Taxation of pension death benefits

A flexible approach

KEY POINTS

  • Generally, death benefits paid under registered pension plans are free of inheritance tax and are an effective tax planning tool.
  • If benefits exceed the lifetime allowance, there could be a 55% lifetime allowance charge on excess lump sum payments.
  • The recipient of death benefits depends on whether the amounts are being paid as a lump sum or by way of a FAD account.
  • Benefits paid to a bypass trust will be tax free if the scheme member dies aged under 75. No inheritance tax or income tax should apply to later capital payments made to a beneficiary.
  • If the pension scheme member dies before 75, death benefits under both routes are free of income tax and inheritance tax.
  • The relevant property rules in IHTA 1984, s 81 operate to roll discretionary trusts together for the purposes of calculating inheritance tax on bypass trusts.

Flexi-access pensions were introduced by the Taxation of Pensions Act 2014 (TOPA 2014) which came into effect on 6 April 2015. As part of the package of reforms, special beneficial rules were introduced for the taxation of death benefits. After a period of uncertainty, we now have relative tax clarity on how these rules will operate. There are several issues to consider, including:

  • how death benefits can be paid under a money purchase or defined contribution (DC) pension scheme;
  • who can benefit from lump sum and income drawdown death benefits;
  • the tax rules that apply to those death benefits; and
  • how DC pension plans can be effective for inheritance tax planning.

It is important to note that the rules on flexible pensions apply only to DC schemes. However, they apply irrespective of whether the pension plan is:

  • uncrystallised (no benefits taken); or
  • crystallised; in other words, with benefits such as the tax-free pension commencement lump sum (PCLS) taken and with the residual funds held in drawdown.

Those in defined benefit schemes who wish to use flexi-access pensions should take financial advice before deciding whether to transfer to a DC scheme.

 

Pension plans and inheritance tax planning

Generally, death benefits paid under registered pension plans are free of inheritance tax and are very effective as a tax planning tool. However, inheritance tax implications can still arise in specific situations involving ‘dispositions’ (payments of contributions, creating trusts of death benefits or making pension transfers) by people who are in serious ill health when they enter the transaction and who die within two years of the disposition.

It should also be borne in mind that if benefits – including death benefits – exceed £1,030,000 (for 2018-19) or the higher lifetime allowance (LTA) that a member has elected to protect, there could be a lifetime allowance charge. This is at 55% on lump sum death benefits that exceed the LTA.

 

How can benefits be paid?

Benefits can be paid in three ways: a lump sum, designation to flexi-access drawdown (FAD), or the purchase of an annuity.

First, the scheme administrator will normally be able to make a lump sum payment to any member of the discretionary class under the scheme rules. This may include the trustees of a pilot trust previously created by the scheme member.

Second, alternatively (or additionally) the scheme administrator can designate the pension plan into FAD for the benefit of one or more beneficiaries (nominees or dependants). The person to benefit will normally have been nominated by the pension scheme member while alive. If not, the administrator may, subject to specified rules, nominate them. Once a plan has been placed into FAD for the benefit of a beneficiary, they can drawdown all or a part of the pension fund at will or leave it invested in the pension fund. See Sheila.

For those who do not want a payment of lump sum death benefit to be made directly to an individual on their death, the choice will be between using a FAD account or using a bypass trust. The use of a FAD account for death benefits is effective, simple and tax-efficient. However, there will be drawbacks if the member wants continuing protection for vulnerable beneficiaries – or when, say, they wish to make a provision later for children from a first marriage (see below). Sometimes a combination of both routes may be appropriate. See Arthur.

Who can receive death benefits?

The recipient of death benefits depends on whether the benefits are being paid as a lump sum or by way of a FAD account. It will also be necessary to consider the scheme rules.

If paid by way of a lump sum, the following points should be considered.

  • Discretionary payment. Lump sum death benefits can normally be paid to anybody who is a member of the discretionary class under the scheme rules. This will include individuals (usually family members) and, frequently, the trustees of ‘pilot’ trusts (bypass trusts) created by the member during his lifetime.
  • Integrated trust. Sometimes the rules state that if the member has declared a trust of the death benefits under the pension plan during his lifetime, the scheme administrator must pay the lump sum death benefits to those trustees. This is known as an integrated trust. A payment to this trust will only be made if the scheme administrator decides to pay lump sum death benefits (as opposed to designating the fund to drawdown) or has to pay a lump sum because the FAD option does not exist for the scheme. The trustees of the integrated trust then decide which of the trust beneficiaries benefit and when.

On flexi-access drawdown, following provisions introduced in TOPA 2014, it is possible for death benefits to be paid to beneficiaries who are ‘dependants’ and ‘nominees’ and, on the death of an existing FAD beneficiary, ‘successors’.

It is important to note that, to retain the inheritance tax freedom on death benefits (more on which later), the scheme administrator must retain discretion over who receives
death benefits.

When deciding how death benefits should be paid, it is worth bearing in mind the following points.

  • The choice of route will normally be made by the scheme administrator exercising their discretion, but the member can guide them by completing an expression of wishes. Having considered any expression of wishes and decided whom to benefit, the administrator may then consult the beneficiary to determine the form in which death benefits will be paid.
  • The member should review the letter of wishes regularly because circumstances can change meaning that it may be appropriate to change the way death benefits are paid. Because of the change in the taxation of benefits that takes place at age 75 (see below), it is particularly important to review the position in the run up to that date.

 

Taxation of death benefits

Ignoring the question of the LTA, it is necessary to consider whether income tax or inheritance tax will apply to death benefits.

 

Income tax

The position on the income tax treatment of death benefits depends on whether the member (or FAD beneficiary) dies before they turn 75 or at 75 or over.

If the former, the treatment will be as follows.

  • Flexi-access drawdown. If the death benefits (within the available LTA) are designated into FAD within two years of the member’s death, there will be no tax charge on later withdrawals made by the designated beneficiaries. If an uncrystallised fund is not designated to drawdown (or used to buy a dependant/nominee’s annuity) within two years of a member’s death, subsequent income payments will be taxed on the recipient.
  • Lump sum. There will be no tax charge on lump sum death benefits as long as the scheme administrator pays them within two years of the member’s death. If a lump sum is paid out after that point, or the date the administrator first knew of the death, the amount becomes taxable. If the beneficiary is an individual, the tax is at the recipient’s marginal rate(s). If the individual is acting as a trustee of a trust other than a bare trust (or a personal representative, director of a company, partner in a firm or member of a limited liability partnership), the amount will be subject to the special lump sum death benefit charge (SLSDBC) of 45%.

If a person dies under age 75, the question arises as to whether there is any tax difference in paying death benefits through a bypass trust or flexi-access drawdown.

Benefits paid to a bypass trust will be tax free. However, as with all discretionary trusts, there can be tax implications on later payments made from it to a beneficiary.

If benefits are designated to FAD, no tax should arise on subsequent drawdown payments made by the beneficiary. However, if the current incumbent beneficiary dies aged 75 or above and the fund remains in FAD, future drawdown payments paid to a successor will be taxable on the new beneficiary.

If the individual dies on or after 75, the treatment will be as follows.

  • Flexi-access drawdown. If death benefits are designated to FAD after the death of the member on or after age 75, later drawdown payments made by a beneficiary will be charged to income tax under PAYE at the individual recipients’ rate(s) of tax.
  • Lump sum. If a lump sum death benefit is paid to an individual, it will be taxed as income of that beneficiary. Further, if it is paid to a trust (other than a bare trust) there will be a 45% SLSDBC. This charge will therefore apply to payments to most bypass trusts (see below). However, F(No 2)A 2015, s 206 introduces relief against this 45% tax charge if subsequent payments are made to beneficiaries of the trust.

The current position on payments to trusts after the death of a member aged 75 or over is therefore as follows:

  • If a lump sum payment is made to a trust, the scheme administrator must pay the SLSDBC of 45%. So, if the death benefit is £100,000, £45,000 goes to HMRC and £55,000 to the trust.
  • If the trustees then distribute capital out of the trust to a beneficiary, that sum (plus the appropriate tax credit on it) is taxed as the recipient’s income in that tax year.
  • Any tax credit on the payment that does not ‘frank’ the actual tax liability on the payment out of the trust can be offset against the individual’s other income tax liability in that year – but cannot be carried back or carried forward.

This is illustrated by the example of John’s Trust.

Looking at John’s Trust, it should be noted that it is not possible to carry forward (or back) the tax credit on a payment out of the trust. However, HMRC has recently confirmed that if the overpaid tax on the lump sum exceeds the tax the beneficiary pays on other income, they will be able to recover the overpayment from HMRC.

HMRC has also confirmed that it is up to the trustees to categorise the payment made to a beneficiary in terms of whether it represents the original capital received from the pension scheme or subsequent growth on those funds within the trust.

The option to pay death benefits as a FAD or a lump sum continues to exist on the death of later beneficiaries.

 

Inheritance tax

In general, under the new flexible pension regime, pension death benefits will be free of inheritance tax. However, several aspects require closer examination.

 

Letters of wishes or nominations

For death benefit payments to be free of inheritance tax, the scheme administrator must retain discretion on who should benefit on the member’s death. In this respect, HMRC has confirmed that the nomination of a dependant, nominee, or successor by a pension scheme member or beneficiary will not cause them to be treated as making a transfer of value for inheritance tax purposes as long as:

  • the member/beneficiary does not have power under the scheme’s rules to irrevocably choose the beneficiary who should be entitled to death benefits on their death; and
  • the administrator has a discretionary power to choose who should receive death benefits.

So, for example, even though the pension scheme member may have nominated person A to receive income drawdown death benefits, as long as the scheme administrator could still override this nomination and pay lump sum death benefits to person B, there will be no inheritance tax.

This applies even in cases when the administrator has, in effect, no option but to follow the member’s nomination if it is desired to pay FAD income benefits.

This official view is now embodied in HMRC’s Inheritance Tax Manual at IHTM 17052.

 

IHT exit charges on payments to beneficiaries

HMRC has also confirmed that the naming of a dependant/nominee who is entitled to FAD death payments, followed by the scheme administrator exercising their discretion to designate FAD funds in the beneficiary’s favour, would not give rise to an inheritance tax exit charge from the discretionary trust as regards the whole fund. This is on the basis that a FAD fund is an arrangement under which property continues to be held for the purposes of a registered pension scheme. It is therefore within IHTA 1984, s 58(1)(d) and is not relevant property. Any payment out of a FAD fund is therefore not an exit from a relevant property trust even if it is made more than two years after the member’s death.

Omission to exercise a right

Until 2011, there was a potential inheritance tax problem if a person was old enough to draw pension benefits (aged 55 or more) but chose not to on the basis that he was in ill health and might soon die. In such cases, it might have been better to keep the plan intact and leave it free of inheritance tax as death benefits to a beneficiary. On the other hand, had the benefits been drawn and not spent they would have been added to the deceased member’s estate on death.

IHTA 1984, s 3(3) – the ‘omission to exercise a right’ rule – prevented the avoidance of inheritance tax in such cases and could cause the deceased to be treated as making a chargeable lifetime transfer of value which took place immediately before death. However, the application of the rule was complicated, as shown by DM Fryer & Others (Personal Representatives of Ms P Arnold) v HMRC (TC398).

Fortunately, under changes to s 3(3) in 2011 (new IHTA 1984, s 12(2ZA)) and in 2016 (new IHTA 1984, s 12A) an inheritance tax charge cannot now arise on pension funds in such cases. In effect, this change means that the value of a FAD pension fund will not be treated as being in the taxable estate of a member, a nominee or a successor on their death. This applies notwithstanding that the beneficiary, in effect, has complete access to the fund and could have drawn it until the date of death. Therefore, the funds are, in general, free of inheritance tax.

Because there is no tax (income tax or inheritance tax) on pension death benefits if the member dies before 75, from an inheritance tax planning standpoint, it will currently be best for a living pension scheme member to draw down and spend other assets (such as collectives and ISAs) leaving the pension fund intact. Those other investments are liable to inheritance tax, so it makes sense to reduce their value during the member’s lifetime. As age 75 approaches it is important to review the arrangements.

 

Flexi-access drawdown or bypass trust?

The new flexibility to pass pension scheme money through generations has caused people to question whether the use of FAD for death benefits is now preferable to paying a lump sum benefit to a bypass trust.

The prime objective of such a trust is to provide a wealth protection mechanism to the member’s family in the future and perhaps tax efficiency. Does a FAD account, if it permits ongoing flexi-access death benefits, provide the same benefits as a bypass trust with the added advantage of ongoing investments being held in a tax-free environment?

Space does not permit a full analysis, but the following are some of the main issues to consider when comparing the two routes.

  • Ongoing funds.
  • Death benefits.
  • Children from previous marriages.
  • Divorce and bankruptcy
  • Loans to beneficiaries.
  • Ongoing inheritance tax.

 

Taxation of ongoing funds

Money kept in a FAD account will continue to grow free of income tax and capital gains tax.

On the other hand, if lump sum death benefits are paid to a bypass trust, income within that discretionary bypass trust that exceeds £1,000 will be taxed at 38.1% (dividends) and 45% (other income). Capital gains of more than £5,850 will, in general, be taxed at 20%. Of course, the income tax and capital gains tax downsides of a bypass trust can often be reduced by choosing tax-efficient investments, such as collectives geared towards capital growth or single premium investment bonds.

Overall, the retention of funds in a FAD pension arrangement looks more tax efficient.

 

Taxation of death benefits

If the pension scheme member dies before 75, death benefits under both routes are free of income tax and inheritance tax. However, if death occurs on or after 75, any lump sum paid to a bypass trust will be charged to income tax at 45%. Although credit for this tax can be given to beneficiaries when money is paid out of the trust, the 45% SLSDBC is a substantial initial ‘hit’ on the value of the trust.

By contrast, payments from a FAD account will be taxed only when they are drawn by the beneficiary. They can therefore exercise control over when the tax is paid.

 

Benefiting children from previous marriages

For pension scheme members who have remarried, want their new spouse to benefit from the fund throughout the rest of their life, but want children from an earlier marriage to eventually benefit from any residual amounts in it, the bypass trust will be a better route to follow.

 

Divorce and bankruptcy

Irrespective of the tax issues, it is wise to remember that, if the FAD route is chosen, the value within that account is very likely to count as part of the dependant’s, nominee’s or successor’s assets in the event of bankruptcy or divorce proceedings. This is because the beneficiary has become entitled to FAD and they can, in effect, draw down the whole fund, resulting in it being considered as ‘available’ to them.

In this case, the bypass trust will tend to offer more protection over the funds.

 

Payments of loans to beneficiaries

When the bypass trust route is used, the trustees could consider making payments to a beneficiary (say the surviving spouse) in the form of a loan when access to funds is required. As long as the loan is spent, this should improve inheritance tax efficiency on the surviving spouse’s death.

 

Ongoing inheritance tax

Because a bypass trust will be a flexible or discretionary trust, it will be subject to the inheritance tax relevant property rules. The FAD account will not.

So there can be a periodic charge on ten-year anniversaries and an exit charge when property leaves the trust. Because the trustees will normally be entitled to a nil rate band, there should be a charge only on amounts above that threshold and then at a maximum rate of 6% (30% of 20%).

The relevant property rules in IHTA 1984, s 81 operate to roll together discretionary trusts for the purposes of calculating inheritance tax. So, if property moves from trust A to trust B and both are relevant property trusts, trust B will be treated as starting when trust A did.

On the basis that a pension scheme represents a trust of a member’s benefits, this means that if death benefits are paid to a bypass trust, that trust will, in fact, be treated as beginning when the member joined the original pension scheme (assuming it is either trust-based or contract-based and the scheme administrator has a power to appoint benefits).

Therefore, if payments to the bypass trust come from more than one trust-based pension scheme (even if they have moved through one such pension plan to another, say as part of a consolidation process), there may be multiple trusts for inheritance tax purposes within the bypass trust and more than one nil rate band will be available.

 

Third, as another option (or in addition), the scheme administrator may decide to buy an annuity for a dependant or nominee. This will give the recipient a guaranteed income for life but with no access to capital. Annuity rates remain at relatively low levels and therefore returns are limited.

It should be remembered that it is not essential to pay just one form of death benefit – a mixture can be arranged.

Taxation of pension death benefits

By:

Developments on Making Tax Digital for VAT

Where are we now?

KEY POINTS

  • Businesses will not be mandated to use Making Tax Digital until April 2019 and then only for those above the VAT threshold.
  • In April 2018, simple VAT-registered entities were invited to join the pilot programme.
  • Interested parties have time to pause and aim for a more achievable implementation date.
  • HMRC has published a VAT guide, stakeholders’ communication pack and list of software suppliers.
  • Bridging software that will enable data to be taken from spreadsheets and converted into an MTD-friendly format is becoming available.
  • The government will not widen MTD before April 2020 at the earliest.

What? A minister who listens? It’s a little over a year ago since the then recently-appointed Financial Secretary to the Treasury, Mel Stride, published a written statement (tinyurl.com/HMT-7423) responding to disquiet about the proposals for Making Tax Digital (MTD). This said: ‘Having listened carefully to the concerns raised by the Treasury Select Committee, parliamentarians and stakeholders, the government is announcing policy changes that will be reflected in the legislation to be introduced.’

He continued: ‘Businesses will not be mandated to use the Making Tax Digital system until April 2019 and then only to meet VAT obligations. This will apply to businesses with a turnover above the VAT threshold. Businesses with turnover below the VAT threshold will not be required to use the system but can choose to do so. Businesses will also be able opt in for other taxes, benefiting from a streamlined, digital experience.’

Mr Stride’s action was a commonsense move born out of a series of delays that had beset the rollout of MTD. These dated from when George Osborne announced ‘the death of the tax return’ in his March 2015 Budget speech although, I hasten to add, they were not of HMRC’s making.

 

Impact of the announcement

The effect of this about-face was equivalent to a release of pressure from a safety value. All parties could pause, regroup and aim for the more achievable April 2019 target with a much-reduced administrative burden.

Although income tax mandation for the self-employed and unincorporated landlords (hereafter both referred to as the self-employed) might be off the table in the short term, HMRC promised to continue working with software developers along its original delivery roadmap. The aim was to ensure that MTD-compliant products from third parties would be available for those wishing to join the new income tax pilot.

 

What happened next?

In response, almost all software companies redeployed their internal development resources away from attempting to meet the demands of HMRC’s MTD income tax quarterly filing requirement to ensuring delivery of the more straightforward VAT-MTD compliant products well ahead of April 2019 VAT mandation.

At the end of October 2017, HMRC released the application programming interfaces (APIs) required to transmit to HMRC all the data contained in nine boxes of information and the associated declaration that make up a traditional VAT return.

An API is, in effect, the virtual plumbing (programming) required to connect third-party software to HMRC’s platform so that data can be transmitted to and received from it. This is in much the same way as banking apps on a smartphone can send and retrieve data from a bank’s back-end system.

In November, HMRC began to accept the transmission of technical data (test data) from developers as a way of testing that the VAT APIs embedded into their software worked.

Then, in early April 2018 and without a fanfare, HMRC invited VAT-registered entities with the simplest of affairs to sign up to join its MTD-VAT pilot. On 26 April, it released the APIs that developers required to enable their software to transmit live data straight to HMRC’s enterprise tax management platform (ETMP).

Soon afterwards, HMRC received the first MTD-compliant VAT submission.

As MTD is rolled out and more heads of duty are moved on to HMRC’s EMTP, taxpayers will be able see their complete financial picture through their digital account, just as they do in online banking. In the longer term, HMRC’s publication Making Tax Digital for Business: VAT Guide for Vendors states: ‘They will be able to set an over-payment of one tax against the under-payment of another. It will feel like paying a single tax.’ (See here)

 

Private testing

Although it may be accepting live data, VAT-MTD is in a controlled period of testing – known as a private beta testing phase. Only applicants with simple VAT affairs that meet HMRC’s initial tight admission criteria are accepted into this live pilot.

It is likely that the MTD-VAT pilot has significantly fewer than 500 VAT-registered entities taking part now. However, assuming all goes well HMRC will gradually relax its selection criteria, thus permitting a greater range of entities to join.

 

Latest developments

On 13 July, HMRC published:

  • an MTD VAT guide (VAT Notice 700/22: Making Tax Digital for VAT);
  • an HMRC communication pack for stakeholders; and
  • a list of software suppliers supporting Making Tax Digital.

All can be found on the MTD for VAT collection page.

With about eight months to VAT mandation, pressure from commentators to compel HMRC to publish its MTD VAT guide had been ramping up. Not least because guidance was required to clarify what constituted digital record-keeping, what was meant by functionally compatible software and what digital links looked like.

At point 3.2.1.1, the guide covers the post-April 2019 one-year penalty soft landing for those mandated to join next year but who will be unable to establish digital links between one piece of accounting software and another in time.

Many stakeholders, such as trade bodies and software suppliers, had been pressing HMRC to publish the communications pack to provide information and source material so that they in turn could inform their stakeholders.

The publication of the software supplier list allows those advising on or faced with complying with the April 2019 VAT mandation to gain a level of reassurance that large third-party software solution providers such as Intuit have market-ready, VAT-MTD compliant software.

 

Bridging software

From an MTD perspective, bridging software is a third-party, API-enabled software product capable of drawing data digitally from a spreadsheet, turning it into a format compatible with MTD for VAT and then validating it before submitting the information to HMRC at the touch of a button.

Until recently, this long-promised piece of software had been assuming the mythical status accorded to the likes of the Loch Ness Monster – in other words, everyone has heard of it, everyone has a view of what it would look like but … no one had actually seen it.

All that is changing. BTC Software and PwC have recently announced they have market-ready bridging products. What’s more, PwC plans to make its product free to charities that might otherwise struggle to meet the cost of complying with HMRC’s VAT-MTD requirements.

 

Expect others to follow…

The great thing about bridging software is that it promises an affordable way for VAT-registered entities, such as spreadsheet users, to comply with HMRC’s MTD digital end-to-end requirement. It also affords businesses of significant size, often with disparate systems that do not speak to one another or groups with non-integrated accounting, the same opportunity.

What bridging software does not do is provide the level of added-value functionality, such as near limitless management reports, built in as standard to third-party, cloud-based accounting packages.

 

So where are we now?

There are just over 20 developers with VAT-MTD-ready products. Further, HMRC has stated that more than 150 software suppliers have registered an interest in providing software for VAT-MTD. Of those, more than 40 have said they will have software ready during the private beta phase of the VAT-MTD pilot. (See here.)

All this, combined with the filing of MTD-compliant VAT returns during the private beta period puts the department in a much better place to deliver VAT-MTD than it was immediately before Mr Stride’s announcement. That said, I see the position as finely balanced. We are less than eight months away from mandation and it does not look like VAT-MTD will emerge from its private beta phase anytime soon.

At the end of June, the British Chamber of Commerce called for a postponement to ‘allow the Revenue to focus its immediate attention on supporting businesses through the Brexit process, which must be a key priority’. Others, like myself, remain more optimistic.

However, a limited number and type of VAT-registered entities are engaged in private beta testing and there is no clear indication of when the public beta phase will start. Consequently, there will come a point soon – and certainly before the end of the summer (before the middle of October in Civil Service speak) – when HMRC will need to give serious consideration to extending the pilot testing phase by deferring the mandation start date.

 

A glance into the future

Further into his July 17 written statement Mr Stride wrote: ‘The government will not widen the scope of MTD beyond VAT before the system has been shown to work well, and not before April 2020 at the earliest. This will ensure that there is time to test the system fully and for digital record-keeping to become more widespread.’

Given the limited scope of the VAT-pilot and that VAT mandation is just over eight months away, I believe there is insufficient time, using the minister’s own words, ‘to test the system fully and for digital record-keeping to become widespread’ to garner the evidence required to support an earlier extension to mandation.

As well as this, and for the reasons stated earlier, there is not the income tax MTD-compliant third-party software products available (HMRC has a list of four). This situation looks unlikely to change until VAT-MTD is successfully delivered and the software industry is reassured that ministers have an appetite for mandation. Experience suggests that, once an announcement about mandation is made, it will change quickly as developers move quickly to capitalise on the opportunity.

Despite being a passionate believer in what MTD has to offer, and that the future of the accountancy profession is in the cloud, I cannot see further mandation returning to the table before 2021 at the very earliest. In the meantime, ministers and HMRC must contend with that other small cloud on the political horizon … the travails of Brexit.

Developments on MTD for VAT