consideration in money or money's worth. The right, etc is not significant if it:
(1) cannot prevent another person or persons enjoying the land virtually or entirely to the exclusion of the donor;
(2) does not enable the donor to occupy the land immediately after the disposal but would have done so were it not for the disposal; or
(3) was granted or acquired more than seven years before the gift.
Similar provisions also apply to gifts of undivided shares in land under section 102B.
14.12 The gift with reservation of benefit rules do not apply to any disposals which are exempt within any of the provisions of the IHTA 1984 (see below), except for the £3,000 per annum and normal expenditure exemptions[33].
Thus any property enjoyed by or benefiting the donor's spouse did not automatically fall within these provisions but this situation came to an end with effect from 19 June 2003[34]. Prior to that date, the opportunity existed for a settlor to create a trust for the benefit of his or her spouse. The settlor could be a potential beneficiary under the trust without infringing the gift with reservation rules. Some months after the creation of the settlement, the trustees made an appointment away from the settlor's spouse in favour of the children or grandchildren. This course of action constituted a PET by the spouse but a situation had been created whereby a trust had been set up for the benefit of the settlor's children or grandchildren, but under which both the settlor and his spouse were potential beneficiaries and the gift with reservation rules had not been breached. From 19 June 2003 onwards, however, this is only the case whilst the settlor's spouse actually has the interest in possession. Once this is appointed away, if the original settlor is still a potential beneficiary, the gift with reservation rules would apply.
Where the disposal by way of gift was made in connection with an insurance policy (issued before 18 March 1986), the gift with reservation provisions will not apply unless the policy is varied on or after that date so as to increase the benefits secured or extend the term of insurance. Any change made in the policy terms in pursuance of an option or other power conferred is deemed to be a variation, apart from the exercise of an indexation option with respect to benefits or premiums before 1 August 1986 if the option or power could only be exercised before that date[35].
The following are examples of changes which will be regarded as increasing the benefits or extending the term[36]:
(1) altering from one class of assurance to another;
(2) converting from an endowment assurance to a low cost endowment assurance or vice versa;
(3) reducing the term of an endowment assurance if premiums are being simultaneously increased;
(4) converting from a without- to a with-profits policy for the same sum assured;
(5) adding premium waiver benefit or double accident benefit or the addition of an option not previously included in the policy.
14.13 Historically, HMRC have sought to litigate in situations where they feel that the gift with reservation rules have been infringed. Where they have lost cases (Ingram and another v IRC[37] and IRC v Greenstock[38]) they have amended the legislation to render planning of that nature ineffective. However, HMRC were becoming increasingly frustrated that tax advisers were finding ever more complex ways to circumvent the gift with reservation legislation.
It was therefore decided to introduce a completely new tax, pre-owned assets tax which, from 6 April 2005, has the effect of imposing an income tax charge each year on the benefit people enjoy when they have arranged free continuing use of major capital assets that they once enjoyed.
The legislation concerning the tax is contained in Schedule 15 of the Finance Act 2004. Three classes of assets are covered by the new rules: land, chattels and intangible property which includes policies of life assurance.
Each class of assets has its own rules, but for life assurance policies, a pre-owned assets income tax charge can arise where any income arising under a settlement would be treated by virtue of sections 624 and 625 of the Income Tax (Trading and Other Income) Act 2005 (income arising under a settlement where the settlor retains an interest) as income of the settlor.
The life assurance policy would be valued at the time that it first falls within the charge and thereafter HMRC has stated in correspondence with the ABI that it should be sufficient for policies to be revalued every five years. This would hold good for regular premium policies too assuming the chargeable person remains in normal health throughout the five-year period. Once valuation has taken place, a rate of interest equal to the official rate of interest (5% at the time of writing) would be applied. There is a de minimis limit of £5,000 on the value of the benefit assessable so if the amount calculated as above was below this figure, no tax would be payable. Note that where the same settler has made a number of gifts all of which are potentially liable to pre-owned assets tax, the taxable benefits of each gift must be added up to see whether the overall £5,000 limit has been breached. If the benefit is in excess of £5,000, pre-owned assets tax will be payable on the whole benefit at the settlor's marginal rate of tax.
It should be noted that it is not possible to make a gift with reservation and also to pay pre-owned assets tax on the same gift. It must be either one or the other. The combination of the two taxes does, however, mean that it is now very difficult to make a gift, retain a benefit under it and avoid being liable for one of the taxes.
14.14 When an individual has been left property by will, under the intestacy rules, or under the right of survivorship, any transfer of that property would, prima facie, be a transfer of value, and potentially liable to IHT. Provisions exist[39] to mitigate this where the original donee is simply redirecting (or disclaiming) the deceased's dispositions. In certain circumstances, such a variation (or disclaimer) will not be treated as a transfer of value and will be treated as if the deceased had effected the variation (or the disclaimed benefit had never been conferred).
A variation occurs when the individual who benefits or would benefit under the deceased's will (or intestacy or otherwise) redirects property to another party of his choosing; a disclaimer occurs when the property is merely refused by the individual and the property falls into residue. The provisions apply equally to variations and disclaimers (referred to hereafter as variations), but do not apply to settled property in which the deceased had an interest in possession[40] or to property which is deemed to be included by virtue of the gift with reservation of benefit provisions[41].
To be within these provisions, the following conditions must be satisfied:
(1) The variation must be made within two years after the death of the testator or intestate.
(2) The variation must be made by an instrument in writing made by the individual(s) who benefit or would benefit under the dispositions. Any such individual must be aged 18 or over and must be of sound mind. A deed is usually used[42], although any instrument in writing will be effective. In Crowden v Aldridge[43], a unanimous direction by residuary legatees by memoranda (even though it was executed in contemplation of executing a formal deed which never in fact was executed) was held to be an effective variation of the estate.
(3) An election in writing must be submitted to HMRC that the provisions should apply. This election can be contained within the deed itself. The election must be made by the individual(s) who effected the instrument (and also by the personal representatives, if the variation causes more IHT to be payable) within six months of the date of the instrument (or such longer period as the board may allow).
(4) The variation must not be made for a consideration in money or money's worth unless the consideration is itself a qualifying variation or disclaimer relating to another of the deceased's dispositions.
A deed of variation may be rectified[44] and there may be more than one deed of variation in respect of the same estate, but each deed can only vary property that has not already been varied.
A deed of variation can be used to set up what would otherwise be a gift with reservation. For example, if a grandfather leaves property on trust to his son in his will, the son could redirect that property onto trust for himself and his own children as the beneficiaries. For IHT purposes, this variation will be treated as being made by the testator, not by the son and thus would not be a gift with reservation of benefit.
14.15 Under the provisions set out in Section E, it is possible to sever the beneficial interest in a joint tenancy with, for IHT purposes at least, retrospective effect. It would normally be used where property is owned jointly by husband and wife or by two registered civil partners and one party dies without making use of the nil rate band, and with insufficient assets in the free estate for the surviving spouse or registered civil partner to redirect other property. It would then be appropriate to sever the beneficial joint tenancy to pass the deceased's share of the property to other beneficiaries to use up the nil rate band, whilst utilising the remaining free assets for the benefit of the surviving spouse or registered civil partner.
14.16 A court may order financial provision for family and/or dependants of a deceased person out of his net estate. Property so redirected is treated for IHT purposes as having devolved on death subject to the provisions of the court's order[45].
14.17 Where a surviving spouse or registered civil partner elects under section 47A of the Administration of Estates Act 1925 to take the capital value of his or her life interest in the residuary estate in lieu of the income for life, the election is not a transfer of value. The surviving spouse or registered civil partner is treated as having been entitled not to the life interest, but to a sum equal to the capital value of the interest[46].
14.18 When two individuals die in such circumstances that it is impossible to know which died first, the general law, and the law of succession to property, presumes that the older was the first to die[48]. For transfers on death, this rule is excluded, and it is presumed instead that the deaths occurred at the same instant[49], thus avoiding a double charge.
Example
If mother and daughter die in a road traffic accident, the general law would treat any property bequeathed by the mother to the daughter as passing to the daughter's estate and then to the beneficiaries under the daughter's will (or intestacy). However, because of section 4(2), IHT is charged only on the transfer to the daughter's estate and not again on the transfer to the daughter's ultimate beneficiaries.
14.19 Where under the terms of a will, or otherwise, property is held for a person if he survives another for a specified period of not more than six months, the dispositions at the end of the specified period (or that person's earlier death) are treated as having had effect from the beginning of that period[50].
14.20 Relief is available from the IHT charge on death where the value of the deceased's estate has been increased by a chargeable transfer to him within the preceding five years.
For property not comprised in a settlement, the tax charged on the death is reduced by a percentage of part of the tax paid on the earlier chargeable transfer[51]. The percentage varies according to the period between the transfer and the death as follows:
Not more than 1 year |
100% |
1 to 2 years |
80% |
2 to 3 years |
60% |
3 to 4 years |
40% |
4 to 5 years |
20% |
14.21 It was stated earlier that IHT is charged on the value transferred by a chargeable transfer which, in the case of a lifetime gift, means any transfer of value made by an individual which is not exempt. The IHTA 1984 provides for fully exempt transfers[52]. The Finance Act 1986 introduced PETs[53]. Further, there will be no IHT if the property transferred is excluded property.
14.22 In measuring the loss to an individual's estate following a transfer (or the value of the estate upon death), no account is to be taken of 'excluded property'. The main categories of excluded property are:
(1) property situated abroad belonging to an individual not domiciled or treated as not domiciled in the UK[54], and
(2) reversionary interests, eg interests following life interests (other than those acquired for money or money's worth), or those, for settlements made after 15 April 1976, where either the settlor or his spouse are beneficially entitled[55].
14.23 An exempt transfer is the most efficient transfer for IHT purposes as, following the transfer, the property is immediately treated as being out of the estate of the transferor. The exemptions are not mutually exclusive and a transfer may fall within one or more of the exemptions and be freed from IHT partly by one exemption and partly by another. If a transfer is exempt, no IHT is ever payable. Some exemptions apply to a transfer whether made during lifetime or on death. Others apply either only to lifetime transfers or only to transfers on death. The following is not an exhaustive list, but does contain the principal exemptions for most practical purposes.
14.24 Transfers between spouses or registered civil partners from 5 December 2005 (whether living together or not) during lifetime and on death are exempt[56]. The exemption does not apply where the transfer:
(1) depends on a condition which is not satisfied within 12 months after the transfer; or
(2) 'takes effect' on the termination after the transfer of any interest or period[57].
The exemption is not excluded merely because the gift is dependent on the recipient surviving the other spouse for a specified period. It is therefore quite common for a will to be drawn so that the surviving spouse or registered civil partner is not to benefit unless surviving for, say, 28 days (but the period must not be any longer than six months) and the exemption will apply[58].
If, immediately before the transfer, the transferor is domiciled in the UK, but the spouse or registered civil partner is not, the exemption is limited to a cumulative total of transfers of £55,000[59] (which is in addition to the nil rate band). After 17 March 1986 gifts in excess of £55,000 may qualify as PETs.
The separate taxation of spouses or registered civil partners is important for a number of reasons. They are each entitled to the benefit of the reliefs and exemptions and in calculating the rate of tax on a chargeable transfer by one spouse, gifts made by the other are not taken into account. These principles obviously have great significance for estate planning as will be considered in Chapter 15. The relationship between them is not overlooked entirely, however, and for certain valuation purposes[60], spouses or registered civil partners are treated as one.
For the purposes of the remainder of this Chapter, apart from the next paragraph, references to spouse also apply to registered civil partner.
14.25 Where an individual's spouse died before 13 November 1974, leaving an interest in possession in property to the surviving spouse, estate duty would have been payable on that first death. To avoid a double charge to tax, there is no charge to IHT on either the subsequent death of the surviving spouse, or on the lifetime termination of that interest, provided that there would have been no charge on death[61].
14.26 during lifetime in any one tax year[62] are exempt up to £3,000 in total[63]. For this purpose, transfers are not required to be grossed up. If the exemption is not utilised, or not fully utilised in any one tax year, it may be carried forward to the following year and used to relieve transfers in that year only. If the exemption is unused by year three, it cannot be carried forward into that year.
Subject to two exceptions, the £3,000 annual exemption is available in addition to the other exemptions and reliefs, ie it applies to the residue of value remaining after applying any other reliefs or exemptions. It is not cumulative with the 'small gifts' exemption (see below), nor is it applicable to PETs arising as a consequence of a donor releasing his interest in property subject to a reservation[64].
14.27 Transfers of value made by a transferor during lifetime in any one tax year by outright gifts to any one person are exempt up to £250 (without grossing up) per transferee[65].
Gifts to the trustees of a settlement are not 'outright' and so fall outside the exemption. This exemption is available only if the total of all gifts made by the transferor to the transferee in any tax year does not exceed £250. (It should be remembered that this actually refers not to the value received but the loss to the transferor's estate.) There is no carry forward facility for this exemption.
14.28 A transfer of value is exempt if or to the extent that it fulfils, during lifetime, the following conditions:
(1) it was made as part of the transferor's normal expenditure;
(2) it was made out of his income (taking one year with another); and
(3) after allowing for all transfers of value forming part of his normal expenditure, the transferor was left with sufficient income to maintain his usual standard of living[66].
A gift is regarded as part of the transferor's 'normal' expenditure if its amount and type are consistent with his usual pattern of gifts. 'Normal' is regarded as broadly equivalent to regular or habitual[67]. The first gift in a series can qualify as 'normal' provided there is evidence that further gifts are intended, for example, a contract with a life office. This would cover the payment of the first premium under a regular premium life assurance policy written in trust. If there is no such evidence, but in fact further normal payments are made, the first premium may, retrospectively, qualify for this exemption.
'Income' for this purpose means net income and is determined with normal accountancy (rather than income tax) rules. The exemption is not lost merely because of fluctuations of income from one year to another; nor if the transferor makes a gift from income and, having met some exceptional expense, is obliged to resort temporarily to capital to meet ordinary living expenses.
The capital element of a purchased life annuity bought after 12 November 1974 is not regarded as part of the transferor's income for this purpose in relation to transfers of value made after 5 April 1975[68]. Furthermore, where an individual has effected a life policy as part of a 'back-to-back' arrangement[69], the premiums payable would not automatically qualify for the normal expenditure exemption. Similarly, withdrawals taken from single premium bonds would not qualify.
14.29 Certain gifts in consideration of marriage are exempt up to various limits (without grossing up). The limits are as follows:
(1) £5,000 if the transferor is a parent of a party to the marriage;
(2) £2,500 if the transferor is a remoter ancestor of a party to the marriage;
(3) £2,500 if the transferor is a party to the marriage;
(4) £1,000 if the transferor is any other person[70].
The exemption applies to gifts made at the time of, or shortly before, the marriage. Strict proof is required when a gift made after the marriage is alleged to be in consideration of it.
14.30 A disposition is not a transfer of value if it is made by one party to a marriage in favour of the other party or of a child of either party and is for the maintenance of the other party or for the maintenance, education or training of the child in any period up to the year in which he attains the age of 18 or, if later, when he ceases to undergo full-time education or training[71]. 'Marriage' in relation to a disposition made on the occasion of the dissolution or annulment of a marriage, and in relation to a disposition varying a disposition so made, includes a former marriage[72]. A disposition in favour of a dependent relative is exempt if it constitutes reasonable provision for the relative's care and maintenance[73]. Note that 'child' includes illegitimate, legitimated and adopted children.
14.31 There are some other exemptions, including: gifts to charities[74], gifts to qualifying political parties[75], gifts to registered housing associations[76], gifts for national purposes[77] and gifts for the public benefit provided they were made before 17 March 1998[78]. Further, there is no charge to IHT where a member of the armed forces dies from a wound inflicted, accident occurring or disease contracted on active service[79]. Exemptions which have particular reference to life assurance are dealt with in Section 7A, 14.67.
14.32 A PET is a transfer of value made by an individual (on or after 18 March 1986) which would otherwise be a chargeable transfer to:
(1) another individual or property which becomes comprised in his estate or increases the value of his estate;
(2) an absolute or bare trust (although it should be borne in mind that, at the time of writing, HMRC take the view that the creation of an absolute trust for the benefit of a minor beneficiary would constitute a chargeable lifetime transfer rather than a potentially exempt transfer);
(3) an accumulation and maintenance trust provided the transfer was made before 22 March 2006[80];
(4) a disabled person's trust[81];
(5) an interest in possession trust on or after 17 March 1987 but before 22 March 2006.
A transfer out of an interest in possession trust is also a PET (since 17 March 1987) if the transferee is an individual, an interest in possession trust, an accumulation and maintenance trust, or a disabled person's trust provided that the trust was created before 22 March 2006 and that the beneficiaries with the interest in possession have not been varied since that date (or, if they have, such variation took place before 6 April 2008).
If the transferor survives for seven years after the date of the PET, it becomes fully exempt and is never taxed, but if the transferor dies within seven years, the PET becomes a chargeable transfer and there will be an IHT computation[82] based on the value of the property at the time of the gift, the transferor's seven-year cumulation at the time of the gift and the death rates in force at the time of death or the rates in force at the time of the gift if this results in a lower amount of tax being payable. (Note that unless and until a PET becomes chargeable, it is regarded as exempt for all purposes, so that it would not be aggregated with a later chargeable transfer (eg a transfer to a discretionary trust) for the purposes of establishing the appropriate rate of tax for the chargeable transfer.)
14.33 There are a number of reliefs available from the charge to IHT. This Section deals with two main areas of relief, namely agricultural property relief and business property relief.
14.34 Agricultural property relief is available for transfers of the 'agricultural value' of agricultural property, during lifetime, on death and on transfers into and out of settlements. The relief also extends to certain transfers of shares in companies which own or occupy farms[84].
For the purposes of this relief, 'agricultural value' is the value the property would have if it were subject to a perpetual covenant not to use it otherwise than for agricultural purposes. 'Agricultural property' is agricultural land or pasture in the UK, the Channel Islands and the Isle of Man and includes woodland and any building used in connection with the intensive rearing of livestock or fish if the woodland or building is occupied with agricultural land or pasture and the occupation is ancillary to that of the agricultural land or pasture; and also includes such cottages, farm buildings and farmhouses, together with the land occupied with them, as are of a character appropriate to the property[85].
The relief operates before deduction of the annual exemption and other exempt transfers and before grossing up (if applicable) by reducing the value transferred (automatically, without claim) by the following percentages[86]:
(1) 100% if immediately before the transfer the transferor had the right to vacant possession of the property or the right to obtain it within 12 months;
(2) 100% subject to the old limits (£250,000 or 1,000 acres per transferor) where the transferor would have been entitled to 50% relief under the old rules and had been entitled to his interest since before 10 March 1981 and satisfies certain conditions;
(3) 100% if the property is let subject to an agricultural tenancy commencing after 31 August 1995;
(4) 50% in all other cases.
14.35 To qualify for relief, the transferor must, immediately before the transfer, either:
(1) have occupied the agricultural property for agricultural purposes for at least two years; or
(2) have owned the agricultural property for the last seven years and throughout the period the property must have been occupied for agricultural purposes (whether by him or another)[87].
For this purpose:
(1) If the transferor inherited the property on the death of another, his period of ownership is regarded as beginning on the date of that death. Where the transferor was a spouse, the spouse's period of occupation may be added[88].
(2) Occupation by a company controlled by the transferor is treated as occupation by the transferor[89].
(3) If at the time of the transfer, the transferor had occupied the property for agricultural purposes for less than two years but it replaced property he had previously occupied for agricultural purposes, the occupation condition is treated as satisfied if he had occupied one or other of the properties for a combined period of at least two out of the five years preceding the transfer[90].
(4) In similar circumstances to (3) the ownership condition is treated as satisfied if the transferor had owned one or other property for a combined period of at least seven years out of the ten preceding the transfer and, throughout, they had been occupied for agricultural purposes[91].
14.36 Agricultural relief at the rate of 100% also apples where shares or securities in a company are transferred[92], if:
(1) agricultural property forms part of the company's assets and part of the value of the shares and securities can be attributed to it;
(2) the company was controlled by the transferor immediately before the transfer;
(3) the agricultural property had been occupied for agricultural purposes by the company or the transferor for the two years immediately before the transfer or owned by the company and occupied for agricultural purposes for seven years immediately before the transfer; and
(4) the shares or securities had been owned by the transferor for a corresponding period.
The relief in these circumstances extends to that part of the value of the shares or securities transferred which is attributable to the agricultural value of qualifying agricultural property.
Relief is not available if at the time of the transfer, the agricultural property or the shares or securities are under a binding contract for sale[93].
Where the transfer falls within seven years of the transferor's death, relief is given only if the property was owned by the transferee throughout the period from the date of the transfer to the date of death and throughout that period the property was agricultural property occupied either by the transferee or another for the purposes of agriculture[94].
14.37 Relief is available for transfers of 'relevant business property' at a reduction (before any grossing up) of 100% or 50%, according to the category in which it falls. The relief is available for transfers during life, on death and also for transfers of settled business property.
Subject to certain conditions, relief is available on transfers of the following categories of 'relevant business property' at the rates shown:
(1) 100% relief for:
(a) a sole proprietor's business or an interest in a partnership; or
(b) a holding of unquoted shares or shares in a company quoted on the Alternative Investment Market (AIM).
(2) 50% relief for:
(c) land, buildings, plant or machinery owned by a partner or controlling shareholder and used wholly or mainly in the business of the partnership or company immediately before the transfer, provided that the partnership interest or shareholding would itself, if it were transferred, qualify for business relief;
(d) settled business property used by a life tenant in his own business; or
(e) a holding of shares giving control of a public company either by itself or in conjunction with the related property rules.
The relief takes the form of a percentage reduction in any value transferred which is attributable to relevant business property, and any exemptions or other reliefs applying are given after the business relief has been given.
14.38 Relief is given only if:
A holding of shares is treated as giving an individual control of a company if he has voting control on all questions affecting the company as a whole[98]. Shares which form 'related property'[99] (eg owned by the spouse) are taken into account for this purpose.
Relief is not available where the business is engaged wholly or mainly in dealing in securities, stocks or shares, land or buildings or holding investments[100] – unless it is the holding company of a trading group. Relief is also denied if the business or shares are subject to a binding contract for sale[101].
In addition, the value attributable to an excepted asset within a business does not qualify for relief. The main excepted assets are property rented to third parties, investments (for example unit trusts, single premium bonds) and large cash balances which are in excess of future business requirements — see Barclays Bank Trust Co Ltd v IRC[102].
The relief also applies to PETs[103] in a way similar to that for agricultural property, covering situations where the transfer was within seven years of the transferor's death. The relief will only be available where the transferee has retained ownership of the original property from the date of the transfer to the date of death and the property must qualify as relevant business property at the latter date (apart from the minimum two-year ownership requirement).
14.40 IHT is levied by reference to the transfers of value made in the previous seven years[106] (the principle of cumulation) as well as by reference to the value (in terms of loss to the transferor's estate) of the particular transfer. The rates at which IHT is charged are set out in Schedule 1 to IHTA 1984. There is currently a 'nil rate band' within which chargeable transfers do not attract tax. The value of the nil rate band for transfers made on or after 6 April 2006 is £285,000. Chargeable lifetime transfers in excess of the nil rate band are charged at the lifetime rate which is half the death rate[107] (currently, therefore, 20%). However, where the transferor dies within seven years of that transfer, subject to the availability of taper relief, additional tax may be payable. Transfers on death are charged at the death rate in force (currently 40%), although PETs which prove chargeable may be charged at the death rate in force at the date of the gift if this results in less tax. Many transfers of value during lifetime are not immediately chargeable transfers, but PETs, upon which IHT will not be payable unless the transferor dies within seven years of effecting the transfer. If death so occurs, the PET becomes chargeable and tax is levied on a tapering scale[108] as shown below:
number of years before death |
% of applicable death rate |
less than 3 |
100% |
more than 3 but less than 4 |
80% |
more than 4 but less than 5 |
60% |
more than 5 but less than 6 |
40% |
more than 6 but less than 7 |
20% |
When computing the tax, the value of each transfer is the amount of the original transfer (not the current value of the property representing it) and the taper relief applies to the figure of IHT due, not to the value of the property.
PETs made within three years of death are charged at the full death rate. Chargeable transfers made more than five years before death on which the lifetime rate was charged will not bear any further IHT, but transfers made more than three years but less than five years before death, will. The extra tax is effectively the difference between the relevant percentage of taper relief and the percentage of the property on which tax has already been paid (ie 50%). For example, after four years, but less than five, the extra tax would be 60%, less 50%, namely 10%.
14.41 Transfers of assets between UK domiciled spouses have always been exempt from IHT as described earlier. Thus, if a husband died and left all his estate to his spouse, there would be no IHT to pay at that time. However, the problem with this course of action had always been that this effectively wasted the husband's nil rate band. This situation was altered by legislation[109] enabling the personal representatives of a surviving spouse who died on or after 9 October 2007 to claim any unused nil rate band that existed on the death of the first spouse. The claim is based on the proportion of the unused nil rate band available on the death of the first spouse, not the cash amount, therefore effectively 'index linking' the nil rate band.
It is also possible for any unused nil rate band to be transferred from more than one deceased spouse up to a limit of one additional nil rate band. So, if someone has survived more than one spouse, then on their death it may be possible to claim unused nil rate bands from more than one estate. However, the unused nil rate band accumulated for this purpose is limited to a maximum of the nil rate band in force at the relevant time (ie the survivor's death).
14.42 As IHT is charged on the loss to the transferor's estate resulting from the chargeable transfer, if the transferor pays the IHT, this will increase the loss and must be taken into account by 'grossing up' the net transfer to find the sum that, after the deduction of the IHT, leaves the net value transferred. (Tax is paid on the grossed-up value, which must be added to the transferor's cumulative total.)
The IHTA 1984 does not provide a specific method of grossing up. One example is by using fractions. On a chargeable lifetime transfer (eg transfer to a discretionary trust) the tax due (on the current rates) is 20% of the total, therefore the value actually transferred is 80% of the total. The fraction to find the tax due is therefore: (value actually transferred x 20/80).
If the transferee pays the IHT there is no need to gross up. (Even when the transferee pays the IHT, the amount of tax is calculated by reference to the transferor's cumulative total.)
PETs are not grossed up because no tax is chargeable at the time of the PET and should the PET prove chargeable upon the transferor's death, the primary liability will fall upon the transferee.
14.43 The primary liability to pay IHT on a chargeable lifetime transfer always lies with the transferor, with secondary liabilities on any person whose estate is increased in value by the transfer, any person in whom the property becomes vested or who has an interest in possession in it and, where the property becomes settled, any person for whose benefit the property or income from it is applied[111].
As to transfers on death, (other than property comprised in a settlement), the deceased's personal representatives have the primary (personal) liability. If, as a result of death, a PET proves chargeable or additional tax is due on lifetime transfers, the liability rests with the transferee, although if this is not paid within 12 months, the liability rests with the deceased's personal representatives[112].
For the liability arising under settlements, the primary liability lies with the trustees[113], although it may be paid, by agreement, by the beneficiaries, and where tax is payable on the death of an individual with an interest in possession, there is a secondary liability on the deceased individual's personal representatives.
14.44 The liability of the persons above is not without limit. A person acting in a representative capacity is only liable to the extent of the value of the assets which they hold or have control over[114].
14.45 It was stated in Section 2A, 14.4 that IHT is charged on transfers of value made by individuals[115]. However, special provisions exist to bring into charge dispositions in respect of settled property[116]. For IHT purposes, settlements are divided into two types, and two entirely different methods of taxation exist, depending on whether or not there exists a person(s) beneficially entitled to an interest in possession in the settled property. The following is a broad outline of the position.
It should be noted that the IHT treatment of gifts into settlements changed fundamentally from 22 March 2006 when all gifts into settlements (unless for the benefit of disabled persons as defined in section 89 of IHTA 1984) became chargeable transfers.
14.46 For the purposes of IHT, a settlement is defined as any disposition whereby property is:
(1) held in trust for persons in succession or for any person subject to a contingency;
(2) held by trustees on trust to accumulate income or under discretionary powers; or
(3) charged with the payment of any annuity or periodic payment otherwise than for full consideration[117].
It will not, therefore, include a bare trust although, at the time of writing, HMRC was of the opinion that the creation of a bare trust for a minor beneficiary would be a settlement.
14.47 Although the IHTA 1984 contains specific rules in relation to interests in possession[118], it does not define it. HMRC's understanding of the term, however, is as follows:
'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 that a discretion or power, in whatever form, which can be exercised after income arises so as 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 a power to withhold it, unless any accumulations must be held solely for the person having the interest or his personal representatives.'[119]
The term was the subject of an important House of Lords case:
Pearson v IRC[120]
Three beneficiaries were absolutely entitled to a trust fund, subject to powers in the trustees of appointment and accumulation. The trustees exercised their powers of appointment by deed dated 20 March 1976 to appoint irrevocably to one of the beneficiaries a capital sum to be held on trust to pay the income to that beneficiary during her lifetime or the trust period, whichever was the shorter. HMRC sought to collect tax on what they considered to be the creation of an interest in possession. The question was therefore whether or not an interest in possession existed prior to the appointment (as if it did, there would be no charge to tax when the power of appointment was exercised). The Chancery Division and the Court of Appeal found in favour of the trustees, holding that an interest in possession did so exist. The House of Lords, however, (by a bare majority) agreed with HMRC's approach. It was stated that the term 'interest in possession' must be given its ordinary meaning which implies that there must be a present right to present enjoyment. As the trustees had a discretionary power to accumulate, there was no such present right in this case, merely a right to later payment of such income as the trustees, either by deliberate decision or by inaction for more than a reasonable time, did not cause to be accumulated.
14.48 In short, it can be said that a beneficiary has an interest in possession if he has a present right to present enjoyment of the net income of the settled property without any requirement for any further decisions of the trustees.
The test is not whether the beneficiary is entitled to all the income, but whether he is entitled to the net income as it arises. To determine what constitutes net income, a distinction must be drawn (and was in Pearson) between two types of powers exercisable by the trustees: dispositive and administrative. Net income refers to the income arising after the payment of trust expenses (which are payable out of trust income in accordance with general trust law principles). These expenses will be met by the trustees exercising their administrative powers. Where, however, the trustees have a dispositive power, ie the power to appropriate the income in favour of any person other than the beneficiary in question, that beneficiary cannot have an interest in possession[121]. It should be noted that an overriding power of appointment does not prevent the existence of an interest in possession.
Where the property does not actually produce any income (eg a life assurance policy), it is still possible to have an interest in possession (life office specimen trust forms have generally contained a deeming provision to this effect). The relevant question is whether the beneficiary would be entitled to the income as it arose if the property were income-producing[122].
However, it is felt that the practice of life offices may change following the Finance Act 2006 which stated that, from 22 March 2006, all gifts into interest in possession trusts and accumulation and maintenance trusts would be taxed for IHT purposes, in the same way as gifts into a settlement without an interest in possession.
14.49 The legislation provides[123] for Scotland that an interest in possession is a right under a settlement to enjoy property. Thus, the term has the same meaning as it has, albeit undefined, in England and Wales.
14.50 There are three parties to consider: the settlor, the primary beneficiaries (the life tenant(s)) and the remaindermen.
14.51 A transfer into an interest in possession settlement made before 22 March 2006 was a PET, which will only become chargeable if the settlor dies within seven years of the transfer. A transfer into such a settlement from 22 March 2006 onwards will be a chargeable lifetime transfer.
14.52 A fundamental rule for property settled before 22 March 2006 is that a beneficiary with an interest in possession is treated as beneficially entitled to the whole of the property in which the interest subsists[124]. Where there is more than one beneficiary with an interest in possession, beneficial entitlement of the property for IHT purposes is apportioned according to their shares of the income[125]. When that interest ceases, a transfer of value for IHT purposes takes place[126].
If the cessation occurs during lifetime (whether by selling, surrendering or assigning), and the primary beneficiaries are those either that were actually in place as at 22 March 2006 or if there was a variation of the primary beneficiaries subsequent to that date and such variation took place before 6 April 2008, the transfer may be a PET (if it satisfies the conditions of section 3A of IHTA 1984, see Section 4C, 14.32), eg a transfer to another individual. If the beneficiary whose interest in possession remains as a potential beneficiary under the trust, HMRC's current view is that he would be treated as having made a gift with reservation of benefit in these circumstances. If the cessation occurs during lifetime and after 6 April 2008, and the primary beneficiaries have been varied since that date, the transfer will be a chargeable transfer, assuming the trust continues in force – see 14.56 – again subject to the comments above regarding gifts with reservation.
If there is a depreciation in the value of the trust property as a result of the trustees entering into certain transactions, the beneficiary's interest will be treated as having come to an end to the extent of the depreciation[127]. It may be possible, however, to claim the exemption of 'no intention to confer any gratuitous benefit'[128].
If the cessation occurs on the death of a beneficiary, the capital value of the trust fund representing his income entitlement will be treated as part of his estate. If the death of the primary beneficiary occurs on or after 6 April 2008 and the trust continues in force, the trust will become a 'relevant property' trust and the principal charge and exit charge as described at 14.58 and 14.59 will apply.
There is no charge to IHT on a cessation of an interest in possession in the following instances[129]:
(1) where the beneficiary becomes absolutely entitled to the property;
(2) where the property reverts to the settlor or the settlor's spouse (or within two years of the settlor's death, the widow or widower), provided that the interest was not acquired for consideration in money or money's worth and the spouse or widow or widower is domiciled in the UK. This applies to trusts created before 22 March 2006 only;
(3) if the transfer is a PET.
If the interest is disposed of for a consideration in money or money's worth, the amount of the consideration will reduce the value transferred.
14.53 The interest of the remaindermen comes into effect only when a prior interest (that of the primary beneficiary, or life tenant) ends and is a reversionary interest and is thus excluded property[130].
14.54 The liability for any IHT falls on the trustees of the settlement[131] and the rate of tax will be determined by the beneficiary's cumulative total of chargeable transfers within the preceding seven years.
14.55 There is a relief for IHT where a second charge arises within five years of the first charge. The conditions for the relief are that the transferor must be entitled to an interest in possession, the first transfer was of the same property and the property became, or it was already, settled property on the first transfer[132]. The relief is calculated as a percentage reduction in tax payable on the first transfer and is allowed as a deduction against tax due on the second transfer.
14.56 Prior to 22 March 2006, the settlements within this class were primarily discretionary trusts. However, with effect from that date, gifts into interest in possession trusts and accumulation and maintenance trusts are now treated in the same way for inheritance tax purposes and hereafter the term 'discretionary trusts' will be used to cover any trust which is not an absolute or bare trust. It will be useful to state some basic points and define some relevant terms in relation to the taxing of discretionary trusts for IHT purposes:
(1) Once property is the subject of a discretionary trust, only half the normal IHT rates are relevant.
(2) The IHT charges apply to relevant property, which is settled property in which there is no qualifying interest in possession[134].
(3) A qualifying interest in possession is an interest to which an individual or a company is beneficially entitled[135]. (As stated earlier, there is no statutory definition of the term and so the principles established in Pearson v IRC[136] are equally relevant here – but the new rules applicable to trusts created on or after 22 March 2006 mean that for settlements created on or after that date, even where an interest in possession exists, this will still be a relevant property trust – that is subject to possible entry, ten yearly and exit charges.)
(4) The ten-year anniversary is the tenth anniversary of the date on which the settlement commenced and each subsequent tenth anniversary (although no ten-year anniversary could fall before 1 April 1983)[137].
(5) A related settlement is one made by the same settlor which commenced on the same day as the settlement in consideration (unless one or both of them are charitable)[138].
An IHT charge for a discretionary trust can arise in any of the following situations:
(1) on its creation, as a chargeable transfer;
(2) on every tenth anniversary (the 'principal charge', known formerly as the 'periodic charge');
(3) on distribution of capital by the trustees or on its termination ('exit charges').
14.57 A transfer into a discretionary trust is always a chargeable transfer. If the settlor has utilised his nil rate band, IHT will be due and may be paid by the settlor (after grossing up) or by the trustees. Thereafter, the tax treatment of the trust varies depending on whether the trust was created before 27 March 1974 (ie pre-CTT) or after 26 March 1974. The discussion below refers primarily to settlements created after 26 March 1974.
14.58 The principal charge is levied where, immediately before a ten-year anniversary, a settlement contains relevant property. The rate of IHT is three-tenths of the effective rate applied to the relevant property in the settlement at the date of the charge.
The effective rate is the average rate of tax that would be charged by applying half the IHT rates on a notional transfer made by an individual with a hypothetical cumulative total of transfers. The notional transfer is the sum of (a) relevant property in the settlement, (b) the value of any property in the settlement which has never been relevant property and (c) the value of any property in a related settlement. The hypothetical cumulative total of transfers is the sum of (a) the cumulative total of transfers, if any, made by the settlor in the seven years before the settlement commenced (ten years for transfers before 18 March 1986) and (b) the amount which was subject to the 'exit charge' (see below) in the previous ten years, ie the value of the property which has left the settlement in the preceding ten years and on which an exit charge was payable.
To calculate the effective rate, one must calculate the tax payable on a transfer of the notional transfer by a person with the hypothetical cumulative total as stated above. The effective rate is then the tax payable divided by the value of the notional transfer, expressed as a percentage.
Example
On 1 May 2001, S effects a whole life assurance policy subject to a discretionary trust with a sum assured of £250,000 and an annual premium of £3,000. There are no related settlements and S has made previous chargeable transfers of £325,000 during the preceding seven years.
The first ten-year anniversary is 1 May 2011. On that day, the amount of relevant property (ie the policy) in the settlement is £30,000 (ie the premiums paid).
The effective rate of tax would be calculated as follows:
(1) Calculate the value of the notional transfer
There is no non-relevant property, nor any related settlement, so the value of the notional transfer is equal to the value of the relevant property: £30,000.
(2) Calculate the transferor's previous chargeable transfers plus any values which have been the subject of exit charges
There are previous chargeable transfers of £325,000 and no amounts subject to exit charges.
(3) Calculate the tax on such a notional transfer
Cumulative total
Tax
Previous transfers £325,000
325,000
Nil
Notional transfer £30,000
355,000
4,000
Total tax
4,000
Tax on the notional transfer
4,000
The effective rate is therefore (4,000/30,000) x 100% = 13.33%.
(4) Calculate the actual rate
Three-tenths of the effective rate is 4.0%.
(5) Calculate the actual IHT payable on the ten-year anniversary
4.0% of the relevant property (£30,000) is £1,200.
There are further provisions, and necessary calculations in situations where the relevant property was either not relevant property or not comprised in the settlement for the whole of the ten-year period[139]. Basically, the rate at which tax is charged is reduced by one-fortieth for every complete quarter in which it was not relevant property or not comprised in the settlement.
Further, if there were additions to the settled property after the commencement date, in calculating the hypothetical cumulative total, one can take the values of the chargeable transfers made by the settlor in the seven years prior to the commencement date of the settlement, or prior to the date of the addition, whichever is the higher[140].
It should be noted that on the current rates, the maximum possible rate is 6%.
14.59 A charge to IHT arises where property in a discretionary settlement ceases to be relevant property[141]. This may occur due to the settlement coming to an end, when the property is distributed to the beneficiaries, when an individual becomes beneficially entitled to an interest in possession in the settled property, when the property is held on an accumulation and maintenance trust or when the property becomes excluded property.
A charge to tax will also arise when the trustees make a disposition, ie do some act or deliberately fail to exercise a right that results in a reduction in the value of the settled property (although it may be possible to claim the exemption that the disposition was not intended to confer any gratuitous benefit)[142].
The rate of the exit charge is a fraction of the rate which was applied at the ten-year anniversary. The fraction is calculated as one-fortieth for each complete period of three months that has elapsed since the last ten-year anniversary[143]. The tax is charged on the amount by which the value of the relevant property in the settlement is diminished as a result of the event giving rise to the charge. Note that no tax is payable if the event in question occurs in the first quarter of a ten-year period.
Example
Using the figures from the previous example, the last ten-year anniversary IHT charge was £1,200 in respect of the £30,000 relevant property in the settlement. Five years (ie twenty-quarters) later, the life assured dies and the sum assured of £250,000 is paid out by the trustees. Assuming no changes in the general rates of tax since the last ten-yearly charge, the £250,000 will be taxed at the fraction of 20/40 of the rate of 4.0% (ie 2.0%) so that £5,000 will be payable.
Again, special rules apply if any property has been added to the settlement or any property in the settlement has become relevant property since the last ten-year anniversary.
14.60 Where an exit charge falls due before the first ten-year anniversary, the rate of tax is a fraction of the 'effective rate' calculated in much the same way as the effective rate for the ten-yearly charge. The value of all the property in the settlement at the time of creation is taken together with all the property in any related settlement. The hypothetical cumulative total of the settlor's chargeable transfers in the seven years (ten years for transfers before 10 March 1986) prior to the creation of the settlement is also brought into the calculation. The actual rate is three-tenths of the 'effective rate' so calculated. The fraction is again calculated as one-fortieth for each complete period of three months which has elapsed since the creation of the settlement. The actual rate is, therefore, the sum of the 'effective rate' x (3/10) x (number of complete quarters since the trust was set up/40).
14.61 The calculation of the rate of tax is modified if the settlement was created before 27 March 1974.
In calculating the ten-yearly charge, the settlor's cumulative total of chargeable transfers, the value of other non-relevant property and the value of property in related settlements are all disregarded.
In calculating the exit charge arising before the first ten-year anniversary, the rules were modified[145], in particular as to the calculation of the notional transfer. Further, the rate was simply three-tenths of the 'effective rate' (as modified), there was no account of the number of quarters elapsing between commencement and the time of the disposition.
14.62 Although no qualifying interest in possession subsists in them, the property in the following types of trust is not to be treated as relevant property[146]:
14.63 The life assurance practitioner should be aware of these trusts, which are basically settlements with no interest in possession which were introduced on 15 April 1976. Prior to 22 March 2006, to come within the definition of an accumulation and maintenance trust and thereby avoid the principal charge or any exit charges, certain conditions had to be satisfied[153]:
(1) There must be no interest in possession in the settled property and income not applied for the maintenance, benefit or education of the beneficiaries must be accumulated.
(2) One or more beneficiaries had to become entitled to the settled property, or to an interest in possession in it, by the age of 25 at the latest. This was an absolute requirement and means that a beneficiary must not be able to be disentitled from acquiring the necessary interest under the terms of the settlement[154]. By concession[155], HMRC regarded the age requirement as being satisfied if it is clear that a beneficiary would in fact become entitled by the age of 25, even if it was not specified in the trust instrument.
(3) Either not more than 25 years have elapsed since the commencement of the settlement, or, at such later time as the conditions in (1) and (2) have become satisfied, all the beneficiaries must be or were grandchildren of a common grandparent, or children, widows or widowers of such grandchildren who were themselves beneficiaries but died before they became entitled. If this criteria is satisfied, the trust could continue indefinitely (subject to the trust rules on perpetuity).
If the trust has been for the benefit of children who do not have a common grandparent, then it can only last for 25 years. After 25 years, it will revert to being a regular discretionary trust and would incur the usual ten-year anniversary and exit charges to inheritance tax. In addition, the trust fund would incur an inheritance tax charge of 21% of the value of the property in the trust fund on losing its accumulation and maintenance status.
If the trust is caught by this, the trustees will have to consider the implications of paying the charge, which will reduce the cash held in the trust and may result in having to sell investments with a possible CGT charge.
It may be possible to avoid the charge by appointing or advancing the capital of the fund onto fixed interest trusts, bare trusts or absolutely for the benefit of any beneficiaries or to re-settle the funds on new accumulation and maintenance trusts. It should be noted that if the settlor was non-UK domiciled when the property was settled on trust, the charge would only apply to the extent that the trust holds UK assets.
If the trust was created on 15 April 1976, the 25-year period ended on 15 April 2001 and thus, this was the earliest time when the 21% tax charge could apply.
14.64 Following the Finance Act 2006, all transfers into A&M trusts on or after 22 March 2006 are treated as chargeable transfers and are thus taxed in the same way as discretionary trusts as described above, that is that there may be an immediate charge to IHT to the extent that the value transferred, after deducting any available exemptions and taking account of any existing chargeable transfers made by the same settlor within the previous seven years, exceeds the current nil rate band.
Ten yearly charges and exit charges may also be payable.
However, an exception to this general rule is a trust created in a will or on intestacy in favour of a minor child of a deceased parent which can vest the benefit absolutely in the child between the ages of 18 and 25 (a so called '18 to 25 trust'). If the benefit vests absolutely at age 18, then no charge to tax will arise at that time. If the trust continues after age 18, then at age 18 the trust will become subject to the 'relevant property' trust regime but there will be no entry charge.
This means that, if the child becomes absolutely entitled at the last possible time for 18 to 25 trusts – ie at the age of age 25 – then the discretionary trust regime will apply, but the trust will be treated as having started when the beneficiary attained age 18 for the purpose of determining the appropriate fraction of the effective rate to charge.
The maximum exit charge that can therefore arise when the beneficiary becomes absolutely entitled at age 25 is 4.2% which is 28 quarters into the first ten yearly charge period. If the beneficiary became absolutely entitled, say at age 21, then the maximum exit charge would be 1.8%, that is, three-tenths of 6%.
If the value of the gift to the trust on death plus the cumulative total of chargeable transfers made by the deceased in the seven years prior to death is less than the nil rate band applicable when the beneficiary becomes absolutely entitled, there will be no tax charge.
14.65 Transfers to A&M trusts before 22 March 2006 were classed as PETs and consequently fell outside the regime for 'relevant property' trusts.
The original proposals in the Finance Bill 2006 stated that if such a trust was not amended before 6 April 2008 to give the beneficiary an absolute right to the trust capital on attaining age 18, then it would automatically become a 'relevant property' trust from that date with the ten yearly charges starting on the first ten yearly anniversary of the creation of the trust after 6 April 2008 (albeit on a proportionate basis in view of the fact that the trust property had not been 'relevant property' for the whole of the ten-year period).
However, these proposals were amended by the Finance Act 2006 so that the tax treatment outlined above in connection with '18 to 25 trusts' is also generally available for pre-22 March 2006 A&M trusts irrespective of the identity of the settlor where the beneficiary is currently under 18, provided that the trust is amended to meet the '18 to 25 trust' rules as above.
14.66 Although the IHTA 1984 contains certain provisions specifically relating to life assurance, one is left, generally, to apply the basic charging principles of IHT to situations involving life assurance contracts and policy trusts.
14.67 Premiums paid by the life assured on an own-life, own-benefit policy, or by the grantee on a life-of-another policy for the grantee's benefit, are not liable for IHT as there is no transfer of value.
Premiums paid on trust policies are transfers of value because they reduce the payer's estate. Where life assurance premium relief is available, the amount of the transfer is the net premium paid.
From 22 March 2006, gifts into new interest in possession trusts become chargeable lifetime transfers. However, in most cases, premiums will fall within one of the available exemptions, eg the £3,000 annual exemption[156] or the normal expenditure out of income exemption[157]. Any premiums in excess of the available exemptions will be chargeable lifetime transfers and will need to be taken into account in computing the settlor's IHT liability if he should die within seven years.
Prior to 22 March 2006, where the trust in question was an interest in possession trust, the first premium over and above any available annual exemptions constituted a PET[158] since the value transferred was attributable to property (the policy) which by virtue of the transfer (the payment of the first premium) became comprised in the estate of another individual. Subsequent premiums were treated as PETs[159] only to the extent that the value of the estate of the beneficiary(ies) was increased, ie to the extent that the value of the policy is increased[160]. Premium payments in the early years of a policy may not have increased the value of the policy, eg where there is no surrender value and the payments are taken up by charges. It was advisable, therefore, to gift cash to trustees (the cash then becoming settled property, which was comprised in the estate of an individual). The trustees then used this cash to pay the premiums directly to the life office. In this instance, the transfers will prove chargeable only if the payer dies within seven years of effecting the transfer.
For regular premium policies written subject to interest in possession trusts which were in force on 22 March 2006, HMRC have confirmed that they view the payment of ongoing premiums as merely maintaining the policy in force rather than adding to the trust property and thus the existing IHT treatment will remain and the trust will not become a 'relevant property' trust. It should, however, be noted that if the practice of the settlor gifting cash to the trustees to enable them to pay any premiums over and above the exemptions is continued, this will have the effect of placing the trust within the new relevant property regime as each payment to the trust will be viewed as a new gift.
HMRC have also confirmed in guidance notes issued to the ABI that where there are increases in premiums due to ten-yearly plan reviews or the exercise of cost of living or indexation options or where the policy provides for premiums to automatically increase over the term of the policy then provided such increases occur as a result of options contained within the policy or of specific policy terms, the exercise of these options would not be sufficient to place the policy in the relevant property regime. This is also true of paying further single premiums under an existing pre-22 March 2006 single premium bond provided there is an option in the original policy to do this.
14.68 Where an existing policy is put into trust, the transfer of value is measured by the special rules of valuation in relation to life assurance policies (see 14.71).
14.69 If the individual beneficially entitled to an interest in a life policy (eg the life assured under an own-benefit policy or a beneficiary with an interest in possession in a trust policy) transfers his interest during his lifetime then, unless the transfer is for full consideration, there is a transfer of value for IHT purposes. The transfer will be a PET if the usual conditions apply[161] (but will be subject to 52 if the trust was created prior to 22 March 2006). One of the available exemptions may apply to the transfer, eg the spouse exemption[162], however, the small gifts and normal expenditure out of income exemptions do not apply. The same principles apply to the transfer during lifetime of an interest in an annuity.
Where the trust was created on or after 22 March 2006, the trust will be treated for IHT purposes as one without an interest in possession and thus, the alteration of a beneficiary will have no IHT implications.
14.70 On the death of the life assured under an own-benefit policy, or a policy written under a trust in which the settlor reserved a benefit (unless effected before 18 March 1986 and not subsequently varied so as to increase the reserved benefits or to extend its terms), the value of the policy (ie the proceeds payable on death) will form part of his estate for the charge to IHT on the transfer on death[163]. Note that where the settlor's spouse is a beneficiary, there is no reservation of benefit provided that there is no intention that benefits accruing to the spouse will be used or are in fact used for the benefit of the settlor.
The death of the grantee under a life-of-another policy and the death of a beneficiary with an interest in possession in a settled policy (provided that the settlement had been created prior to 22 March 2006) (or a beneficiary under a simple trust policy) will constitute transfers and form part of the deceased's estate for IHT purposes.
The death of the life assured, other than the settlor under a trust policy, will not be a chargeable transfer unless the beneficiaries have predeceased him and he has acquired an interest in possession through the will or intestacy of the last of them to die.
The spouse exemption may apply to any of the transfers on death mentioned above.
14.71 If there is a transfer of value of the interest in a life policy or reversionary annuity during lifetime then special rules apply for determining the value transferred[164]. The value is taken to be not less than the total of the premiums or other consideration paid under the policy or contract less any sums previously paid to the policyholder by way of partial surrender. The market value (either the surrender value or the second-hand value) will apply if it is higher.
The special valuation rule does not apply to term assurances of three years or less or where, if the term exceeds three years, premiums payable in any one year are not more than twice those in any other years. There is a relaxation of the rule for unit-linked assurances[165], in that any drop in the value of units allocated is allowed as a deduction from the total premiums. In both these cases the value taken is broadly the market value which, in the case of term assurances, will depend upon the state of health of the life assured and the remaining length of the term.
14.72 These arrangements involve the purchase by A of an immediate purchased life annuity and a whole life policy on A's life written in trust for B. In this way, A reduces the value of his estate by purchasing the annuity (which ceases on his death and therefore does not fall back into his estate) and also creates a source of income for his life which enables him to pay premiums under the policy. The policy proceeds should normally be free of IHT as they are in trust for B and thus are not part of A's estate. Thus A's dutiable capital is replaced by non-dutiable assets in the form of a policy belonging beneficially to B.
However, great care should be taken to avoid the potential impact of section 263 of IHTA 1984 which concerns 'associated operations' as defined by section 268 of that Act. Where a life assurance policy is taken out on or after 27 March 1974 and, at the time the insurance is made, or at any earlier or later date, an annuity on the life of the insured person is purchased and the benefit of that policy is vested in another person, then unless it can be shown that the effecting of the contracts is not an associated operation, the purchaser of the annuity shall be treated as making a transfer of value at the time the policy became so vested, of the lesser of:
(1) the purchase price of the annuity plus the premium under the policy; or
(2) the value of the greatest benefit capable of being conferred by the policy at any time.
HMRC have stated that the purchase of an annuity and the effecting of a life assurance policy will not be treated as an associated operation if it can be shown that the policy was issued after full medical evidence of the assured's health had been obtained and that it would have been issued on the same terms had the annuity not been purchased – see HMRC Statement of Practice E4. With effect from 31 December 1987, HMRC have regarded a policy as being issued on full medical evidence if it can be shown that the life office has, as a minimum, obtained a private medical attendant's report and has used it as the basis of its normal underwriting procedures in the same way as it would have done had the annuity not also been purchased. HMRC can ask for the medical evidence to be produced in any case.
Perhaps the best way to establish that the two contracts do not constitute an associated operation is to use different life offices for each contract. This will also be beneficial in that the best rates can be obtained in both cases.
The normal expenditure from income exemption may not be available to exempt the premiums from tax because the capital element of the annuity would not be regarded as income for this purpose. If, however, the investor has enough other income which could have been utilised, this exemption may be available provided the investor does not have to resort to capital to maintain his standard of living.
14.73 A Lloyd's underwriter is entitled to business property relief at 100% on the value of his underwriting interest.
Business property relief is available on the value of the whole underwriting interest, which includes investments and cash held in the Lloyd's deposit (which underwriters are required to deposit up to a stated amount); underwriting reserves (the member's personal reserves and his special reserve); and profits on the open years' accounts at death.
If, however, the underwriting interest is thought to be excessive in comparison to the level of business written, the excess will not attract relief, as it cannot be categorised as 'relevant business property'.
Where an underwriter has funded his deposit or underwriting reserves by a letter of credit or guarantee from a bank or a life office, assets held by the bank or life office as security for those arrangements (eg a charge on a life policy) will also qualify for 100% relief up to the value of the guarantee or the letter of credit[167]. In this way, the proceeds of any life policy may qualify for business property relief.
Note. The impact of IHT on life assurance is greater than it has been possible to consider in this Section, which has dealt only with the direct effect of the tax on life assurance contracts. Accordingly, Chapter 15 looks more closely at matters such as the role and use of life assurance in estate planning for IHT, the considerations which should be applied to an assured's existing policies, and the effect of IHT on various policy trust wordings.
14.74 An annuity involves the payment of a capital sum to an insurance company in return for an (immediate or deferred) payment of income, commonly for the rest of the annuitant's life. A single life annuity (unless there is a guaranteed capital return element) will cease on death and thus there will be nothing in the estate on which to charge IHT.
Where the annuity provides a capital return upon death of the annuitant, if that capital benefit is paid to the deceased's personal representatives, it will form part of his estate for IHT purposes and be taxable accordingly. It is possible, however, to place the capital return element in trust, in which case the value of the gift will need to be determined for IHT purposes. The CTO drew attention to this point[168], and stated that the value of the gift for IHT purposes will generally be substantially more than the value of the death benefit the right to which has been gifted. This is because the value is determined in accordance with the loss to the transferor's estate principle, under which the value would be the difference between the purchase price of the annuity and the open market value of the right to receive the unprotected annuity payments during the annuitant's lifetime. The CTO have pointed out that the open market value is likely to be less than the amount for which the insurance company would have sold an unprotected annuity on the same individual's life. The main reason for this difference is due to the fact that a purchaser in the open market (unlike an insurance company) would need to buy life cover to protect his investment, the cost of which would vary in accordance with the usual underwriting considerations.
14.75 Most joint annuities are on the lives of husband and wife, either purchased by one of them or by both jointly. Because of the spouse exemption, no IHT charges will arise on the purchase of the annuity or on the death of one annuitant leaving the other surviving, and this will be so whether the contract is (1) a joint annuity payable to them jointly and thereafter to the survivor or (2) a single life annuity for one followed by a reversionary annuity for the other.
Where a proposer purchases an annuity in joint names, to be payable during the joint lifetime of himself and his wife and then during the life of the survivor and the policy provides for payments after the first death to be made to the survivor, it may be that the law will presume, in the absence of evidence to the contrary, that the husband intended to provide for the wife. But in view of the opinions expressed in Pettitt v Pettitt[169] to the effect that the former presumption of advancement in favour of a wife is now of little force, it is perhaps desirable on the comparatively rare occasions when the annuitants are not both contributing to the purchase price that the purchaser should make clear, at the time of making the proposal, that he intends his wife to take beneficially any annuity payable after his death.
Where the wife is the purchaser or in any case where the purchaser is not the husband or parent of the other life, there will not be any presumption that the purchaser intended the other to enjoy the annuity beneficially, and if that is indeed the intention the annuity policy should express a trust for that person.
14.76 This book covers the law of life assurance and not the law of pensions. However, it would not be complete without some mention of the subject, as the life assurance practitioner will invariably need to consider benefits under registered pension schemes and the IHT implications for individuals whose assets are large enough to bring them within the IHT net.
Details of registered pension schemes are given in Chapter 16.
14.77 It can be seen from Chapter 16 that there are a wide range of structures for registered pension schemes, and a wide range of benefits that might be provided. In addition, the individual often has a good deal of flexibility in tailoring the form of the benefits for his or her personal circumstances, and deciding when to start drawing the benefits. This makes the interaction with the IHT legislation somewhat complex. However, over the years, there have been a number of exemptions from the IHT legislation for scenarios where the value of benefits under registered pension schemes would otherwise have been caught. These exemptions have been significantly extended with effect from 6 April 2011, which means that most scenarios are now outside the IHT net, but not all. So, for most cases, the value of the benefits will not form part of the estate for assessing IHT. Particular issues for each type of registered pension scheme are considered later, but first a few general observations can be made.
14.78 Any contribution made by an individual to his or her registered pension scheme will not normally be classified as a transfer of value (section 12 of IHTA 1984). However, a transfer of value may occur where the individual was in ill health when the contributions were paid and dies within two years. But if the contributions were a continuation of an established pattern of contributions over several years there will not be a problem.
It should be borne in mind that it is possible for an individual to make contributions to another individual's pension arrangement (for example, a grandparent paying contributions into a stakeholder pension scheme for a grandchild). Looking at the situation from the perspective of the contributing individual's estate, HMRC has advised that, where such contributions do not fall within either the £3,000 annual exemption or normal expenditure out of income exemption, the contributions will constitute potentially exempt transfers.
14.79 Any lump sum payable as of right to the legal personal representatives on the individual's death will clearly form part of the estate for IHT purposes. This situation would normally be encountered where the individual has legal ownership of the policy and all the terms governing the pension arrangement are contained in the policy. Retirement annuity policies and 'left scheme' policies would come within that category.
A retirement annuity policy, or 'left scheme' policy, can be made subject to a discretionary trust (whether at the outset or by a later declaration of trust and assignment). The whole of the policy must be made subject to the trust, but the terms of the trust will specify that the retirement benefits will be retained for the benefit of the individual. The trustees will only have power to dispose of the moneys that become available on the individual's death. The normal IHT exit charge will not arise so long as distribution takes place within two years of the date of death. If the moneys remain in the environment of a discretionary trust for more than two years, the normal rules for periodic and exit charges will apply. Making the policy subject to a discretionary trust would constitute prima facie a transfer of value for IHT purposes – but the value of the death benefit transferred is regarded as nominal provided the individual was not in serious ill-health when the transfer was made. HMRC would only investigate further if the individual died within two years of the date of setting up the trust (see Section 9A6).
14.80 Occupational pension schemes normally contain provisions such that the lump sum is distributed at the discretion of the scheme trustees to beneficiaries selected from a specified range, such distribution to take place within two years of the date of death. In these circumstances, the value of the benefit will not normally be included in the estate for IHT purposes. The legal personal representatives can be included in the range of potential beneficiaries. If the trustees decide to make payment to the legal personal representatives through the exercise of the discretionary powers, the benefit will not normally form part of the estate for IHT purposes – the only exception is where no other potential beneficiary can be traced, in which case the trustees would not actually be exercising any discretion.
14.81 Personal pension schemes (including stakeholder pension schemes) established by deed poll fall between the retirement annuity policy and occupational pension scheme structures. The individual has legal ownership of the policy, but the provisions for the payment of benefits are contained in the scheme rules. For a lump sum death benefit, the scheme rules will usually provide that the lump sum would be paid to a discretionary trust set up for the policy by the individual, or, if there is no trust, the lump sum would be paid by the scheme administrator through the discretionary provisions.
Personal pension schemes set up by trust deed have similar death benefit provisions to those set up by deed poll. The only difference is that the discretionary trust would relate to the lump sum death benefit under the scheme rather than the policy (because any insurance policy would be held by the trustees of the scheme, and there would be assets other than just an insurance policy if the scheme is a self-invested personal pension scheme).
The terms of a discretionary trust will specify that the retirement benefits will be retained for the benefit of the individual. The trustees will only have power to deal with the moneys that become available on the individual's death. The normal IHT exit charge will not arise so long as distribution takes place within two years of the date of death. If the moneys remain in the environment of a discretionary trust for more than two years, the normal rules for periodic and exit charges will apply. Making the policy subject to a discretionary trust would constitute prima facie a transfer of value for IHT purposes – but the value of the death benefit transferred is regarded as nominal provided the individual was not in serious ill-health when the transfer was made. HMRC would only investigate further if the individual died within two years of the date of setting up the trust (see Section 9A6).
Where there is no trust, the lump sum will be distributed at the discretion of the scheme administrator to beneficiaries selected from a specified range, such distribution to take place within two years of the date of death. In these circumstances, the value of the benefit will not normally be included in the estate for IHT purposes. The legal personal representatives can be included in the range of potential beneficiaries. If the scheme administrator decides to make payment to the legal personal representatives through the exercise of the discretionary powers, the benefit will not normally form part of the estate for IHT purposes – the only exception is where no other potential beneficiary can be traced, in which case the scheme administrator would not actually be exercising any discretion.
14.82 Section 151 of IHTA 1984 applies to pensions being paid on the 'secured pension' basis (ie by means of an annuity or 'scheme pension'). It provides that an interest in a pension or annuity, that comes to an end on the death of a member, shall not be taken into account in determining the value of the estate for IHT purposes. This means that any capital value that could otherwise have been placed on the pension at the time of death will be left out of account.
Where there are remaining pension payments due under a guaranteed period (which can be up to ten years from the date the 'secured pension' commenced):
(1) if the remaining payments are payable as of right to the legal personal representatives, a capital value will be ascribed to those payments and included in the value of the estate for IHT purposes;
(2) if the remaining payments are payable at the discretion of the trustees or scheme administrator of the 'registered pension scheme', no IHT charge will arise.
14.83 Where the member dies and the remaining fund is paid as a lump sum (less 55% tax), the process for dealing with the lump sum will be the same as described in Section 9A2. In particular it should be noted that an IHT charge could arise if the lump sum is payable to the member's estate as of right, or if a trust is set up whilst in ill health and death occurs within two years. The IHT charge would be in addition to the 55% charge, giving a total tax charge of 73%. If there are no dependants, the lump sum could be paid to a charity, in which case there would be no 55% charge nor IHT charge.
Where the remaining fund is used to provide pension benefits for a dependant, there will not be a value to include in the member's estate for IHT purposes.
Where the remaining fund is used to provide pension benefits for a dependant, the following situations could arise:
(a) The pension for the dependant could be provided on the 'secured pension' basis (by means of an annuity). On the dependant's death, the pension would simply come to an end and there would be no further value to consider. So, no IHT charge would arise in respect of the dependant's estate.
(b) The pension for the dependant could be provided on the 'drawdown pension' basis. On the dependant's death, the remaining fund will normally be paid as a lump sum (less 55% tax). The process for dealing with the lump sum will be the same as described in Section 9A2. In particular it should be noted that an IHT charge could arise if the lump sum is payable to the dependant's estate as of right, or if a trust is set up whilst in ill health and death occurs within two years. The IHT charge would be in addition to the 55% charge, giving a total tax charge of 73%. If there are no other dependants of the member, the lump sum could be paid to a charity, in which case there would be no 55% charge nor IHT charge.
14.84 Where the member died and the remaining fund is paid as a lump sum (less 35% tax), the process for dealing with the lump sum will be as described in Section 9A2. In particular it should be noted that an IHT charge could arise if the lump sum is payable to the member's estate as of right, or if a trust is set up whilst in ill health and death occurs within two years. The IHT charge would be in addition to the 35% charge, giving a total tax charge of 61%.
Where the member died and the remaining fund is used to provide pension benefits for a dependant, there will not normally be a value to include in the member's estate for IHT purposes although there is a possibility that the situation described in Section 9A6 could arise.
14.85 Where the remaining fund is used to provide pension benefits for a dependant, the following situations could arise:
(a) The pension for the dependant could be provided on the 'secured pension' basis (by means of an annuity). On the dependant's death, the pension would simply come to an end and there would be no further value to consider. So, no IHT charge would arise in respect of the dependant's estate.
(b) The pension for the dependant could be provided on the 'drawdown pension' basis. On the dependant's death, the remaining fund will normally be paid as a lump sum (less 55% tax). The process for dealing with the lump sum will be as described in Section 9A2. In particular it should be noted that an IHT charge could arise if the lump sum is payable to the dependant's estate as of right, or if a trust is set up whilst in ill health and death occurs within two years. The IHT charge would be in addition to the 55% charge, giving a total tax charge of 73%. If there are no other dependants of the member, the lump sum could be paid to a charity, in which case there would be no 55% charge nor IHT charge.
14.86 Where there is no 'dependant' the following situations could arise:
(a) Where the remaining fund is to be paid as a lump sum to a charity, or charities, there will be no charge to IHT in respect of the member's estate.
(b) Where the fund is disposed of by means of an unauthorised payment (ie paid out of the scheme to a recipient other than a charity, or transferred to another arrangement within the scheme for the benefit of another individual), there will be a charge to IHT in respect of the member's estate based on the value of the remaining fund (section 151A of IHTA 1984). The IHT due will be paid by the scheme administrator from the fund. The balance will then be paid as an unauthorised payment subject to the relevant tax charges.
The amount of IHT due will be notified to the scheme administrator by HMRC Inheritance Tax. It will be calculated based on the aggregate value of the member's personal estate and the remaining fund in the pension scheme, and then apportioned between the two. So, the personal estate and the pension scheme will each benefit from a share of the nil-rate threshold.
14.87 Where there is a 'dependant' the situation is quite complex. The pensions tax legislation in the Finance Act 2004 requires the remaining fund to be used to provide pension benefits for the 'dependant'. But the inheritance tax legislation in IHTA 1984 has different provisions depending on the relationship between the dependant and the member. Accordingly it is necessary to split the range of possible 'dependants' into two categories:
A The member's wife, husband, civil partner, or any other individual financially dependent on the member (defined as a 'relevant dependant' in IHTA 1984).
B Any individual who would fit into the definition of 'dependant' but who is not a 'relevant dependant', for example, a child of the member under the age of 23 who is not financially dependent on the member.
Where the remaining fund is used to provide a pension for a dependant in category A, there is not an immediate IHT charge on the member's estate. However, the charge is only treated as deferred until the dependant's death, at which time a charge is levied against any fund remaining – the charge still being in relation to the member's estate (section 151B of IHTA 1984).
The following situations could arise on the death of the category A dependant:
(a) Where the pension for the dependant is being provided on the 'secured pension' basis (by means of an annuity), the pension would simply come to an end and there would be no further value to consider. So, no IHT charge would arise.
(b) Where the pension for the dependant is being provided on a 'drawdown pension' basis, there will be a charge to IHT based on the value of the remaining fund (section 151B of IHTA 1984). The IHT due will be paid by the scheme administrator from the fund in the pension scheme.
The amount of IHT due will be notified to the scheme administrator by HMRC Inheritance Tax. The tax is charged as if the remaining fund was the top slice of the member's estate. The rate of tax and the nil-rate threshold will be those applicable as at the date of the dependant's death.
The remaining fund after the IHT charge will then be paid as a lump sum, subject to a 55% tax charge, as described in Section 9A2. So, potentially the fund could be hit with a total tax charge of 73%.
It appears that an IHT charge could also arise in relation to the dependant's estate if the lump sum is payable to the dependant's estate as of right, or if a trust is set up whilst in ill health and death occurs within two years. This IHT charge would be in addition to the charges described above.
If there are no other dependants of the member, the lump sum could be paid to a charity, in which case there would be no 55% charge, nor IHT charges.
Where the remaining fund is used to provide a pension for a dependant in category B, there will be an immediate charge to IHT on the member's estate based on the value of the remaining fund (section 151A of IHTA 1984). The IHT due will be paid by the scheme administrator from the fund. The balance will then be used for the benefit of the dependant.
The amount of IHT due will be notified to the scheme administrator by HMRC Inheritance Tax. It will be calculated based on the aggregate value of the member's personal estate and the remaining fund, and then apportioned between the two. So, the personal estate and the pension scheme will each benefit from a share of the nil-rate threshold.
The following situations could arise on the death of the category B dependant:
(a) Where the pension for the dependant is being provided on the 'secured pension' basis (by means of an annuity), the pension would simply come to an end and there would be no further value to consider. So, no IHT charge would arise in respect of the dependant's estate.
(b) Where the pension for the dependant is being provided on the 'drawdown pension' basis, the remaining fund will be paid as a lump sum, subject to a 55% tax charge, as described in Section 9A2. In particular it should be noted that an IHT charge could arise if the lump sum is payable to the dependant's estate as of right, or if a trust is set up whilst in ill health and death occurs within two years. The IHT charge would be in addition to the 55% charge, giving a total tax charge of 73%. If there are no other dependants of the member, the lump sum could be paid to a charity, in which case there would be no 55% charge, nor IHT charge.
14.88 An IHT charge might be considered under section 3(3) of IHTA 1984 where decisions have been made by the individual prima facie with the aim of benefiting others on death, rather than to make provision for the individual's own retirement. Sections 12(2A)–(2D) provide that, in certain circumstances, the failure to exercise an option in connection with the pension rights, which was available before death, can give rise to a lifetime charge to IHT under section 3(3). The circumstances where a claim might arise are where there is evidence to indicate that the individual had become aware he or she was in ill-health and was likely to die within two years, and at or after that time took some action which affected the value that could otherwise have formed part of the estate.
HMRC has stated that, in practice, they expect to see very few cases where a claim would even be considered. HMRC would not pursue a claim where the death benefit was paid to the individual's dependant (ie spouse, civil partner or any other individual financially dependent on the individual) or to a charity. In addition, a claim would not be made where the individual survived for two years or more after making the relevant decision.
Examples of the scenarios where a claim might arise are as follows:
(a) An individual reaches the age at which retirement benefits become due under the terms of the pension arrangement (eg the vesting date under a retirement annuity or personal pension scheme). He decides to defer drawing the benefits because he is in ill-health and wishes the fund to be available as a lump sum death benefit for the benefit of his family.
Where the death benefit would automatically go to the estate anyway (eg under a retirement annuity where there is no trust), the act of deferring the benefit would not have any significance in itself. But if the individual set up a trust for the policy after the vesting date, or paid extra contributions to a policy already under trust, HMRC might raise a claim.
Where the death benefit would not automatically go to the estate (eg under a personal pension scheme where the benefit would be payable through the discretionary provisions), the act of deferring the benefit would be sufficient in itself for HMRC to consider raising a claim. But no claim would be made if the lump sum was paid to a dependant or to a charity.
(b) An individual is in ill-health and decides to take pension on the 'unsecured pension' basis rather than purchasing an annuity – the reason being that there will be a fund available on his death for the benefit of his family.
(c) An individual becomes ill whilst taking pension on the 'unsecured pension' basis and decides to reduce the amount of income being taken so that the fund on death is higher than it otherwise would have been.
The value for a section 3(3) claim is determined from the loss to the estate at the instant before death. At that point the individual had the right to use the whole remaining fund for the purchase of an annuity. The section 3(3) claim is therefore determined as follows:
(a) The provider of the pension scheme will determine the annuity that could have been purchased, using its current annuity rates, on the basis of single life only, guaranteed ten years, non-escalating, payable monthly in advance. (If the provider does not write annuity business, HMRC will determine the annuity.)
(b) HMRC will then determine a value for the ten years' guaranteed payments that would have been made.
NOTE: The effect of sections 3(3) and 12(2A)-(2D) was removed where the 'failure to exercise an option' arose on or after 6 April 2011. The 'failure to exercise an option' is considered as continuing right up to the moment before death. So, even though the original point at which the 'failure to exercise an option' arose may have been before 6 April 2011 (for example, the benefits were not taken under a retirement annuity policy which had a vesting date of 15 January 2011), the fact that death occurred on or after 6 April 2011 will mean that there will be no charge to IHT.
14.89 An IHT charge might arise under section 3(1) of IHTA 1984 where a transfer of value arises which has the effect of benefiting others on death, rather than to make provision for the individual's own retirement. The circumstances where a claim might arise are where there is evidence to indicate that the individual had become aware he or she was in ill-health and was likely to die within two years, and at or after that time took some action which affected the value that could otherwise have formed part of the estate.
The scenarios where a claim might arise are as follows:
(a) An individual sets up a trust for the lump sum death benefit that would be payable under a policy of which the individual is the legal owner – ie a retirement annuity policy or a 'left scheme' policy. The individual was in ill health at the time and dies within two years. The lump sum would have been paid to the estate had the trust not been set up, so HMRC would take the view that a transfer of value had taken place for the purposes of section 3(1).
The same situation would arise where an individual sets up a trust in respect of a lump sum death benefit that could arise under a personal pension scheme (whether established by a deed poll or trust deed). Under a personal pension scheme, the rules may provide for the lump sum to be paid to the individual's estate if there is no trust, which would be analogous to the situation above. But, more likely, the rules of the personal pension scheme will provide for the lump sum to be paid to a beneficiary selected at the scheme administrator's discretion from a range of specified potential beneficiaries. In that scenario the lump sum would not normally be assessable to IHT anyway. So, HMRC's practice of bringing the lump sum into account where a trust has been set up, in relation to a scheme where the lump sum would have otherwise been paid through discretionary provisions, seems unduly harsh.
(b) An individual transfers the value of his or her benefits from one registered pension scheme to another. The individual was in ill health at the time and dies within two years. Here HMRC takes the view that:
(i) by taking a transfer, the individual has the opportunity to transfer to a scheme where the lump sum death benefit would be paid to the estate;
(ii) if the transfer ends up in a scheme where that does not happen there has been a 'transfer of value' for the purposes of section 3(1).
There is some logic to this stance in the context of the situation where the transfer is being made from a retirement annuity policy or a 'left scheme' policy (where the lump sum on death would have gone to the estate and become subject to IHT) to a personal pension scheme (where the lump sum on death would be paid through the discretionary provisions and hence would not have been subject to IHT). But where the transfer is being made from, for example, a personal pension scheme, where the lump sum on death would be paid through the discretionary provisions and hence would not have been subject to IHT anyway, HMRC's practice seems unduly harsh.
14.90 The lump sum can derive from:
(1) the retirement fund;
(2) any separately insured lump sum death benefit.
Where the member dies after reaching age 75, there will be a 55% tax charge on the lump sum.
The insurer will deal with payment of the lump sum as follows:
(a) where the policy is subject to an individual discretionary trust, payment will be made to the trustees of that trust;
(b) where (a) does not apply, payment will be made to the legal personal representatives.
Where the lump sum is payable as of right to the legal personal representatives, as in (b), then it will clearly form part of the estate for IHT purposes.
Where payment is made to an individual discretionary trust, no IHT liability will normally arise if the money is distributed within two years of the date of the individual's death. If distribution does not take place within two years, the normal rules for discretionary trusts will apply from that time, and periodic and exit charges will arise. Many policy trusts become fixed trusts in favour of the default beneficiary(ies) if distribution does not take place within the two-year period. In these circumstances, the relevant value would form part of the beneficiary's estate.
Where the individual sets up the policy trust whilst in ill-health, and dies within two years, HMRC might raise a section 3(1) claim as explained in Section 9A7.
Prior to 6 April 2006 it was possible to formally assign a separately insured lump sum to a lender in connection with a mortgage (although that practice had become largely defunct in the latter years). The legislation from 6 April 2006 prohibits all assignments of benefits, apart from assignment to a trust for the purpose of holding lump sum death benefits. Where an assignment to a lender was made before 6 April 2006, it appears that payment to the assignee can be made without infringing the new legislation, and no IHT charge will arise.
14.91 The annuity can be set up with a guaranteed period of up to ten years. On death in the guaranteed period, the remaining guaranteed payments will be payable as of right to the legal personal representatives. A capital value will be determined for the remaining payments which will be added to the value of the estate for IHT purposes as described in Section 9A2.
HMRC has expressed the opinion that it is not possible to create a trust for such an annuity.
14.92 Retirement annuity policies were all established before the drawdown option became available. In theory, an insurer could add the option, but most likely it would be necessary to transfer the fund, before vesting, to the insurer's personal pension scheme to gain access to the option. If, exceptionally, an insurer does add the option then the same principles would apply as described for personal pension schemes in Section 9C3.
14.93 The lump sum can derive from:
(1) the Non-Protected Rights Fund; and
(2) any separately insured lump sum death benefit.
Where the member dies after reaching age 75, there will be a 55% tax charge on the lump sum.
The rules for most schemes will provide for the scheme administrator to deal with payment of the lump sum as follows:
(a) in accordance with any specific provision regarding payment of such sums under the contract;
(b) if (a) is not applicable, and the contract is subject to an individual trust (under which no beneficial interest in a benefit can be paid to the member, the member's estate or the member's legal personal representatives), payment will be made to the trustees of the trust; or
(c) if (a) and (b) are not applicable, payment will be made at the discretion of the scheme administrator to beneficiaries determined from a specified range of potential beneficiaries.
In scenario (a) (which is now rare), it is likely that the specific provision under the contract will mean that the lump sum is payable as of right to the legal personal representatives. In those circumstances, the lump sum will clearly form part of the estate for IHT purposes.
In scenario (b), where payment is made to an individual discretionary trust, no IHT liability will normally arise if the trust distributes the money within two years of the date of the member's death. If distribution does not take place within two years, the normal rules for discretionary trusts will apply from that time, and periodic and exit charges will arise.
Many policy trusts become fixed trusts in favour of the default beneficiary(ies) if distribution does not take place within the two-year period. In those circumstances, the relevant value would form part of the beneficiary's estate.
Where the member sets up the policy trust whilst in ill-health, and dies within two years, HMRC might raise a section 3(1) claim as described in Section 9A7.
In scenario (c), the lump sum will be distributed at the discretion of the scheme administrator to beneficiaries selected from a specified range, such distribution to take place within two years of the date of death. In those circumstances, the value of the benefit will not normally be included in the estate for IHT purposes. The member can give the scheme administrator an 'expression of wish' form, indicating who he would like the scheme administrator to consider paying the lump sum to. But this form will not be binding on the scheme administrator (otherwise the IHT exemption would not apply). The legal personal representatives can be included in the range of potential beneficiaries, and if the trustees decide to make payment to the legal personal representatives through the exercise of the discretionary powers, then the benefit will not normally form part of the estate for IHT purposes.
Prior to 6 April 2006 it was possible to formally assign a separately insured lump sum to a lender in connection with a mortgage (although that practice had become largely defunct in the latter years). The legislation from 6 April 2006 prohibits all assignments of benefits, apart from assignment to a trust for the purpose of holding lump sum death benefits. Where an assignment to a lender was made before 6 April 2006, it appears that payment to the assignee can be made without infringing the new legislation, and no IHT charge will arise.
14.94 If there is a Protected Rights Fund under the scheme, and the member leaves a widow(er) or civil partner, then the Protected Rights Fund must be used to provide a pension for that individual. However, if there is no widow(er) or civil partner, the Protected Rights Fund will be paid as a lump sum in accordance with the following rules:
(a) in accordance with any direction given by the member to the scheme administrator in writing; or
(b) if (a) is not applicable, to the member's estate.
If no directions have been left for the payment of the Protected Rights Fund as a lump sum, it will be payable as of right to the legal personal representatives, and will clearly form part of the estate for IHT purposes.
Where the member has given a written direction, the IHT situation depends on whether the direction is 'revocable' or 'irrevocable'. 'Revocable' means that the member is able to change the direction at any time during his or her lifetime. A direction will be 'revocable' unless it is specifically stated to be 'irrevocable', in which case it cannot subsequently be changed. Where the direction is 'revocable', the value of the lump sum will be added to the estate for IHT purposes. This is on the basis that the member could have revoked the direction right up to the point of death, in which case it would have been paid to the estate. If the direction is 'irrevocable', the value of the lump sum will only be included in the estate for IHT purposes if death occurs within two years and the member was in ill health when the irrevocable direction was made.
14.95 The annuity can be set up with a guaranteed period of up to ten years. On death in the guaranteed period, the remaining guaranteed payments may, or may not, be payable as of right to the estate. Usually the annuity policy will be bought in the name of the member and will cease to be covered by the terms of the scheme. In that situation, the remaining guaranteed payments will be payable to the estate, and will clearly be subject to IHT.
Exceptionally, the annuity may remain subject to the terms of the scheme. The rules of most personal pension schemes will provide for the scheme administrator to decide who should receive the payments. Hence the payments will not be due as of right to the estate and no IHT liability should arise.
Where the remaining guaranteed payments are payable as of right to the estate, a capital value will be determined for the remaining payments which will be added to the value of the estate for IHT purposes as explained in Section 9A3.
HMRC has expressed the opinion that it is not possible to create a trust for such an annuity.
14.96 The member can make various arrangements for the disposal of the remaining fund on his or her death.
The member can leave written instructions that the remaining fund is to be used for the benefit of a named dependant (ie the widow(er), civil partner or other individual who is financially dependent on the member). In those circumstances, the fund would not form part of the member's estate for IHT purposes.
The dependant would normally have the following options:
(a) take the fund as a lump sum (less the 55% tax charge);
(b) use the fund to provide income on the 'drawdown pension' basis; or
(c) use the fund to purchase an annuity.
Where the member does not specify that the remaining fund is to be used for the benefit of a dependant, or the dependant has predeceased the member, the fund will be paid as a lump sum. Normally, the lump sum (less the 55% tax charge) will be paid in accordance with the process set out in Section 9C1, with the possibility of an IHT charge as described. But there is an additional option – if there are no dependants, the lump sum could be paid to a charity, with no 55% tax charge, nor IHT charge.
14.97 The various scenarios, and the IHT charges that could arise, are as follows:
(a) Where the dependant's pension was being paid from an annuity, no further benefit would arise. Hence there would be no IHT charge.
(b) Where the dependant's pension was being paid on the 'drawdown pension' basis, having been derived from the member's 'drawdown pension' fund (or the member's 'unsecured pension' fund where the member's death occurred before 6 April 2011), the remaining fund will be paid as a lump sum. Normally, the lump sum (less the 55% tax charge) will be paid in accordance with the process set out in Section 9C1, with the possibility of an IHT charge as described. But there is an additional option – if there are no other dependants of the member, the lump sum could be paid to a charity, with no 55% tax charge, nor IHT charge.
(c) Where the dependant's pension was being paid on the 'drawdown pension' basis, having been derived from the member's 'alternatively secured pension' fund (where the member's death occurred before 6 April 2011), the remaining fund will be paid as a lump sum. Normally, the lump sum (less the 55% tax charge) will be paid in accordance with the process set out in Section 9C1, with the possibility of an IHT charge as described. There may also be an IHT charge triggered in respect of the member's estate as explained in Section 9A5. But there is an additional option – if there are no other dependants of the member, the lump sum could be paid to a charity, with no 55% tax charge, nor IHT charge.
14.98 Under a defined benefits scheme, the benefits payable would be specified in the rules of the scheme. The benefit would typically be:
(1) a lump sum based on a defined multiple of salary (up to four times), the liability for which would usually be insured under a group life assurance contract;
(2) a return of the individual's own contributions, with or without interest;
(3) a pension payable to a dependant.
Under a money purchase scheme, the benefits are not specifically defined. What will normally happen is that moneys will become available to the trustees which will derive from:
(1) the retirement fund;
(2) any separately insured lump sum death benefit.
Where the member dies after reaching age 75, there will be a 55% tax charge on the lump sum.
The rules of the scheme will normally give the trustees power to pay the lump sum to beneficiaries determined from a specified range of potential beneficiaries, such distribution to take place within two years of the date of the individual's death. In these circumstances, no IHT liability will arise. The individual can give the trustees an 'expression of wish' form indicating who he would like the trustees to consider paying the lump sum to. This form will not be binding on the trustees (otherwise the IHT exemption would not apply). The legal personal representatives can be one of the potential beneficiaries considered by the trustees, and an exercise of discretion in favour of the legal personal representatives will not give rise to an IHT liability.
14.99 The pension can be set up with a guaranteed period of up to ten years. On death in the guaranteed period, the remaining guaranteed payments may, or may not, be payable as of right to the legal personal representatives. That depends on the provisions in the scheme rules.
The rules of most occupational pension schemes will provide for the trustees to decide who should receive the payments. Hence the payments will not be due as of right to the legal personal representatives and no IHT liability should arise.
Where, exceptionally, the rules of the particular occupational pension scheme provide for the remaining guaranteed payments to be payable as of right to the legal personal representatives, a capital value will be determined for the remaining payments which will be added to the value of the estate for IHT purposes as described in Section 9A3.
14.102 Since 6 April 2006, these schemes have effectively become personal pension schemes. The provisions outlined in Section 9C for personal pension schemes will apply.
14.103 The lump sum can derive from:
(1) the retirement fund;
(2) any separately insured lump sum death benefit.
The insurer will deal with payment of the lump sum as follows:
(a) where the policy is subject to an individual discretionary trust, payment will be made to the trustees of that trust;
(b) where (a) does not apply, payment will be made to the legal personal representatives.
Where the member dies after reaching age 75, there will be a 55% tax charge on the lump sum.
Where the lump sum is payable as of right to the legal personal representatives, as in (b), then it will clearly form part of the estate for IHT purposes.
Where payment is made to an individual discretionary trust, no IHT liability will normally arise if the money is distributed within two years of the date of the individual's death. If distribution does not take place within two years, the normal rules for discretionary trusts will apply from that time, and periodic and exit charges will arise. Many policy trusts become fixed trusts in favour of the default beneficiary(ies) if distribution does not take place within the two-year period. In these circumstances, the relevant value would form part of the beneficiary's estate.
Where the individual sets up the policy trust whilst in ill-health, and dies within two years, HMRC might raise a section 3(1) claim as explained in Section 9A7.
14.104 The annuity can be set up with a guaranteed period of up to ten years. On death in the guaranteed period, the remaining guaranteed payments will be payable as of right to the legal personal representatives. A capital value will be determined for the remaining payments which will be added to the value of the estate for IHT purposes as described in Section 9A2.
HMRC has expressed the opinion that it is not possible to create a trust for such an annuity.
14.105 The extent to which the 'drawdown pension' option will be available under a 'left scheme' policy will depend on whether the particular insurer is prepared to allow the option. It may be necessary to transfer the fund, before vesting, to the insurer's personal pension scheme to gain access to the option. (Care is needed when considering a transfer as there may be protected tax-free lump sum rights.)
If an insurer does provide a 'drawdown pension' option, the issues to be aware of are the same as for personal pension schemes as described in Section 9C4–C6.
14.106 'Employer-financed retirement benefit schemes' (EFRB schemes) is the term used for schemes which are not registered with HMRC and therefore do not obtain the various tax reliefs available to registered pension schemes.
Many of these schemes were set up before 6 April 2006 as 'unapproved schemes'. They became important since the introduction of the 'earnings cap' in 1989 and had their own tax treatment which was broadly set out in the Inland Revenue Guide entitled 'The Tax Treatment of Top-up Pension Schemes'. The benefits can be funded in advance by the employer (in which case the scheme will usually be established under a trust), or the benefits can be unfunded (in which case the arrangement will usually be contractual between the employer and the individual). The terms 'funded unapproved retirement benefit schemes' (FURBS) and 'unfunded retirement benefit schemes' (UURBS) became established.
From 6 April 2006 there will be no tax-advantages to EFRB schemes. HMRC will treat them in the same way as any other arrangement operated by an employer to provide benefits for employees.
Despite the fact that lump sum death benefits may be payable through discretionary provisions in scheme rules, there will be no IHT exemption.
However, the pre-6 April 2006 IHT treatment will continue to apply to the portion of the fund accrued up to 6 April 2006, as described below:
(1) Where the documentation governing the arrangement provides for the lump sum to be paid at the discretion of the trustees (in the case of a scheme set up under trust), or the employer (in the case of a contractual arrangement), an IHT liability will not normally arise, so long as the range of potential beneficiaries does not include the legal personal representatives. (If the legal personal representatives are included, there may be an IHT 'gifts with reservation' charge.)
(2) It has been confirmed by HMRC that if an individual reaches the age of 75 and decides not to take his benefits at that time, the benefits can remain subject to the trust and can be paid free of IHT on his subsequent death. However, having taken that decision at the age of 75, it will never subsequently be possible for the individual to buy an annuity at some stage in the future should his circumstances change.
14.107 It is sometimes the practice for partners or shareholder directors of companies to enter into an agreement (known as a 'buy and sell' agreement) whereby, in the event of the death before retirement of one of them, the deceased's personal representatives are obliged to sell and the survivors are obliged to purchase the deceased's business interest or shares, with funds for the purchase frequently being provided by means of appropriate life assurance policies.
This arrangement, and its variants, are considered in more detail in Chapter 17. However, it is appropriate to state in this Chapter that, in HMRC's view, such an agreement, requiring as it does a sale and purchase and not merely conferring an option to sell or buy, is a binding contract for sale within section 113 of IHTA 1984[170]. As a result, IHT business property relief will not be available on the business interest or shares.
14.108 There are a number of special rules applying to certain kinds of property, eg life policies, debts, options[171], but the general principle of valuation for IHT is that the value at any time of any property is taken to be the open market value[172], with no reduction on the grounds that the whole property is hypothetically to be placed on the market at one time.
In determining the open-market price of unquoted shares or securities[173] it is assumed that a prudent prospective purchaser has all the information he might reasonably require if he were proposing to purchase them from a willing vendor by private treaty and at arm's length.
In valuing property, no account is taken of the value of property owned by others unless it is 'related property'[174]. Property is related to the property comprised in a person's estate if either (1) it is comprised in the estate of his spouse; or (2) it is, or has been within the preceding five years, the property of a charity, charitable trust or one of the political national or public bodies to which exempt transfers may be made. Where a person transfers related property, he is regarded as transferring the value of his proportion of the total value of all the related property. Thus, for example, where husband and wife own 40% each of shares in a company and husband transfers all his shares to his son by gift, he is treated as having transferred property equal in value to one-half of an 80% holding and not a single 40% holding.
14.109 For persons domiciled in the UK, IHT applies to all of their property wherever it is situated; whilst for persons domiciled outside the UK, it applies to any property situated in the UK. Domicile has its usual meaning, ie the country of permanent home, birth, dependency or choice. However, a person who would not under the general law be regarded as domiciled in the UK may nevertheless, for IHT purposes, be deemed to be domiciled at the time of a transfer if:
(1) he was domiciled in the UK on or after 10 December 1974 within the three years immediately preceding the transfer (ie three years' domicile outside the UK is needed to acquire a foreign domicile); or
(2) he was resident in the UK on or after 10 December 1974, in not less than 17 of the 20 years of assessment ending with the year of assessment in which the transfer was made[175].
For the purposes of (2), 'resident' has the same meaning as for income tax purposes.
14.110 The general rule is that a chose in action, such as a life policy, is situated in the country where it is properly recoverable or can be enforced[176]. Thus, if an individual who is not domiciled in the UK owns a policy issued by a life office in the UK, the policy moneys would, in the normal course of events, be regarded as situated in the UK and be liable to IHT. However, if the person beneficially entitled to the chose in action is domiciled outside the UK and the property is situated outside the UK, the property is 'excluded property' for the purposes of IHT[177], as stated above. The general rule stated above does not apply to specialty debts (which will include a life policy effected under seal), in that a debt due on a specialty is treated as situated in the country where the specialty itself is situated. It is possible therefore for a non-UK domiciliary to avoid IHT by ensuring that the policy is effected under seal.
14.111 Generally, IHT is due six months after the end of the month in which the chargeable transfer is made or, in the case of a transfer made after 5 April and before 1 October in any year otherwise than on death, at the end of April in the next year[179].
As previously stated, the primary liability to pay the tax lies on the transferor for lifetime gifts, the personal representatives of the deceased for transfers on death, the trustees where the transfer is of settled property and the donee when a PET or a chargeable transfer become liable for IHT or for additional IHT upon the death of the transferor. If tax is not paid by the due date it can be recovered from the donee or other persons who come into possession of the property transferred[180]. A right of recovery of tax from a transferor's spouse is provided but the sum recoverable is limited to the market value of the transfer when it was made to the spouse[181].
There are provisions for the optional payment of IHT in ten annual instalments[182] on certain property passing on death, notably land of any description, shares or securities giving control (as defined) of a company and other shares or securities not quoted on a recognised stock exchange in respect of which certain conditions are satisfied. The provisions apply also to (1) lifetime transfers where the IHT is paid by the transferee; and (2) settled property, where the property is retained by the trustees. Interest is chargeable on the whole of the unpaid tax at each instalment date; the rate with effect from 29 September 2009 is 3%[183].
Instalments of IHT are to be free of interest, however, where the value transferred represents land which qualifies for agricultural relief, a business or shares or securities in a company (including land and buildings if held as business assets).
Where any tax or interest is unpaid, an 'HMRC charge' may be imposed for the due amount on any property to which the tax is attributable by its transfer; and any property comprised in a settlement where the charge arises in connection with the settlement[184].
[1] For a detailed treatment of IHT see one of the major works on the subject, eg Foster Inheritance Tax.
[2] IHTA 1984, s 1.
[3] Section 2(1).
[4] Section 3A.
[6] IHTA 1984, s 3(1).
[8] IHTA 1984, s 10(1).
[9] IHTA 1984, s 270 and Taxation of Chargeable Gains Act 1992, s 286.
[10] IHTA 1984, s 10(2).
[11] Section 11.
[12] Section 13. (See also ss 12, 14, 15, 16.)
[13] Ward v IRC [1956] 1 All ER 571 (an estate duty case).
[14] IHTA 1984, s 3(3).
[15] IRC v Buchanan [1958] Ch 289 at 296 (an income tax case). See also Grey v IRC [1959] 3 All ER 603.
[16] IHTA 1984, s 268(1), see IRC v Macpherson [1988] STC 362, HL.
[17] See HC Official Report, SC A, 13 February 1975, Col 1596.
[18] IHTA 1984, s 5.
[20] Section 49(1).
[21] Section 4(1).
[22] Section 171.
[23] Section 171(2).
[24] Sections 160 and 167(2)(a).
[25] Section 131.
[27] Section 53.
[29] Finance Act 1986, s 102, Sch 20.
[30] For the Inland Revenue's interpretation on gifts with reservation of benefit and their interpretation of the de minimis rule see FRPI/80 and Tax Bulletin Issue 9 (November 1993).
[32] [1999] STC 37.
[33] Finance Act 1986, s 102(5).
[34] Sections 102(5A) and 102(5B).
[35] Sections 102(6) and 102(7).
[36] See Life Insurance Council Circular 139/86 in a letter dated 21 November 1986 from the Life Insurance Council of the Association of British Insurers to LIC members following clarification from the Inland Revenue confirming that in deciding whether a policy is varied as mentioned in the Finance Act 1986, s 102(6), account would generally be taken of the Inland Revenue's interpretation of the corresponding wording used in the provisions relating to life assurance premium relief (see Chapter 13).
[37] [1999] STC 37.
[38] [2003] STC 825.
[39] IHTA 1984, ss 17(a), 142.
[40] See ss 142(5), 49(1).
[41] See s 142(5), (6), Finance Act 1986, s 102, Sch 19, para 24.
[42] See Law Society Gazette 18 December 1991.
[43] [1993] 3 All ER 603.
[44] Russell v IRC [1988] STC 195, Matthews v Martin [1991] STI 418, Schneider v Mills [1993] 3 All ER 377.
[45] IHTA 1984, s 146(1).
[46] Sections 17(c) and 145.
[48] Law of Property Act 1925, s 184.
[49] IHTA 1984, s 4(2).
[50] Section 92.
[51] Section 141.
[52] IHTA 1984, Part II, Ch I.
[53] Section 3A.
[54] Sections 6(1), 48(3).
[55] Section 48(2).
[56] Section 18(1).
[57] IHTA 1984, s 18(3).
[59] Section 18(2).
[60] See s 161 (ie related property).
[61] Schedule 6, para 2.
[62] 6 April–5 April.
[63] IHTA 1984, s 19(1).
[64] Section 19(3A)(a).
[65] Section 20.
[66] Section 21(1).
[67] Bennett and others v IRC 1995 STC 54.
[68] Section 21(3), (4).
[70] IHTA 1984, s 22.
[71] Section 11.
[72] Section 11(6).
[73] Section 11(3). See Inland Revenue Pamphlet IR 1 (1992) F12 for the considerations applying as to whether a disposition is exempt if made by a child in favour of his unmarried mother.
[74] Section 23.
[75] Section 24.
[76] Section 24A.
[77] Section 25.
[78] Section 26, but subsequently repealed by Finance Act 1998, s 143(1).
[79] Section 154.
[80] Section 71.
[81] Section 89.
[82] In accordance with IHTA 1984, s 7. See Section 5.
[83] Sections 115–124.
[84] Section 122.
[85] Section 115.
[86] Section 116.
[87] Section 117.
[88] Section 120.
[89] Section 119.
[90] Section 118.
[91] Section 118.
[92] Section 122.
[93] Section 124.
[94] Sections 124A and 124B.
[95] Sections 103–114. For specific reference to Lloyd's underwriting interests, see Section 7C, 14.72.
[96] Section 106.
[97] Section 107.
[98] Section 269.
[99] Section 161.
[100] Section 105(3).
[101] Section 113.
[102] 1998 (STC 125).
[103] Sections 113A and 113B.
[104] Sections 125–130.
[105] Section 150.
[106] From 27 July 1981 to 17 March 1986, a ten-year period applied.
[107] IHTA 1984, s 7(2).
[108] Section 7(4).
[109] Section 8A
[110] Sections 199–210.
[111] Section 199(1).
[112] Section 200.
[113] Section 201.
[114] Section 204.
[115] Section 2(1).
[116] See Part III of the 1984 Act.
[117] Section 43.
[118] Sections 49–54.
[119] Inland Revenue Press Release, 12 February 1976.
[120] [1980] 2 All ER 479.
[121] See also Miller v IRC [1987] STC 108.
[122] See Westminster Bank Ltd v IRC [1957] 2 All ER 745.
[123] IHTA 1984, s 46.
[124] Section 49(1).
[125] Section 50(1).
[126] Section 52(1).
[127] Section 52(3).
[128] Section 10.
[129] Section 53.
[130] See ss 53(1) and 48(3).
[131] Section 201.
[132] Section 141.
[133] See generally ss 58–85.
[134] Section 58.
[135] Section 59.
[136] 2 All ER 479.
[137] Section 61.
[138] Section 62.
[139] Section 66(2).
[140] Section 67.
[141] Section 65(1).
[142] Section 10.
[143] Section 69.
[144] Section 68.
[145] Section 68.
[146] Section 58.
[147] Section 76.
[148] Sections 71 and 58.
[149] Section 73.
[150] Section 72.
[151] Section 77.
[152] Section 70.
[153] Section 71.
[154] See Lord Inglewood v IRC [1983] STC 133.
[155] Extra Statutory Concession F8(1992).
[156] Section 19.
[157] Section 21.
[158] IHTA 1984, s 3A.
[159] Section 3A(2)(b).
[160] See letter dated 28 October 1987 from the Life Insurance Council (LIC) of the Association of British Insurers to LIC members following clarification from the Inland Revenue.
[161] Section 3A.
[162] Section 18.
[163] Section 171.
[164] Section 167.
[165] Section 167(4).
[166] See Tolley's Taxation of Lloyds Underwriters (9th edn 2000). Note that this section does not refer to corporate membership of Lloyd's, which has been possible since 1 January 1994.
[167] See IRC v Mallender [2001] STC 514.
[168] See Life Assurance Council Circular 160/1994 in a letter dated 26 July 1994 from the Association of British Insurers to all LIC members and the Taxation (Life Policies) Panel.
[169] [1970] AC 777.
[171] See generally IHTA 1984, ss 160–170.
[172] Section 160.
[173] Section 168.
[174] Section 161.
[175] Section 267.
[176] See Dicey and Morris The Conflict of Laws (11th edn) vol 2, p 907.
[177] IHTA 1984, s 6(1).
[178] Sections 226–232.
[179] Section 226.
[180] Section 199.
[181] Section 203.
[182] Section 227.
[183] See Inland Revenue Press Release, 24 April 2001.
[184] IHTA 1984, s 237.