Last week the Office of Tax Simplification (OTS) published its second report on simplifying the Inheritance Tax regime. There has been a lot of comment and discussion in the press about it since, much of it focusing on headline grabbing proposals relating to how lifetime gifts are taxed. One area which has received less attention is the recommendations relating to the Inheritance Tax treatment of life assurance policies and pensions.
In most cases, lump sum death benefits paid out by a pension provider after death will not be subject to Inheritance Tax, provided that the death benefits are paid at the discretion of the pension scheme trustees. Often the pension scheme trustees will exercise their discretion to pay the death benefits in accordance with the (non-binding) wishes of the deceased.
However, the Inheritance Tax free status of a death benefit payment can be put at risk if the pension holder makes changes to their pension within two years of death. Changes can include assigning the death benefits to a trust, or transferring the pension fund from one pension scheme provider to another. As the OTS note in their report, where pension funds are transferred from one pension scheme provider to another "the primary drivers are likely to be lower fund management costs, consolidation of several pensions into one, to have a greater number of investment options or greater control of investments and the ability to access flexible drawdown. In most of these cases, the beneficiaries are unlikely to change".
Despite the fact that in most cases changes made are not motivated by a desire to avoid Inheritance Tax, HMRC nonetheless may take the view that the changes made within two years of death are likely to constitute a "transfer of value" which may then trigger an Inheritance Tax charge. It is then for the scheme member (or their estate) to prove otherwise. The rules in this area are complicated and the guidance provided by HMRC is limited and opaque at best. The OTS's call for clearer guidance on this issue is therefore welcome.
On the subject of life assurance policies, the OTS highlights the fact that where life policies are written in trust they will, in the most cases, fall outside of an estate for Inheritance Tax purposes. Conversely, a life policy which isn’t written into trust and so pays out to the estate on death may result in Inheritance Tax charge on the value of the policy. Writing a policy into trust need not be complicated or require legal assistance. Often insurance companies will provide standard documentation which will allow the policyholder to set up a trust arrangement when they first purchase the policy.
Whilst there may be reasons why policyholders decide not to write life policies into trust, in most cases the failure to do so probably comes down to nothing more than a lack of knowing that the trust option is available. The result is that two policyholders may, on the face of it, have identical policies but whilst one policyholder's policy will pay out tax free, the other policyholder will find that their policy suffers a 40% tax charge on death, simply due a lack of knowledge of the trust option. The OTS therefore recommends doing away with this anomaly entirely by treating benefit payments from life assurance policies in the same way for Inheritance Tax purposes, whether or not the policy was written in trust.