IHT TREATMENT OF BY-PASS TRUSTS

By-Pass Trusts can play an important role in IHT planning using lump sum death benefits from pension schemes. How they are subject to inheritance tax (IHT) at the 10 year anniversary (periodic charges) or when property leaves the trust (exit charges) going forward can be important. In this respect HMRC seem to have recently changed their interpretation on an important aspect. Advisers will need to bear this in mind when giving tax advice on such a trust.

For some years, financial planners have used By-Pass Trusts as a means of holding lump sum death benefits from a pension scheme. The By-Pass Trust has two advantages in these circumstances:-

(i) it enables third party trustees chosen by the member to decide who benefits from the fund at a later date. Such trustees are likely to be more familiar with the member’s circumstances than the pension scheme trustees and they can be guided by a letter of wishes from the pension scheme member; and

(ii) it means that the lump sum is not aggregated with any one individual’s taxable estate – for example, that of a surviving spouse. Instead cash can be released from the trust as and when it is needed.

It is questionable whether By-Pass Trusts (BPT) are as useful in the new era of Flexi-Access Pensions where pension funds can be rolled down through the generations with no adverse inheritance tax implications. However, because of the greater control they offer, By-Pass Trusts will undoubtedly continue to remain useful for some people.

Inheritance tax on By-Pass Trusts

By-Pass Trusts are generally established in one of two ways. Either the pension scheme member sets up a pilot discretionary trust with a gift of £10 and then completes a letter of wishes requesting the Scheme Administrator to pay lump sum death benefits to the By-Pass Trust as a member of the discretionary trust under the Rules. This is generally known as a pilot by-pass trust.

Alternatively, the individual may (if the Scheme Rules permit) declare a trust of the death benefits under the Pension Plan. In the event of death, the Scheme Administrators must then pay death benefits to those trustees. Thus the element of discretion imposed on the Scheme Administrators is removed. Instead the trustees of the personal trust will take over the power to appoint benefits. This is known as an integrated trust.

In both cases, it is necessary to know what the IHT treatment will be of any funds held within the By-Pass Trust in the future. The removal of the 2 year IHT rules by the Taxation of Pensions Act 2015 means that there should now be no IHT when payments are made from the pension scheme to the Trust. Instead we have the special lump sum death benefit charge (SLSDBC) to consider which, where it applies, is at 45%.

Periodic and Exit Charges

As is well known, a discretionary trust, as a relevant property trust, can be subject to IHT on every 10 year anniversary of the trust (periodic charge) as well as when property is paid out of the trust (exit charge).

For these purposes, HMRC take the view that where the money in the By-Pass Trust originated from a trust-based pension scheme, then the trust will be treated as commencing when the individual joined the pension scheme. This is because the member will be treated as the settlor of a trust comprising of his pension rights when he joins the scheme. In turn, this means that section 81 IHT Act will apply so that the member’s trust of his pension rights and the By-Pass Trust are rolled-together and treated as one trust for IHT purposes.

Example

Dolly

Dolly joins the ABC Personal Pension Scheme (PPS) on 1 August 2012 paying contributions of £1,000 per month. No transfer payment is made. Dolly creates a By-Pass Trust for £10. On her death on 14 June 2019, the Scheme Administrator exercises its discretion to pay death benefits to the By-Pass Trust. For IHT purposes the By-Pass Trust is treated as commencing when Dolly set up her ABC PPS on 1 August 2012 and the first 10-year anniversary will occur on 1 August 2022 – even though this is just 3 years after her death.

Brenda

Brenda started an ABC PPS on 1 August 2012 with a transfer from her trust-based pension plan with Transindental Life which she set up on 1 June 1987. No other contributions have been made to the ABC PPS. Brenda also creates a By-Pass Trust. On her death, the Scheme Administrator exercises its discretion to pay benefits to the By-Pass Trust.

In these circumstances, for IHT purposes, the cash representing the transferred amount would be treated as being held in a discretionary trust that was created on 1 June 1987.

So far so good. But what exactly do HMRC regard as a trust-based pension scheme? What if Brenda had joined a pension scheme which was governed by a deed poll (rather than a master trust) with supporting rules?

Well in this situation in the past, there may have been a tendency to classify a scheme constituted by a deed poll as a ‘contract based’ scheme. Therefore, logic would suggest that any By-Pass Trust would only commence when it was physically established (i.e. by the nominal £10) and/or when cash was added to it from the pension scheme.

However, HMRC have now confirmed to us in detailed correspondence that this is not the case. It seems that if, under the ‘contract-based’ scheme, the Scheme Administrator has a discretion to pay death benefits to anybody in the discretionary class, HMRC would regard those funds as being held in a settlement. This means that if the Scheme Administrators exercise their discretion to pay the cash to a By-Pass Trust, section 81 would apply. This is because the death benefits would have been treated as being held in trust from the date the member joined the scheme (or the date of joining any earlier trust based scheme the benefits of which have been transferred to the contract based scheme). The commencement date of the trust, for the purposes of calculating any ten year or exit charges, would then be the date the member joined the scheme (or any earlier trust based scheme from which a transfer has been made).

Integrated By-Pass Trust

This raises the question of what the position is in relation to an integrated by-pass trust. This, remember, is one that the Scheme Administrator must pay lump sum death benefits to, if declared .

The commencement date of the trust, in this situation, will depend on when the integrated trust is declared, as we set out below:-

(a) If an integrated trust is declared immediately

If the integrated trust is declared immediately the member joins the new scheme, the trust will be treated as commencing then. If the funds in the personal pension comprise of funds that were a part of a previous trust-based pension scheme that had been transferred to the new scheme, section 81 will apply with the effect that it is the date of joining the first trust based pension scheme that determines future ten year anniversaries.

(b) Integrated trust not declared immediately

If the integrated trust is not declared immediately and, in the meantime, the death benefits are payable at the Scheme Administrator’s discretion, HMRC will regard the death benefits as being in trust – regardless of whether or not an integrated trust is later declared.

The effect of this will be that section 81 would apply to the subsequent declaration of an integrated trust and the relevant date for determining 10 year periodic charges would be the date of joining the scheme (or the date of joining any earlier trust based-pension scheme if there had been a transfer into the current scheme). The date the integrated trust was itself declared would only be relevant if, in the unlikely event that prior to that time, the Scheme Administrator had no discretion over the payment of any death benefits.

This would appear to be a change in practice by HMRC and should be brought to the attention of any trustees who are calculating IHT on death benefits held in By-Pass Trusts where the trust fund is derived from a contract-based scheme.

It should also be noted that where death benefits are paid out of a pension scheme and into a trust on or after 6 April 2016 and a 45% SLSDB charge arises (mainly in cases where the member dies at age 75 or more), a credit for this tax charge will be available where a later payment is made to an individual beneficiary. This means that if the beneficiary’s income tax charge on the payment is at a rate of less than 45%, it may be possible to offset the excess credit against tax on other income in that tax year. Full details of this provision are contained in section 21 Finance (No 2) Act 2015.

Given the above we feel it is important that a review is completed where you are aware a By-Pass Trust has been put in place, particularly given the new pension flexibilities.