The end of the ill-health IHT transfer trap?

A recent ruling from the Upper Tax Tribunal casts serious doubt over HMRC’s position on pension transfers where the member is in ill-health. Previously these had been open to challenge for Inheritance Tax purposes, but this may no longer be the case if the transfer takes place for genuine financial planning reasons.

Background

The majority of pension schemes are written under trust, which means they are outside of the member’s estate for Inheritance Tax (IHT) purposes. This is normally the end of the story.

As many advisers will be aware, however, there is a potential pitfall where a member transfers from one pension scheme to another. If they were knowingly in ill-health and they die within two years of the transfer, HMRC may look to challenge it as a ‘transfer of value’ for IHT purposes under section 3(1) of the Inheritance Tax Act 1984.

In other words, they may view it as a disposition by the member that has reduced their estate, meaning less IHT potentially payable.

Of course millions of pounds worth of pension funds are transferred each year without problem. The reason for this is the exemption in section 10 of the 1984 Act. This says that a pension transfer will not be a transfer of value as long as it was not intended to confer a ‘gratuitous benefit’ on any other person.

Almost all transfers use the section 10 exemption. However, if a member transfers their funds to a pension scheme in which the death benefits are distributed at the discretion of the scheme administrator, and while knowingly in ill-health, HMRC maintain that the exemption does not apply – the transfer is a transfer of value.

First Tier Tribunal (FTT)

The background to the present case (Parry & Others v HMRC) was that the pension scheme member, Mrs Staveley, had an occupational pension that was overfunded. The employer connected to the scheme was the business belonging to Mr Staveley, to whom Mrs Staveley had been married prior to an acrimonious divorce.

The terms of the scheme would have allowed any overfunding to be returned to the employer. Mrs Staveley was keen that this did not happen as it would effectively be handing cash back to her former husband.

In 2006, the rules changed such that the ten-year transfer embargo, which had applied to the scheme, fell away. Mrs Staveley arranged for a transfer into a new personal pension plan (PPP). Unfortunately, Mrs Staveley had developed cancer and she passed away a few weeks later.

HMRC argued at the FTT that the purpose of the transfer was two-pronged – (1) IHT planning; and (2) to confer a gratuitous benefit on her sons, who she had nominated as beneficiaries under the PPP.

In the evidence submitted to the tribunal, however, it was clear that (1) the principal purpose was actually to prevent funds being returned to her former spouse; and (2) her sons received no benefit as they were already the beneficiaries of her Will anyway, so no change.

The following section from the FTT report is perhaps the most indicative of their view.

“The entire premise of Section 10 is that a benefit is conferred. It presupposes that the benefit did not exist before and is newly conferred. If [HMRC] was right, a transfer from one PPP to another PPP for commercial reasons (perhaps to get a better rate of return), without any change in beneficiaries, would be caught. We do not think that this was intended by Parliament.”

Upper-Tier Tribunal (UTT)

HMRC appealed the decision, so fast forward to the recent decision. Here, however, the UTT agreed with the FTT that the transfer was not a transfer of value, noting the following.

“…we find that it has been shown that the disposition by the transfer of funds to the… PPP was not intended… to confer a gratuitous benefit on any person, and that it was made in a transaction at arm’s length between persons not connected with each other.”

So what now?

Many will have puzzled over this ill-health transfer rule before. It appears to be predicated on the curious reasoning that the member had the choice in theory to transfer their pension rights to a pension scheme under which their estate would have been entitled to the death benefits. The fact that they have chosen to transfer it to another scheme whereby death benefits are paid at the discretion of the scheme administrator means that they have diminished the value of their estate.

This applies even though the funds may already have been in a similar scheme before. In other words, they are deemed to have brought the funds into their estate and then out again.

Two tax tribunals have now come to the conclusion that this doesn’t really add up.

The primary purpose of the transfer in this case was very specific to Mrs Staveley’s circumstances, but the comments of the FTT, as endorsed by the UTT, suggest that transfers for other planning purposes may be sufficient to bring the section 10 exemption into play, even if the member is in ill-health.

The FTT in the initial ruling referred to “commercial reasons (perhaps to gain a better rate of return)”. While they didn’t explore this in any more detail, it would appear to give us some hope that this might include things like investment choice, flexibility of pension benefits, consolidation and lower charges.

Where it will pay to remain cautious, however, is where the primary purpose is to take advantage of more flexible death benefits. This could indicate that there is more than one eye on the final distribution of funds rather than on any commercial benefit that member might enjoy during their lifetime.

In the meantime though, this is a positive step towards a much more sensible approach to pensions and IHT planning.

Technical Resources Consultant

After completing his post-graduate studies at Lancaster University, Martin spent two years working for a leading insurance company before joining AJ Bell in April 2007. Martin worked initially on the AJ Bell Investcentre product before moving to a technical role in 2009.

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