Trusts Of Pension Death Benefits: All the News that's Fit to Print

Capital Tax Planning 1993 pages 52-56

A recent publication of the College of Law notes that

And it is quite easy for a practitioner to give the advice and prepare the documentation-provided that he or she consults only one of the several publications dealing with the subject and assumes that it tells the whole story. To research more widely is to discover that published texts contradict one another on important points and that none of them (or none that the writer has discovered) tells a story which can be called complete.

This unexpected situation must provide the excuse for this article. Its scope is accurately reflected in the quotation set out above, since it is confined to the retirement annuity contracts (RACs) issued by insurance companies and personal pension policies (PPPs) issued by insurance companies or other approved providers.

The origins of RACs lie in the Finance Act 1956. They were subsequently developed and the then existing legislation was consolidated in ss 226 and 226A of ICTA 1970. Further development was followed by further consolidation, and they are now governed by ss 620 and 621 of ICTA 1988.

PPPs were introduced by the Finance (No 2) Act 1987, and the relevant legislation is now to be found in ICTA 1988 Part XIV, Chapter IV.

Several texts issued by the Revenue will be mentioned in the course of this article and the time has come to identify one of these. It consists of guidance issued in 1988 under the heading 'Inheritance Tax on benefits under superannuation schemes'. It includes statements about the inheritance tax treatment of RACs in general (not merely the death benefits) and its principles presumably apply also to PPPs. It has not appeared as a Statement of Practice but is to be found, for example, in Dymond's Capital Taxes, p 11028, In McCutcheon on Inheritance Tax, 3rd Edition, Para 17-41A, and in Capital Taxes and Estate Planning Quarterly, 1988, No 2, p 19. In what follows it will be referred to as 'the 1988 Guidance'.

If the death benefits have not been placed within a trust (or assigned outright to some particular individual) they will be payable to the personal representatives of the insured and will accordingly be subject to inheritance tax as part of his or her estate. This is confirmed by paragraph (A)(1) of the 1988 Guidance. If they pass to the spouse of the insured, they are of course exempt from tax but it cannot be known whether the spouse will predecease or survive the insured and, even if the spouse survives, some or all of the value representing the death benefits is likely to pass again on the spouse's later death and to attract inheritance tax at that stage.

If the value of the death benefits is substantial, therefore, it is better that they should not form part of the estate of the insured but be 'hived off' by a life-time disposition. Options may be kept open through an assignment to the trustees of a discretionary trust, and this is the method usually adopted. The tax treatment of discretionary trusts created for this purpose is favourable.

In practice the initial assignment to the trustees of the discretionary settlement will normally be a non-event for inheritance tax purposes. The chances are that (even in the case of a non-pension policy) the death benefits will never become payable at all; so, although technically a chargeable transfer, the assignment will be of property having a

very small, or even a negligible, value. The position would be different if the insured were in bad health at the time of the assignment: more is said about this below.

Not long ago some fear was expressed that an inheritance tax charge might arise, not on the assignment itself but (at least in certain circumstances) because of later events. RACs and PPPs usually give the insured an option to take the main pension benefits at a relatively early age. (The retirement age under an RAC may be between 60 and 70, and that under a PPP between 50 and 75.) If the insured settled the death benefits and then reached this age and did not take the pension, and the death benefits subsequently became payable, the Revenue had apparently suggested that this decision not to take the pension at the earliest possible moment was an 'omission to exercise a right' within Inheritance Tax Act 1984, s 3(3), and (since it preserved and prolonged the possibility of the death benefits becoming payable) was a taxable transfer of value to the trustees.

This threat has now largely disappeared. In a statement prepared at the request of the Association of British Insurers (and published in the Inland Revenue's Tax Bulletin for February 1992 (p 11) and elsewhere in the legal press), the Inland Revenue has made it clear that the point will be taken only in very rare circumstances. If the insured postponed the main benefits merely be cause he or she wanted to go on working and to let them build up for his or her own benefit, all is well. No problem will arise unless there is evidence that the decision was taken in order that the death benefits should become payable to the settlement beneficiaries. To this end, the statement says,

The 'arrangements' which will be scrutinised in these circumstances include not only the postponement of the pension benefits but also

(1) assigning the death benefits under an existing policy to settlement trustees,

(2) taking out a new policy and assigning the death benefits to the settlement and

It is clear (and the statement implicitly confirms) that, subject always to the health of the insured, the payment of further premiums on a policy already assigned to a settlement would have no inheritance tax significance. In theory such premiums would be for the benefit of the settlement beneficiaries in so far as their amount was attributable to the death benefits, but (except perhaps in the case of some non-pension policies) the element of bounty ascertained on this basis would be very small and (in all cases) would almost certainly fall within the 'normal expenditure out of income' exemption provided by IHTA 1984, s 21. Paragraphs (D)(l)-(3) of the 1988 Guidance may indeed be read as suggesting that, except in the case of a non-pension policy, the payment of premiums is regarded as not chargeable at all.

Nor is there any risk that, between the assignment and the death, the ten-yearly charges to which a discretionary settlement is normally subject would give rise in practice to any tax charge. The small value of the (possible) death benefits alone would usually preclude this. In fact, however, it seems that (for reasons given in the next paragraph but one) the potential death benefits do not rank as 'relevant property' at all and so are not subject to the ten-yearly charge.

Suppose, then, that at some time after the making of the settlement, the insured dies and the death benefits become payable to the settlement trustees. It is clear from what has already been said that the money has been taken out of his or her estate for inheritance tax purposes and (subject only to the health question) that up to this point no inheritance tax has become due and there have been no inheritance tax disadvantages. And there is good news still to come because the Revenue will allow distribution of the money to take place within two years of the death without seeking to exact the exit charges normally payable when property is transferred out of a discretionary trust.

This last advantage is concessionary but its existence has recently been confirmed in the course of a letter to the writer's firm from the CTO. The basis for it is that RACs and PPPs fall within the provisions of IHTA 1984, s 151, and if the death benefits are held on discretionary trusts they are prevented from being 'relevant property' by the provisions of s 58(l)(d). The CTO says that if distribution

This is not so, however, if the insured, despite having settled the death benefits, has retained a general power of appointment over them. In those circumstances, s 151(4) would modify s 5(2) in such a way that the death benefits, even though settled property, would be treated for inheritance tax purposes as part of the insured's free estate. The existence of such a power should therefore be avoided at all costs, for it will nullify the scheme.

One further advantage of the settlement of death benefits may be noted: they could be collected by the settlement trustees immediately after the death. There would be no need to wait for a grant of probate or letters of administration.

The settlement will normally be made by the insured, and it will be convenient under this heading to refer to him or her as the settlor.

The basic form of the settlement will be that of a conventional discretionary trust with a wide power of appointment over capital. There is no pressing reason why the power should be framed so as to end two years after the death, but this is commonly done because exercise within two years is almost always desirable and an express requirement will concentrate the minds of the trustees. It does not follow, of course, that anyone need become absolutely entitled as a result of the exercise: provided the power is wide enough it may be exercised so as to create continuing trusts (even discretionary ones), and an 80-year perpetuity period (running from the date of the settlement) may be specified if desired. Accumulation of income could be required or permitted, and it would be useful for the settlement to specify an accumulation period: this is one of the rare cases in which a period of 21 years from the settlor's death should be selected in preference to one of 21 years from the making of the settlement.

It is quite possible to have a separate settlement for each RAC or PPP. Often, however, the settlor will have two or more policies at the time of the settlement and will wish to assign them all to the trustees, making provision for the future assignment of any policies which may be issued later. There is no reason why the assignment of the existing policies should not be incorporated in the settlement itself.

But this brings us to an important point. Except in the case of some non-pension policies, the main benefits under RACs and PPPs must go to the beneficiaries prescribed by statute and cannot be subjected to the trustees' discretion. Despite this it is the policies themselves (and not merely the death benefits) which must be assigned to the trustees. The reason seems to be that each policy constitutes a single chose in action, and a chose in action may not be split. Careful drafting is needed to ensure that it is only the death benefits which fall within the substantive trusts of the settlement, and that all the other benefits are simply held by the trustees on trust for those who are entitled to them under the terms of the policy. An express provision may be included to allow the insurance companies to pay these other benefits direct to those entitled. The settlement may be submitted in draft to the Pension Schemes Office (formerly the Superannuation Funds Office) of the Inland Revenue (Lynwood Road., Thames Ditton, Surrey, KT7 ODP) who will confirm (if it be the case) that it deals only with the death benefits and does not prejudice the approved status of the policies.

It may be useful to include in the settlement a clause dealing with the respective rights and duties of the settlor and the trustees, in relation to the policies, during the settlor's lifetime. This could make it clear that the settlor has no obligation to keep up premium payments and that the trustees have no duty to require any. It could go on to confirm that any options and decisions left open by the policies as to investment of premiums or in relation to benefits other than the death benefits may be exercised or taken by the settlor and that the trustees must give any necessary co-operation in exercising or taking them.

The usual administrative powers should of course be included in the settlement.

Finally, a point about stamp duty. The writer has consulted the Stamp Office about the duty payable on a settlement which both assigns a policy or policies and declares trusts. They reply that 'in strictness' the latter element attracts 50p declaration of trust duty but that the settlement should also contain a certificate to exempt it from voluntary disposition duty in respect of the former element. It is suggested that an appropriate certificate might be along the following lines:

Some of the published texts maintain a dignified silence about the points to be discussed under this heading, and some seem even to suggest that any RAC or PPP may be the subject of a settlement. This is by no means the case, because several obstacles may arise.

It is obvious enough that if the insured has already imposed a discretionary (or other) trust on the death benefits payable under a policy, he or she cannot assign them to another trust. Insurance companies themselves will usually supply, on request, trust documentation of their own devising, and use may be made of this at the time of issuing the policy. If, at the request of the insured, the policy is actually written in trust, then the insured will usually be the sole original trustee but will have power to appoint additional or replacement trustees. An insured who plans to assign existing policies to a new settlement must therefore make sure that none of these things has already happened-but this should be easy enough because they will not have happened except at his or her express request .

What is much less obvious is that the insurance company itself may (without any request on the part of the insured) have incorporated a discretionary trust of death benefits in its standard form of RAC or PPP. This is particularly true of PPPs issued soon after the initiating legislation came into force in 1988. It seems that the Revenue provided insurers with model PPP provisions and that these incorporated a discretionary trust of this kind under which the discretion was vested in the insurance company concerned. These model provisions were adopted by insurers anxious to offer PPPs as soon as Possible, and the death benefits under many policies issued in the early days were therefore unassignable. Although the model provisions were later revised in such a way

as to eliminate the discretionary trust, and policies issued after that are less likely to include one, it is understood that some companies to this day issue their PPPs with an automatic discretionary trust of death benefits.

The fact that the terms of the policy itself incorporate a discretionary trust is not of course unsatisfactory in the present context, although the trust provisions may not always be adequate and some people might prefer not to have the insurance company as the sole trustee. The problem is that the policy itself must be carefully considered, perhaps in conjunction with other documentation to which it refers, before one can be sure that it may be assigned to the trustees of any new discretionary settlement. The alternative is for the insured to assign all RACs and PPPs indiscriminately and accept the fact that, in the case of some, the new trusts may simply be ineffective.

In this respect the law was changed by FA 1980, s 33, which abolished the requirement with 'effect for the year 1980-81 and subsequent years'. What exactly is the result of this change?

As regards existing policies, did the change automatically render the death benefits assignable; and is there any need to differentiate between benefits provided by premiums paid before the change and those provided by post-change premiums? The answer to both questions seems to be, No. When the writer raised them recently in the course of submitting a draft settlement to the Pension Schemes Office, the reply (with italics supplied) was

Nominations fall into two categories. Those in the first category take the form of wishes expressed by the insured to the trustees of a discretionary trust-whether set up by the insured or incorporated in the standard terms of the policy-as to the way in which they should exercise their discretionary powers over the death benefits. Policies in respect of which such nominations have been made are of course unassignable, not because of the nominations but because the death benefits are already held on trust.

But some policies, although containing no actual trust of the death benefits, nonetheless allow them to be nominated in favour of particular beneficiaries. This of itself apparently does not preclude assignment into a settlement, but any nominations which have actually been made should be cancelled.

Once the settlement has been made and existing policies assigned to its trustees, either by a term of the settlement itself or separately, the first step is to pay any necessary stamp duty (which will never be more than nominal). Stamp duty payable where the settlement incorporates the assignment is dealt with above.

Notice of the assignment should be given to the insurance companies concerned.

Further premiums paid on the policies assigned will go automatically to increase the potential benefits within the settlement but if new policies were taken out they would have to be assigned to the settlement trustees. A simple document would achieve this purpose. Again, notice should be given to the insurers.

It would be appropriate for the insured (the settlor) to prepare a letter of wishes setting out the way in which (subject to unforeseen circumstances) he or she would wish the trustees to deal with the death benefits in practice.

The making of the settlement should also be reported to the Revenue. Unless the Settlor has made substantial chargeable transfers in the past, it seems unlikely that this disposition will need to be reported to the CTO (see the Capital Transfer Tax (Delivery of Accounts) (No 2) Regulations 1981, SI 1981/1440), but notice should be given to the Inspector of Taxes using Form 41G (Trust). The form should be accompanied by a letter pointing out that no income will accrue unless and until the death benefits become payable, so that no tax returns should be required of the trustees in the meantime.

R T Oerton, Solicitor

Consultant with Bircham & Co

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