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Major tax blow for beneficiaries of pension transfers

Paloma Kubiak
Written By:
Paloma Kubiak

Beneficiaries of pension transfers made while the holder was in poor health could be hit with shock 40% inheritance tax bills following a landmark court ruling.

Current rules mean that if someone is in ill-health and they decide to transfer their defined contribution (DC) pension but subsequently die within two years, the sum is subject to inheritance tax.

But most transfers are exempt from this charge as long as the transfer was not meant to confer a ‘gratuitous benefit’ on the member.

A tax charge was applied by HMRC in one such case and this was challenged by the pension transfer beneficiaries. However the Court of Appeal ruled in favour of HMRC, meaning it was correct in applying tax.

What was the court case about?

The landmark ruling centres on the decision by Mrs Staveley to transfer her pension and bequeath the money to her children, rather than leave it in an existing scheme benefiting her ex-husband.

This move was taken when she was terminally ill in November 2006 and she died just a month later.

HMRC argued that as she had not drawn on the pension benefit, the transfer conferred a ‘gratuitous benefit’ on to her sons. Further, it said she deliberately designed it to reduce the value of her estate for IHT purposes. As such, HMRC applied an IHT charge.

But this decision was challenged by her sons and the Upper Tribunal of the Tax and Chancery Chamber rejected HMRC’s arguments. But The Court of Appeal has now overturned this ruling in favour of HMRC.

Impact for pension transfer beneficiaries

Pension savers in ill-health are at greater risk of their loved ones being hit with a shock 40% IHT bill.

Tom Selby, senior analyst at AJ Bell, said it’s bizarre that someone who transfers from one DC plan to another now risks being hit with a 40% IHT bill – even if the transfer doesn’t materially change the money that will be passed on if they die within two years.

“This is already something defined benefit (DB) members in ill-health can fall foul of, although whether or not this is the case depends on the interpretation of their intentions at the time.

“What we are left with is a complex, nonsensical web of rules which risk layering on extra worry for beneficiaries at a time where they are likely to be suffering from serious emotional distress,” he said.

Selby added that instead of allowing court rulings to determine whether IHT is due on retirement funds left behind, the government could radically simplify the system by exempting pensions from IHT altogether.

Ian Browne, pension expert at Quilter said terminally ill people will be penalised for good financial planning.

“This is a legacy of an outdated inheritance tax system, which remains off kilter with pension freedoms. In the upcoming Budget and Inheritance Tax Review the Chancellor has the power to set this glaring discrepancy straight.”