Pension Death Benefit Trusts & the Perpetuities & Accumulations Act 2009
The interesting article by John Woolley in Money Marketing entitled Double by-pass confuses points on perpetuity dated 19 April 2010 and the ensuing debate on the Trust Discussion Forum on this issue gives rise to some rather technical issues to be explained to clients thinking of using a pilot discretionary trust to receive their pension death benefits should the trustees of their pension scheme choose to exercise their discretion according to the member’s letter of wishes. It also calls into question the true benefit of making a by-pass trust for this purpose.
The principle of pension by-pass trusts
The principle of the by-pass trust is simple. When a pension scheme member dies the lump sum death benefit can be paid to the member’s spouse/civil partner by the scheme trustees free of inheritance tax (IHT). However, when the spouse or civil partner dies the lump sum from the member’s pension will enhance their estate with the result that in some cases, where the joint estate exceeds the available nil rate band and any transferable nil rate band, the estate will have to pay potentially a large amount of IHT.
If the lump sum death benefit is paid to the trustees of the by-pass trust it does not fall absolutely into the surviving spouse/civil partner’s estate or the member’s own. Instead the trustees of the by-pass trust can pay the money to the children or grandchildren and can even loan money to the surviving spouse/civil partner, which would be repayable on death at which point the debt will reduce her/his estate for IHT purposes.
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Most pension schemes are themselves set up under a trust so the scheme trustees can in fact exercise their own discretion to pay the lump sum death benefit to almost anyone. However, the creation by the member of a by-pass trust enables the scheme trustees to decide to exercise their discretion in favour of the by-pass trust and thereby enable loans to be made by the by-pass trust trustees to the member’s spouse/civil partner or make other arrangements as indicated by the member in any letter of wishes provided to the by-pass trustees.
The only way that the pension scheme trustees can transfer money from the lump sum death benefit to the by-pass trustees is for a letter of wishes to be provided by the member in the form issued by the pension company trustees. It is of course not legally binding on the pension scheme trustees so there is the possibility that they will not decide to pay the lump sum death benefit as the member wished. The pension scheme trustees have two years from the date of the member’s death in which to make the payment otherwise it should properly be paid to the member’s estate (as most schemes’ rules provide) where it loses its exemption from IHT – see IHTM17123 in the HMRC Tax Manual.
The perpetuities point
The trust governing the pension scheme is outside the rule against perpetuities according to s.2 P & AA 2009; however powers of appointment are affected by the rule (s.1) as are the benefits arising under a pension scheme which are the result of exercising a power of advancement under the pension scheme – s.2(5).
Therefore when the pension scheme trustees choose to exercise their special power of appointment or power of advancement within two years of the death of the scheme member they are obliged to pay the lump sum death benefit either outright to whoever they believe is appropriate or to any by-pass trust preferred by the member. If they choose to pay it to the by-pass trust what should be the perpetuity period of the receiving trust given that the money is coming from a pre-existing trust as a result of the exercise of a special power?
The P & AA 2009 clarifies that the perpetuity period starts for such nominations and advancements when the member concerned became a member of the scheme – s.6(3) – and the member concerned is the member in respect of whose interest in the scheme the instrument is made.
Where the member joined the pension scheme after 5 April 2010 the consensus of opinion seems to be that s.6(3) of the Act means the perpetuity period starts when the member concerned became a member of the scheme and s.6 applies to an appointment of the death benefit so the perpetuity period of such a by-pass trust will be 125 years from the date when the member joined the pension scheme.
For members who joined the pension scheme before 6 April 2010 s.15(1)(b) of the Act means that the old rules will still apply i.e. that the instrument creating the power of appointment or advancement will dictate the perpetuity period of the new trust. A pension fund consists of a number of individual trusts for each member and for the purposes of ascertaining the perpetuity period appropriate to a by-pass trust for a particular member the pension trust would be deemed to have commenced when that member originally joined the scheme. So the 1964 Perpetuities & Accumulations Act would apply making the appropriate perpetuity period a life in being (i.e. the member’s life) plus 21 years. Therefore, the by-pass trust would need to end 21 years after the member’s death.
The only problem is that we might be drafting the by-pass trust to-day and therefore automatically the statutory period of 125 years would be the perpetuity period for that new trust. So in preparing a by-pass trust to-day to receive the appointment or advancement from a pension death benefit trust where the member joined the scheme before 5 April 2010 it would be necessary to define the trust period as not the perpetuity period but rather 21 years from the date of death of the scheme member.
The Inheritance Tax treatment
The purpose of the exercise is to save IHT at 40% on the pension lump sum benefit on the death of the member’s spouse/civil partner. It should therefore be noted that if the member starts drawing his or her pension before aged 75 the fund may ‘crystallise’ and the lump sum death benefit changes character to become what the legislation calls an “unsecured pension lump sum”. The effect of this is that whoever the pension trustees pay the lump sum to they have to deduct 35% income tax before paying it over; so the effective tax saving is reduced from 40% IHT to potentially 5% overall (i.e. the difference between the IHT saving at 40% and the income tax charge at 35%, although there may be some IHT to pay rather than none, at no more than 6% on the basis of current law, on the distribution of the funds out of the discretionary by-pass trust which is in the relevant property regime. This will depend on the size of the fund and when it is distributed).
The situation was worse if the member died after reaching 75 without crystallisng the pension fund as there were additional tax charges making a total charge of 70% or more. The Finance Bill (No 2) 2010 has confirmed that this will change for people who reach the age of 75 on or after 22 June 2010 so that from April 2011 there will be no more than 35% charged on uncrystallised funds on death. However, Her Majesty’s Revenue & Customs will retain the power to make a special IHT charge in cases where the deceased pension scheme member has deliberately delayed taking a pension to allow the death benefits to pass to their beneficiaries in this way.
Is it worth it to the client to make a pension by-pass trust? He or she will incur our fees for the careful preparation of an appropriate Deed and we will explain the tax consequences. For many modestly wealthy clients there will be little or no saving as a result of creating such a scheme, always assuming they die before 75, because the joint estate of the member and spouse or civil partner may not exceed two times the nil rate band.
For the higher net worth individual the opportunity to capture IHT free and without aggregation with his or her surviving spouse/civil partner’s estate what could be a sizeable pot and not affect any available nil rate band or transferable nil rate band to set against other assets in the joint estate this is of benefit but only a marginal benefit because of the income tax charge. Nevertheless a 5% tax saving on a large fund can still be significant and may be worth the costs of creating the by-pass trust.
For those who die after 75 (and this surely will be many given the average life expectancy for men is currently 78 and for women is 82) then only with the Finance Bill (No. 2) 2010 amendment will the same 5% marginal saving be made otherwise making such a by-pass trust would have been a significantly tax inefficient thing to do if the member died post 75.
© Gill Steel, LawSkills Ltd