David Anderson and Graeme Perry look into personal pensions and tax charges on death during drawdown

Many people with personal pension schemes who are about to retire will often be advised by their independent financial adviser (IFA) to put their pension into drawdown. Given the poor annuity rates this is a fairly normal and sensible procedure and will involve money being taken out according to HM Revenue and Customs’ (HMRC) rules. However, a particularly nasty sting in the tail exists of which many people are unaware.

If you die during the drawdown period then the amount left in your pension scheme will be subject to what is known as a ‘special lump sum death benefits charge’ at the date of your death. This is governed by section 206 of the Finance Act 2004 and amounts to an income tax charge of 35% on the sum left in your pension. The section also allows for the Treasury to alter the rate of 35%.

The result of this is that even if the pension arrangements are that the fund is to pass to a surviving spouse, they will only receive the balance of the fund, net of 35% UK income tax. This is often not spelt out to people taking out pensions and is a stealth tax which is not properly understood by many.

The legislation provides that it is the pension scheme administrator who is liable to pay this charge. Upon the death of the pensioner, the pension fund trustees must pay the money over to HMRC. The surviving heirs will then receive the pension fund after 35% has been deducted in income tax.

Although it would normally be expected that only inheritance tax should apply on death, the provisions do not work like this. The section in the Finance Act specifically classifies the money as subject to income tax, even though it is clearly a capital sum in the pension fund. In fact the legislation states that the lump sum death benefit is not to be viewed as income even though income tax is payable on it. This is a bizarre way to draft legislation.

Essentially HMRC is clawing back the income tax relief it gives when contributions to the fund were made. It brings into question the sense of having a pension, as the main reason for tying your money up with a pension fund is to get the tax relief – without this no one would have one.

Retiring to the sunWith increasing numbers of people moving abroad, the question of whether the charge applies to a pensioner moving to France, for example, is worth considering.

The legislation is widely drafted and provides that the scheme administrator must pay the charge whether or not they or the recipient of the lump sum is resident, ordinarily resident or domiciled in the UK. The legislation specifically makes the pension scheme administrator the taxable person. Although not stated in the legislation, this must be subject to any double tax treaty as international treaties take priority over both UK and French internal law.

The UK-France double tax treaty of 1968 does preclude, in relation to certain forms of income, a charge to income tax in the UK on French residents, but it is not clear how this unique 35% charge fits in with the treaty. There is the possibility of challenging the legislation as the rules set out in the treaty take priority over domestic law; however, no such challenge has yet taken place.

The treaty certainly covers income tax of this kind and provides in article 18 that any pension and other ‘similar remuneration’ paid in consideration of past employment to a resident of France shall be taxable only in France.

In this case the literal reading of the treaty is that ‘similar remuneration’ – the lump sum being paid to the surviving spouse who is resident in France by the pension fund trustees – is in consideration of the past employment of the recipient’s deceased spouse – who was previously in receipt of the pension – rather than the recipient. As you can see the literal reading of the treaty covers the situation and the 35% UK tax should not be payable.

In our view, any pension fund which has suffered such tax in respect of a deceased pensioner in France should seek to be reimbursed by the pension fund trustees on the basis that they paid it over to HMRC under an error of law.

Not so safe havenThe position is different if you retire to a tax haven such as Monaco. There is no double tax treaty between the UK and Monaco, and, accordingly, the pension fund would be taxed as though the pensioner were resident in the UK and the 35% tax would be payable. In addition, while alive and in receipt of the pension, UK income tax would have to be paid on the money arising in the pension fund, before it is paid out to a Monaco resident.

The contrary is true in France, because the UK-France double tax treaty provides that France, not the UK, has the right to tax income from pensions. So for a French resident receiving a pension, the UK pension fund trustees have to pay the sums gross (without deducting UK income tax) and these will then be taxed in France, normally at a much lower rate. Somewhat counter-intuitively, from a pension point of view you are better off retiring in France than Monaco.

There are other potential routes worth considering to avoid this 35% tax. One possibility is to move abroad and transfer any existing personal pension to a pension provider in that country.

Under UK pensions legislation it would only be possible to transfer into a scheme approved by HMRC, known as Qualified Registered Overseas Pension Schemes (QROPS). A list of QROPS is published on a regular basis by HMRC and there are a number of such schemes in France and other countries. There is no approved QROPS in Monaco. The effect of this is to remove your pension fund from the UK tax net. To be approved, the foreign QROPS must contain similar restrictions on, say, investment and benefits as the UK.

Of course, many people will not be willing to go through the upheaval and stress of a move abroad but will still be interested in making their pension scheme more flexible. There are specialist schemes into which you can export your pension fund to, say, the Channel Islands while remaining UK resident.

These require a detailed analysis of your position and are only suitable for larger funds because of the costs involved. These arrangements can provide additional benefits, for instance, allowing you to avoid having to take an annuity at age 75.

David Anderson is a solicitor and chartered tax adviser and Graeme Perry is a trainee at London firm Sykes Anderson