Transferring while in ill health - 2 year rule

1. Why HMRC Reviews Transfers Within Two Years of Death

HMRC has a long standing interest in pension transactions completed shortly before death. Form IHT409 specifically asks for details of contributions, transfers, and binding nominations made within the previous two years.

Their concern is whether these actions reduce the value of the estate in a way that could be seen as deliberate deprivation. In the case of transfers, HMRC’s view is that a member could direct death benefits to their estate at the point of transfer. If they do not, HMRC may argue that the estate has suffered a loss. A defence against this is that the decision to transfer was not to confer a gratuitous benefit to another (Inheritance Tax Act 1984 section 10).

2. Is HMRC’s Approach Fair?

Most modern personal pension schemes give trustees or administrators full discretion over who receives the death benefits. In such cases the member cannot direct benefits to their estate, they can only express their wishes on what they would like to happen. So when a transfer takes place between two modern pensions with discretion on death benefits, HMRC’s position seems unclear, as all that has changed is the wrapper, the death benefits remain the same both before and after transfer. So advisers will need to proceed with caution. Three practical observations often arise:

• Transfers from defined benefit schemes to defined contribution schemes will almost always appear designed to benefit others, so relying on defence that there was no intention of conferring a gratuitous benefit is unlikely to succeed.
• Transfers from defined contribution schemes where either a binding nomination applies or the rules require death benefits to be paid to the estate, into schemes with full discretion, will usually appear intended to benefit others. As a result, arguing that there was no intention to confer a gratuitous benefit is unlikely to succeed.
• Transfers between similar personal pensions, where options and beneficiaries remain unchanged, are widely viewed as a harsh trigger for IHT treatment because there is no change in benefit before and after the transfer. However HMRC may still try to argue there is a gratuitous benefit conferred.

This issue will fall away once pensions move fully within the IHT net from April 2027. But for now more information can be found in HMRC’s manual.

3. How HMRC Determines the Transfer of Value

When a pension transfer is treated as a transfer of value, HMRC must establish how much value has effectively been transferred. In other words, how much is the lifetime transfer. Where the member is below the minimum pension age and therefore unable to access benefits, the transfer value will generally be nil.

Our understanding is that for members who have reached the minimum pension age, the calculation compares:

1. The open market value of the death benefits created by the transfer, and
2. The value of the pension rights the member has retained.

Step 1: Calculating the Open Market Value of the Death Benefits

Start with the cash equivalent transfer value (CETV) at the date of transfer and adjust it by applying:

• Assumed investment growth of 5% a year over the member’s remaining life expectancy at the time of transfer.
• A 15% annual discount to reflect uncertainty, timing and the return a third party purchaser would require.

These adjustments produce the open market value of the death benefits at the point of transfer.

Step 2: Deducting the Value of the Rights the Member Retained

The following values must then be deducted:

• The pension commencement lump sum(PCLS).

Plus the higher of:

• The value of any guaranteed 10 year annuity, assessed net of income tax,

OR

• For flexi access arrangements, the value of the drawdown fund available to the member, also net of income tax.