The tax treatment of pensions upon death could come under government review following recommendations by the Office of Tax Simplification.
In a consultation paper focusing on inheritance tax published on Friday (July 5), the OTS urged the government to take a closer look at the rules surrounding pensions upon death, specifically pension transfers and the two-year rule.
According to the paper, people are increasingly deciding to move money between different pension providers, primarily driven by lower costs, the consolidation of a number of pensions into one, or greater control over the investments.
However, in certain circumstances, there is a requirement from HMRC for those making the transfer to demonstrate that it has been made without the "intention to confer a gratuitous benefit", meaning to avoid inheritance tax upon death.
The subject of pension transfers has been a subject of interest within the industry recently following the landmark ruling on the Staveley case, which related to the transfer of a pension during ill-health in order to update the beneficiaries and ensure the children benefited upon death rather than her recently divorced ex-husband.
A pension transfer that took place in the two years before the death of the member must be declared to HMRC if the member was knowingly in ill health at the time of the transfer. Any transfers outside of this two-year period are safe from scrutiny.
In the Staveley case the pension owner died shortly after the transfer.
In October 2018, the Court of Appeal found in favour of HMRC in the charging of 40 per cent IHT on the pension because it was a "chargeable lifetime transfer" - a transfer of value for IHT purposes.
This case is now waiting to be heard by the Supreme Court as the defence argued that the transfer was done in order to prevent the ex-husband from benefiting from the pension, rather than for IHT purposes.
The OTS has recommended that HMRC provides further detailed guidance on the circumstances in which a gratuitous benefit may arise when making certain pension transfers, such as from a defined benefit scheme into a personal pension scheme shortly before death.
Sean McCann, chartered financial adviser at NFU Mutual, welcomed the call for greater clarity.
He said: "In most circumstances, money left in pensions on death can be passed on free of IHT. If someone transfers their pension while in ill health and dies within two years however, this can lead to an unexpected tax bill for the family.
"In this instance, HMRC may take the view that a transfer has been made primarily to improve the death benefits for the family. People may want to transfer their pensions for a number of reasons – those in ill health face uncertainty as to whether this will leave a bill for the family."
Rachael Griffin, tax and financial planning expert at Quilter, said the OTS should call for pension rules to be amended so all policies are not subject to IHT.