Today is: 30 July 2010
David Anderson and Graeme Perry of Sykes Anderson LLP solicitors and chartered tax advisers discuss the UK Revenue's position on taxing pensions at 35% on the value at death and its interaction with double tax treaties.
The 'Special lump sum death benefits charge' is an obscure but pernicious pensions "stealth" tax introduced by the Government in section 206 of the Finance Act 2004. This provides that if a pensioner dies when they are drawing down their pension then the amount left in their pension scheme will be subject to an income tax charge of 35%. In short a widow who is entitled to her deceased husband's pension fund on his death will receive the pension money after 35% UK income tax has been paid. This is often not spelt out to people taking out pensions and is not properly understood by many people.
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 the Revenue. The surviving heirs will then receive the pension fund after 35% has been deducted in income tax.
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. However the legislation states in section 206(7) that the money being taxed is not to be "treated as income for any purpose of the Tax Acts" even though income tax is payable on it. The Revenue has maintained this stance in writing with the authors. For the widows and widowers of pensioners who die resident in the UK there is little that can be done other than accept the 35% deduction. For pensioners who die abroad the position is very different especially as many treaties with the UK provide that the right to tax pensions is given to the country in which the pensioner is resident and not the UK.
Because section 206(7) provides the charge is deemed not to be income, the UK Revenue's position is that the charge does not fall within the scope of the UK's treaty network. The flaw in their reasoning is firstly that any domestic legislation must be subject to any double tax treaty, as international treaties have priority over domestic law, and secondly that section 206(7) does not attempt to exclude the application of a tax treaty, which it could not lawfully do, as this would be an attempt by domestic law to override international treaty law. It is telling that the legislation specifically does not purport to extend to tax treaties which must have been a far more pertinent issue in 2004 than in 1968 with the huge increase in the number of pensioners abroad.
The UK-France Double Tax Treaty of 1968, for example, states in Article 1(1) (a) that it applies to "income tax" without any other qualification. In Article 1(2) it says it applies to any "identical or substantially similar future taxes which are imposed in addition to or in place of the existing taxes". The question is whether the 35% income tax charge is a charge to income tax within Article 1 of the treaty. In this case the 35% tax was brought in long after the 1968 treaty entered into force. As such the assumption must be that the exclusive taxing rights granted to France on pension income (expressly contained in the treaty) would continue unless it was clear under the treaty that the UK would somehow claw back the right to tax the money. It is difficult to see how money which is expressly taxed as income tax in the UK and belongs to a person in France cannot be within income tax for treaty purposes.
The UK France treaty precludes, in relation to certain forms of income, a charge to income tax in the UK on French residents. This is of course subject to the income coming within Article 1 as discussed above. This part of the Treaty certainly covers income 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" i.e. the lump sum is being paid to the surviving spouse who is French resident though in consideration of the past employment of the deceased spouse previously in receipt of the pension which was exempt from UK tax. The literal reading of the treaty covers the situation and the 35% UK tax should not be payable.
The other argument of the UK Revenue is that it is the scheme administrator under section 206(3) who is liable to pay the charge which is not affected by the residence of the widow or widower of the deceased pensioner or the scheme administrator's residence. This is irrelevant if the income falls within the double tax treaty as the treaty provides the money is only taxable in France. It little matters that the UK by domestic legislation seeks to impose the collection of the tax on a third party. The wording of section 206(3) provides that the "scheme administrator is liable .whether or not (a) a scheme administrator and (b) the person to whom the lump sum benefit is paid are resident . in the UK". This is an attempt by UK domestic legislation to exclude the application of an international tax treaty which must fail. The section has to be read as subject to any tax treaty.
The UK Revenue may seek to argue that the taxable person is the scheme administrator (and not the deceased pensioner or the widow or widower) and accordingly any tax treaty cannot apply as the scheme administrator is not resident say in France. This is very difficult to sustain because the beneficial owner of the pension money in drawdown is the pensioner and on his death his widow or widower. The scheme administrator must abide by the rules of the pension scheme and cannot treat the money as beneficially its funds. According to the Revenue's view the pension money belongs for tax treaty purposes to the pensioner as the taxable person up until the pensioner's death when for a brief period the administrator owns it for tax treaty purposes and pays 35% tax on it and thereafter it reverts to being the surviving spouse's asset and taxed accordingly under the tax treaty. This is totally illogical and cannot be any form of argument.
In our view any pension fund which has suffered such tax in respect of a deceased pensioner in France should be reimbursed by the UK Revenue.
May 2008