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Table of Contents
16.1 Registered Pension Schemes involving insurance policies can take various forms and can provide various benefits. This Chapter looks at the tax framework which governs the tax reliefs available to these schemes. The entire tax framework of private pension provision was radically changed with effect from 6 April 2006 (commonly referred to as A-Day). The previous jumble of different tax regimes and rules was replaced with a single universal set of rules.
Within the context of this publication, the authors have sought to give only a general view of the pensions tax rules from 6 April 2006. Full details can be found in HMRC's 'Registered Pension Schemes Manual'. This manual is available on the internet, and can be found at: www.hmrc.gov.uk/manuals/rpsmmanual/index.htm
16.2 It has been government policy for many years to provide tax privileges to pension schemes. The aim is to encourage saving (by individuals and/or their employers) for the purpose of providing an income in old age, to reduce dependency on the state. HMRC has the task of controlling those tax privileges. This control is implemented by a framework of prescribed requirements that pension schemes must adhere to if their tax privileged status is to be maintained. Prior to 6 April 2006, these requirements were imposed in two ways – directly through detailed legislation, and indirectly through decisions taken by HMRC under their discretionary powers which were provided by legislation.
Many different types of pension schemes developed over the years, either as a result of legislation to reflect government policy or because of fresh ideas within the pensions industry. Each development resulted in a different raft of HMRC requirements to fit the circumstances. This layering approach resulted in a profusion of different rules for different types of pension arrangements.
Prior to 6 April 2006, the legislation governing tax-approved pension arrangements was contained in Part XIV of the Income and Corporation Taxes Act 1988. Because of the way the legislation had been developed and modified over many years (starting with the Finance Act 1970), a total of eight different tax regimes had emerged. Each regime had its own complex rules limiting the amount an individual could contribute to a pension scheme and the benefits a scheme could pay out.
Following a lengthy period of consultation and development, which started in 2002, the government swept away all the existing pensions tax legislation and introduced a single set of rules. The new rules are contained principally in Part 4 of the Finance Act 2004, and came into effect from 6 April 2006. Subsequent Finance Acts have modified various aspects of the original legislation.
Because the pensions tax legislation lays down a single set of rules, it does not need to distinguish between the different types of pension arrangements. The legislation uses the general term 'registered pension scheme'. This means a pension scheme that has been registered with HMRC as being a scheme that meets all the requirements of Part 4 of the Finance Act 2004. But it must be borne in mind that simply because every pension arrangement is called a 'registered pension scheme' for the purposes of the tax legislation, there are still many different types of 'registered pension schemes', each with their own characteristics. It does not matter whether the arrangement is a multi-member scheme (such as an occupational pension scheme) or a single contract (such as a retirement annuity), each will be classified as a 'registered pension scheme'.
16.3 Pension arrangements that are categorised as 'registered pension schemes', and involve insurance contracts, can take various forms:
(1) Retirement annuities
This type of arrangement takes the form of a contract between the insurer and the individual – ie the policy is written in the name of the individual, and the individual has both beneficial and legal ownership. All the terms governing the operation of arrangement are laid down in the policy.
(2) Provider-sponsored personal pension schemes (including stakeholder pension schemes)
This type of arrangement normally takes the form of a contract between the insurer and the individual – ie the policy is written in the name of the individual, and the individual has both beneficial and legal ownership. Unlike retirement annuities, the contract is held within a 'scheme' structure. The terms governing the operation of the arrangement are contained in the scheme rules, as well as the policy. The scheme itself would have been established by the insurer executing a deed poll, which adopts the rules and appoints the scheme administrator (usually the insurer itself).
It is possible for the insurer to establish the scheme under trust, but this creates a more complex structure and is a method rarely used for fully insured arrangements. Trust-based schemes will be encountered where the scheme is operated as a self-invested personal pension scheme.
(3) Employer-sponsored occupational pension schemes
This type of arrangement is established by the employer executing the trust instrument which adopts the rules and appoints the trustees. The terms governing the operation of the arrangement are set out in the scheme rules. The contract will be between the insurer and the trustees, and the policies will be written in the name of the trustees.
Occupational pension schemes can take many forms:
(i) defined benefit schemes;
(ii) group money purchase schemes (fully insured or self-administered);
(iii) insured money purchase schemes tailored for individuals (executive pension plans);
(iv) small self-administered schemes (SSASs).
(4) Provider-sponsored free-standing additional voluntary contribution schemes
This type of arrangement effectively became defunct with effect from 6 April 2006, and transformed into personal pension schemes. The arrangement was established by the provider executing the trust instrument which adopted the rules and appointed the trustees. The terms governing the operation of the arrangement are set out in the scheme rules. The contract is between the insurer and the trustees, and the policies are written in the name of the trustees.
(5) 'Left scheme' policies – to secure benefits outside the terms of occupational pension schemes
Such policies are effected by the scheme trustees in the name of the individual, for the purpose of providing deferred benefits for an individual who has left service (a 'section 32' buy-out policy), or where the scheme has wound-up (a 'trustees' buy-out policy), or for providing a pension in the form of an annuity (a 'compulsory purchase annuity' policy), or for providing a pension in the form of income withdrawals (an 'income withdrawal' policy).
Similar 'left scheme' policies can also arise from policies originally effected in the name of the trustees being assigned to the individual on leaving service or on the scheme winding up. The benefits cease to be covered by the rules of the scheme, and all the terms governing the operation of the arrangement are laid down in the policy. The individual has both beneficial and legal ownership.
16.4 The following table provides a summary of the way the tax privileges were controlled for the different types of pension arrangements before 6 April 2006.
|
The pensions tax framework before 6 April 2006 | |
|
Type of pension arrangement |
Method of controlling the tax privileges |
|
Employer-sponsored Occupational Pension Schemes (OPS) in their various forms, ie:
|
These schemes had to be approved by HMRC under the provisions of Chapter I of Part XIV of ICTA 1988. Chapter I laid down some basic rules, but mainly it gave HMRC discretionary powers, and hence flexibility, to specify the details. The level of tax relief was controlled by: Limiting the maximum benefits that could be provided, by reference to earnings at the time of retirement and length of service. The criteria for those limits had been varied over the years – ie the pre-87, 87–89 and post-89 regimes. Limiting the way the maximum benefits could be funded in advance. |
|
'Left scheme' policies in their various forms, ie:
|
These policies derived from Chapter I schemes and were regulated by the same rules. |
|
Provider-sponsored Free-Standing AVC Schemes |
These schemes had to be approved by HMRC under the provisions of Chapter I. |
|
Provider-sponsored Personal Pension Schemes (PPS) in their various forms, ie:
|
These schemes had to be approved by HMRC under the provisions of Chapter IV of Part XIV of ICTA 1988. Chapter IV defined everything in detail (and left little to HMRC's discretion). The level of tax relief was controlled by:
|
|
Provider-sponsored Stakeholder Pension Schemes (SHPS) |
These schemes are just a special form of Personal Pension Schemes and were subject to the same HMRC requirements. |
|
Retirement Annuity policies |
These policies were approved by HMRC under the provisions of Chapter III of Part XIV of ICTA 1988. Chapter III defined everything in detail (and left little to HMRC's discretion). The level of tax relief was controlled by:
|
16.5 The following table provides a summary of the way things have changed from 6 April 2006.
The pensions tax framework from 6 April 2006 |
|
Type of pension arrangement |
Regulatory controls |
Employer-sponsored OPSs in their various forms 'Left scheme' policies in their various forms Provider-sponsored Free-Standing AVC Schemes (effectively became PPSs with effect from 6 April 2006) Provider-sponsored PPSs in their various forms Provider-sponsored SHPSs Retirement Annuity policies |
The benefits under all these types of pension arrangements are covered by a single set of tax rules. The tax privileges are controlled by: Monitoring the amount of input each tax year into pension arrangements for the individual against a maximum value which is defined in legislation – the 'annual allowance'. The input for an individual will be made up of all contributions to money purchase arrangements, and/or the increase in the capital value of benefits accruing under any Defined Benefit OPS. Monitoring the total capital value of an individual's pension benefits from all arrangements against a maximum value which is defined in legislation – the 'standard lifetime allowance'. If the total capital value exceeds the standard lifetime allowance, a special tax charge (the 'lifetime allowance charge') will be levied on the excess. The initial standard lifetime allowance set for the tax year 2006/07 was £1,5m. Transitional arrangements were introduced for individuals where the capital value of their benefits accrued before A-Day already exceeded, or were likely to exceed, that initial maximum value. |
16.6 There is no limit on the amount of contributions that can be paid to a registered pension scheme. But there is a limit on the amount that will be eligible for tax relief. (In addition, if the annual allowance limit is breached a tax charge will arise on the member – see 16.7.)
Tax relief on member contributions is limited to 100% of the earnings in the particular tax year (subject to the annual allowance). For a member with low earnings, or no earnings, a contribution can be made up to £3,600 and be eligible for tax relief.
Tax relief on member contributions will normally be given on the 'relief at source' basis – ie each contribution will be treated as though it was paid net of basic rate tax. The scheme administrator will then claim the tax direct from HMRC to apply to the pension arrangement. The member will claim any higher rate relief direct from HMRC through the tax return.
For occupational pension schemes only, it is possible to operate the 'net pay' method. Here member contributions are deducted from salary before tax is applied, and the gross contribution paid to the scheme. This gives immediate tax relief at the highest rate.
Contributions by a member's employer are always gross.
The question of whether an employer's contribution will be allowable as a deduction from the taxable profits of the business will depend on whether the contributions can be considered as being paid 'wholly and exclusively for the purposes of the trade' as described in section 74(1)(a) of the Income and Corporation Taxes Act 1988. This will be a matter for the Tax Office dealing with the employer's affairs to decide. Where contributions are allowed as a deduction, companies will obtain corporation tax relief and partnerships/sole-traders will obtain income tax relief.
Allowance as a deduction will not normally be a problem where the contribution is for an ordinary employee. But a contribution may not be allowed where it is for a controlling director, or for a person connected with a controlling director (such as the director's spouse or registered civil partner). HMRC has indicated that a contribution will not be allowed if there is a non-trade purpose. An example given is where the level of the remuneration package, including the pension scheme contribution, is excessive for the value of the work undertaken by that individual for the employer.
Where the remuneration package paid in respect of a director, who is also a controlling shareholder, or in respect of an employee who is a close relative or friend of the business proprietor or controlling director, is comparable with that paid to unconnected employees, employer contributions will normally be accepted as being paid wholly and exclusively for the purposes of the trade. When there are no employees whose duties are generally comparable with the proprietor or relative, an assessment will be made by the Tax Office of whether the amount is a genuine payment for services rendered in the business. Evidence that the amount may not be a genuine business expense may be that it exceeds a reasonable rate of remuneration on a commercial basis.
16.7 The annual allowance imposes an upper limit on the amount of tax privilege that is available during a tax year.
Where the total contributions paid in a tax year to a money purchase arrangement, plus the increase in the value of any benefits under a defined benefits arrangement, exceeds the annual allowance, a tax charge will arise. This tax charge is known as the 'annual allowance charge', and is payable by the individual. The rate is 40% of the excess over the annual allowance.
Monitoring against the annual allowance, and the imposition of any charge, is dealt with through the self-assessment tax return.
The annual allowance has been set at the following levels:
Tax Year |
Annual Allowance |
2006/07 |
£215,000 |
2007/08 |
£225,000 |
2008/09 |
£235,000 |
2009/10 |
£245,000* |
2010/11 |
£255,000* |
2011/12 |
£50,000 (plus the ability to carry forward up to £50,000 of unused relief from each of the previous three tax years where the value of tax-relieved pension savings in each of those years was less than £50,000) |
2012/13 |
As for 2011/12 (assumed) |
2013/14 |
As for 2011/12 (assumed) |
* In the budget on 22 April 2009, the government announced its intention to limit the tax relief for individuals with taxable income of £150,000 or over. The change was scheduled to come into force for 2011/12 onwards. As an interim measure, anti-forestalling measures were introduced for the tax years 2009/10 and 2010/11. Under these measures, a tax charge (called the 'special annual allowance' tax charge) was applied where:
(1) an individual had taxable income of £150,000 or over (changed to £130,000 or over from 9 December 2009) in any of the tax years 2007/08, 2008/09 & 2009/10;
(2) contributions were paid in excess of the higher of:
£20,000;
the average of single contributions paid 2006/07, 2007/08 & 2008/09, up to a ceiling of £30,000;
(the normal regular pension savings being paid prior to 22 April.
The 'special annual allowance' tax charge was:
(1) for 2009/10, 20% of the excess;
(2) for 2010/11, 20% of the excess which relates to the 40% tax band, 30% of the excess which relates to the 50% tax band.
The proposed changes for the 2011/12 tax year had been heavily criticised by the pensions industry as being very difficult to operate. Following the change of government in 2010, the original proposals were scrapped and replaced with a reduction in the annual allowance from 2011/12 as shown above.
The following is an example of how the normal annual allowance works.
(1) An individual has earnings of £120,000 in the tax year 2010/11. He has no other taxable income, so is not caught by the anti-forestalling measures. He makes contributions to a money purchase arrangement of £100,000. In addition, the employer also makes contributions of £200,000.
(2) The individual will receive tax relief on the £100,000 contributions.
(3) However, the individual will have to report on the self-assessment tax return that the total input for the 2010/11 tax year has been £300,000. This will lead to a tax charge of 40% x (300,000 - 255,000) = £18,000.
(4) Note that it makes no difference whether or not the employer's contribution has been allowed as a deduction under the 'wholly and exclusively' rule.
16.8 There is no limit on the amount of the benefits that may be provided for an individual under registered pension schemes. But if the value of the benefits being paid under a particular scheme, when accumulated with benefits previously paid under that scheme or any other scheme, exceeds a ceiling called the 'lifetime allowance', a tax charge will arise. This tax charge is known as the 'lifetime allowance charge'.
This charge is 25% of the excess where the excess benefits are taken in pension form, and 55% where the excess benefits are taken as cash.
The standard lifetime allowance has been set at the following levels:
Tax Year |
Standard Lifetime Allowance |
2006/07 |
£1.5m |
2007/08 |
£1.6m |
2008/09 |
£1.65m |
2009/10 |
£1.75 |
2010/11 |
£1.8m |
2011/12 |
£1.8m |
2012/13 |
£1.5m |
2013/14 |
£1.5m (assumed) |
The freezing of the lifetime allowance in 2011/12, and the reduction starting in 2012/13, stems from the government's view that the level of the tax advantages under registered pension schemes, that could be attained by the most wealthy individuals, was too generous and needed to be cut back. This was linked to the reduction in the changes in the annual allowance starting in 2010/11.
The legislation specifies the various occasions when an individual will use up part of their lifetime allowance. These occasions are referred to as 'benefit crystallisation events' (BCEs). A BCE arises when benefits under a registered pension scheme become payable, such as when a pension commences or on death.
The way benefits are valued for the purpose of monitoring against the lifetime allowance is as follows:
(1) Under a money purchase scheme, the accumulated fund value is used.
(2) Under a defined benefit scheme, the value is determined as 20 times the pension. If part of the pension is commuted for a lump sum, the value is the lump sum plus 20 times the balance pension.
16.9 The following is an example of how the lifetime allowance works.
An individual takes benefits under a defined benefits occupational pension scheme in the tax year 2007/08. The benefits comprise a tax-free lump sum of £300,000 and a pension of £45,000. This benefits package has the following value for monitoring against the lifetime allowance: £300,000 + 20 x 45,000 = £1,200,000.
Hence at this stage the lifetime allowance has not been exceeded. The individual is treated as using up 75% of the lifetime allowance - ie (1,200,000 ÷ 1,600,000) x 100.
In the tax year 2010/11 the individual takes benefits under a personal pension scheme. The fund stands at £500,000. The individual has already used up 75% of the lifetime allowance, so the available portion of the lifetime allowance in 2010/11 is 25% x £1,800,000 = £450,000. Hence there is an excess of £500,000 - £450,000 = £50,000. The individual takes the benefits in the following form:
A tax-free lump sum of 25% x £450,000 = £112,500.
A pension secured by the balance of £450,000 - £112,500 = £337,500.
A lump sum from the excess. There will be a lifetime allowance charge of 55% x £50,000 = £27,500. The scheme administrator will withhold this tax and account for it to HMRC. The individual will receive the balance of £22,500.
16.10 The introduction of the lifetime allowance charge could have had a retrospective effect by catching large pension benefits that had already accrued before 6 April 2006. The government accepted that it would be unfair to penalise individuals who had accrued large benefits quite legitimately in accordance with the rules that existed before 6 April 2006. So, special provisions were introduced to enable those individuals to protect the value of their pre-6 April 2006 benefits against the lifetime allowance charge that could otherwise arise. (But it should be noted that the government had still effectively placed a cap on the benefits that might have been expected under the old rules as accrual had effectively been frozen at 5 April 2006.)
There are two types of protection – 'primary protection' and 'enhanced protection'. To take advantage of this facility, individuals had to register for protection with HMRC before 6 April 2009. It was possible to register for either type of protection or for both.
The way primary protection works is that the total value of the individual's pension benefits is determined as at 5 April 2006. That is compared to the value of the maximum benefits that would have been approvable by HMRC under the pre-6 April 2006 rules. The lower of the two values is then compared to the standard lifetime allowance. If it is higher than the standard lifetime allowance, the individual can register for primary protection. The higher value will then form the individual's 'personal lifetime allowance' going forward. The 'personal lifetime allowance' will increase each tax year in line with the rate of increase in the standard lifetime allowance. The individual can accrue further benefits from 6 April 2006, but any excess over the personal lifetime allowance will be subject to the lifetime allowance charge. The reduction in the standard lifetime allowance from 2012/13, will not result in a reduction for primary protection purposes - the increase factor for the 'personal lifetime allowance' will be frozen at 1.8/1.5 = 1.2.
Enhanced protection works in a different way. The total value of the individual's benefits has to be determined as at 5 April 2006. If that exceeds the value of the maximum benefits that would have been approvable by HMRC under the pre-6 April 2006 rules, the individual has to give up the rights to the excess. The individual will not then incur any lifetime allowance charge in the future, no matter how much the fund grows. But, there must be no benefit accrual from 6 April 2006. Any sort of accrual will result in the loss of enhanced protection.
16.11 As a result of the reduction in the standard lifetime allowance from £1.8m to £1.5m from 2012/13, a further type of protection has had to be devised to cater for those individuals who were expecting their pension savings to be in excess of £1.5m when they come to take their benefits on or after 6 April 2012. This has been called 'fixed protection'. Fixed protection would mean that an individual would not incur a lifetime allowance charge where the value of their benefits goes above £1.5m, up to a ceiling of £1.8m.
A condition of fixed protection is that the individual would need to stop building up benefits under registered pensions schemes by 5 April 2012. Benefit accrual after that date would result in fixed protection being lost.
16.12 The legislation allows registered pension schemes to provide retirement benefits in various forms. It should be noted, however, that the forms of benefits available under a particular registered pension scheme will depend on what is allowed by the rules governing the scheme. This Section just provides a general description of the possibilities.
It should also be noted that the rules that have been in place since 6 April 2006 around 'unsecured pension' and 'alternatively secured pension', and taking retirement benefits by age 75, have been altered significantly with effect from 6 April 2011. In particular:
(1) the requirement to take retirement benefits by age 75 has been withdrawn;
(2) the rules around taking income on the 'unsecured pension' basis (where the individual is aged less than 75, or less than 77 for those individuals who had not reached age 75 on 22 June 2010), and on the 'alternatively secured pension' basis (where the individual is aged 75 or over), have been replaced by a single set of rules called 'drawdown pension' (all members and dependants who were taking income on the 'unsecured pension' or 'alternatively secured pension' basis were automatically moved to the 'drawdown' pension' basis with effect from 6 April 2011, although there are some transitional rules around income limits);
(3) more flexibility has been built into the rules for 'drawdown pension', which has two variants:
'capped' drawdown, where the maximum income is determined on a similar basis to 'unsecured pension';
'flexible' drawdown, where any amount can be taken as income (including the whole fund in one go if required) providing the individual can satisfy the 'minimum income requirement' (ie. the individual has total guaranteed income for life of at least £20,000 pa – which can be made up of, for example, a pension from the state, a pension from a defined benefits scheme, a pension from a lifetime annuity).
(4) the tax charge on a lump sum paid on the individual's death on or after 6 April 2011, after taking retirement benefits, has been increased from 35% to 55% (but if there are no dependants the lump sum can be paid to a charity with no tax charge);
(5) where an individual aged 75 or over dies, having deferred drawing the retirement benefits, any lump sum paid is subject to a tax charge of 55% (but if there are no dependants the lump sum can be paid to a charity with no tax charge);
(6) a number of changes have been made to the way the Inheritance Tax legislation impacts on benefits (see Chapter 16, Section 9).
16.13 The term 'retirement benefits' is still commonly used. But the concept of 'retirement' in the sense of being in full-time employment one day then ceasing all employment the next is becoming increasingly blurred. It is being gradually replaced by the concept of 'phased retirement', which allows a gradual transition from full-time employment, into part-time employment, and then eventually full retirement. Indeed, the legislation has been deliberately constructed to ensure that the rules on benefit provision from tax-approved pension arrangements can support phased retirement.
The rules of any registered pension scheme (occupational as well as personal) can allow some or all of the benefits to come into payment at any time from the 55th birthday. Benefits can be drawn before the 55th birthday in the event of incapacity or ill-health.
Prior to 6 April 2010, the benefits could be taken at any time from age 50, but had to be taken by the 75th birthday. The minimum age of 50 was increased to 55 with effect from 6 April 2010. The requirement to take benefits by the 75th birthday was removed with effect from 6 April 2011.
The legislation that applied before 6 April 2006 prevented benefits under an employer's occupational pension scheme from coming into payment before the individual had actually left the employment. The removal of this restriction has enabled a more flexible approach to be taken to the provision of retirement benefits. The opportunity is there for those employers who can see advantages in retaining access to the expertise of their experienced staff, whilst at the same time allowing them to move gradually into retirement.
The concept of 'phased retirement' is generally operated under occupational pension schemes by allowing an employee to take the whole of their retirement benefits on reaching a certain age and then continuing in employment on a part-time basis. Phased retirement in the form of the phased provision of benefits as working hours reduce in stages over a period of time is not so common under occupational pension schemes as it could increase the costs of the administration of the scheme. That form of 'phased retirement' is widely available under personal pension schemes, where it is most likely to appeal to self-employed individuals who wish to gradually reduce their workload.
16.14 The rules of a registered pension scheme can allow the members to take part of their benefits in the form of a tax-free lump sum. The lump sum must not exceed 25% of the value of the benefit package coming into payment at that time (except where the member has a protected lump sum entitlement deriving from benefits accrued before 6 April 2006). This lump sum is referred to as a 'pension commencement lump sum'. It can be paid in the period starting 6 months before the date on which the entitlement to the pension arises and ending 12 months after that date.
In the case of benefits under a money purchase arrangement, the maximum pension commencement lump sum is simply 25% of the fund available to secure benefits.
In the case of a defined benefit arrangement, the maximum pension commencement lump sum is more difficult to determine. The maximum lump sum is 25% of the value of the benefit package. The value of the benefit package is made up of the lump sum plus 20 times the reduced pension that is left after commuting part of the full pension for the lump sum. A formula has to be applied which works out how much of the full pension has to be commuted to produce the requisite lump sum, using the scheme's own commutation factors.
16.15 The pension income can be provided in various ways, depending on the type of pension arrangement:
(1) on the 'secured pension' basis by the purchase of an annuity, which may include a guaranteed period of up to ten years and/or a reversionary annuity payable to a dependant;
(2) on the 'secured pension' basis by means of a 'scheme pension', which may include a guaranteed period of up to ten years and/or a reversionary pension payable to a dependant; or
(3) on the 'drawdown pension' basis.
All pensions from registered pension schemes are taxed under the PAYE system.
16.16 The legislation allows registered pension schemes to provide death benefits in various forms. It should be noted, however, that the forms of benefits available under a particular registered pension scheme will depend on what is allowed by the rules governing the scheme. This Section just provides a general description of the possibilities.
Benefits can be provided for a 'dependant'. This term is defined in the legislation and covers:
(1) the member's wife, husband, civil partner, or any other individual who is financially dependent on the member;
(2) a child of the member who has not reached the age of 23 (please note any income withdrawals would cease on the child's 23rd birthday);
(3) a child of the member who has reached age 23 and is dependent on the member because of physical or mental impairment; or
(4) any other individual who is dependent on the member because of physical or mental impairment.
16.17 Benefits can be provided in the following forms:
(1) a lump sum, which could derive from the retirement fund and/or a separately defined lump sum death benefit (a tax charge of 55% will apply if death occurs after reaching age 75, unless the lump sum is to be paid to a charity);
(2) a pension to a dependant – which can be provided in various ways:
on the 'secured pension' basis by the purchase of an annuity;
on the 'secured pension' basis by the provision of a 'scheme pension'; or
on the 'drawdown pension' basis.
Where the member dies before age 75, there is no tax charge on the lump sum (unless the lump sum results in the lifetime allowance being exceeded).
If the member dies after attaining age 75, the lump sum is subject to a tax charge of 55%. In addition, in some cases the lump sum could be treated as forming part of the estate for inheritance tax purposes (see Chapter 14, Section 9). If there are no dependants, the lump sum can be paid to a charity, in which case there would be no 55% tax charge, nor IHT charge.
All pensions from registered pension schemes are taxed under the PAYE system.
16.18 Benefits can be provided in the following forms:
(1) where the member's pension was being paid on the 'secured pension' basis (ie by means of an annuity or on the 'scheme pension' basis):
continuation of pension payments for any remaining guaranteed period; and/or
payment of a lump sum associated with the pension (under 'annuity protection' or 'pension protection'); and/or
commencement of any associated pension to a dependant.
(2) where the member's pension was being paid on the 'drawdown pension' basis, the remaining fund would be disposed of by:
payment of a lump sum; or
provision of a pension for a dependant on the 'secured pension' basis by the purchase of an annuity, or on the 'drawdown pension' basis.
Any lump sum is subject to a tax charge of 55%. In addition, in some cases the lump sum could be treated as forming part of the estate for inheritance tax purposes (see Chapter 14, Section 9). If there are no dependants, the lump sum can be paid to a charity, in which case there would be no 55% tax charge, nor IHT charge.
All pensions from registered pension schemes are taxed under the PAYE system.
16.19 There are various scenarios, as follows:
(1) Where the dependant's pension was being paid on the 'secured pension' basis (ie by means of an annuity or on the 'scheme pension' basis), no further benefit would arise.
(2) Where the dependant's pension was being paid on the 'drawdown pension' basis, having been derived from the member's 'drawdown pension' fund (or the member's 'unsecured pension' fund where the member's death occurred before 6 April 2011), the remaining fund will be paid as a lump sum. The lump sum will be subject to a 55% tax charge. In addition, in some cases the lump sum could be treated as forming part of the dependant's estate for inheritance tax purposes (see Chapter 14, Section 9). If there are no other dependants of the member, the lump sum could be paid to a charity, in which case there would be no 55% tax charge, nor IHT charge.
(3) Where the dependant's pension was being paid on the 'drawdown pension' basis, having been derived from the member's 'alternatively secured pension' fund (where the member's death occurred before 6 April 2011), the remaining fund will be paid as a lump sum. As for (b), there will be a 55% tax charge, and possibility of the lump sum being treated as forming part of the dependant's estate for inheritance tax purposes (see Chapter 14, Section 9). But there may also be an IHT charge triggered in respect of the member's estate as explained in Section 9 A5. If there are no other dependants of the member, the lump sum could be paid to a charity, with no 55% tax charge, nor IHT charge.
16.20 Where a member or dependant dies before 6 April 2011, but the benefits arising as a result of the death could not be finalised until after that date, some aspects of the pre-6 April 2011 rules will continue to apply. For example:
(1) Where the member's pension or dependant's pension was being paid on the 'unsecured pension' basis, any lump sum will be subject to a tax charge of 35% (rather than 55%).
(2) Where the member's pension was being paid on the 'alternatively secured pension' basis, the remaining fund would be disposed of as follows:
If there is a dependant, the fund must be used to provide a pension for that dependant. The pension could be provided on the 'secured pension' basis by the purchase of an annuity, or on the 'drawdown pension' basis.
If there is no surviving dependant, the fund can be paid as a lump sum to a charity, or transferred to another arrangement within the scheme for the benefit of another individual. (This would normally be in accordance with directions given by the member to the scheme administrator.)
(3) Where the dependant's pension was being paid on the 'alternatively secured pension' basis, the remaining fund would be disposed of as follows:
If, exceptionally, there is another surviving dependant of the member, the fund must be used to provide a pension for that dependant. The pension could be provided on the 'secured pension' basis by the purchase of an annuity, or on the 'drawdown pension' basis.
If there is no other surviving dependant, the fund can be paid as a lump sum to a charity, or transferred to another arrangement within the scheme for the benefit of another individual. (This would normally be in accordance with directions given by the member, or the dependant, to the scheme administrator.)
16.21 If a scheme makes a payment to a member that is not authorised by the legislation, various tax charges will arise. Examples of unauthorised payments would be:
(1) a lump sum is paid to the member on retirement which is in excess of the permitted maximum;
(2) a lump sum is paid to the member on retirement more than 12 months after the date on which the entitlement to the pension arises;
(3) the member receives retirement benefits before the minimum permissible age;
(4) the scheme sells an asset to the member for less than it is worth.
Whenever an unauthorised member payment is made, the following tax charges will arise:
(1) an unauthorised payments charge of 40% of the unauthorised payment;
(2) if the unauthorised payment is 25% or more of the total value of the rights under the arrangement, an unauthorised payments surcharge of 15% of the unauthorised payment.
The member is liable for these tax charges and accounts for them through the self-assessment tax return. They are free-standing tax charges which means that any losses a taxpayer may have cannot be set against the charges.
In addition, the scheme could be liable to a scheme sanction charge of 15% of the unauthorised payment (or higher if the member has not paid the other charges). The scheme can withhold this charge from the payment made to the member.
Overall, there is potential for a tax charge of 70%.
16.22 The process of recycling involves drawing the benefits from an existing pension fund, then using the tax-free lump sum (pension commencement lump sum) as a direct or indirect means of paying additional contributions to a registered pension scheme on which tax relief will be generated. Higher rate relief could be used to pay further contributions. Benefits would then be drawn from the further pension fund created, and the tax-free lump sum used to repeat the cycle. So, effectively, the same money is going round in a circle, and picking up extra tax relief on the way.
Not surprisingly, the government considers the recycling concept to be an abuse of the tax reliefs made available to encourage saving for retirement.
The recycling concept is not new. It had always been possible under the pre-6 April 2006 legislation governing personal pensions and retirement annuities. However, the advantage to be gained under that legislation was fairly minimal because of the restrictions placed on the amounts that could be paid as contributions which were eligible for tax relief (ie based on a percentage of earnings, starting at 17.5%, and with the earnings being capped for personal pensions). Those restrictions were removed with effect from 6 April 2006. Individuals can now get tax relief on contributions up to 100% of their uncapped earnings (subject to the annual allowance). So, whilst the government did not think it was worth doing anything about recycling under the pre-6 April 2006 legislation, the tax advantage to be gained by recycling is now too great to be ignored.
The legislation counters recycling by deeming an unauthorised payment to have been made when a tax-free lump sum is recycled. An unauthorised payment will trigger the various tax charges outlined above.
The recycling rule will be triggered if:
the recycling was pre-planned;
the amount of the lump sum, aggregated with any other lump sums taken in the previous 12-month period, exceeds 1% of the standard lifetime allowance; and
as a consequence of the lump sum being taken, the amount of contributions paid into a registered pension scheme is significantly greater than it otherwise would have been. The measure here is that the cumulative amount of the additional contributions exceeds 30% of the lump sum received.
The recycling rule is only intended to catch the relatively small number of larger potential recyclers. The government feels that the legislation strikes a balance between deterring recycling activity, catching the more blatant and artificial cases, and leaving unaffected those smaller pensions savers and those undertaking normal retirement planning.
However, the mere existence of the recycling rule could have a widespread effect on administration. Scheme administrators might feel that they need to make the appropriate warning noises to all cases. Whilst a member might only have a small fund under the particular scheme, the scheme administrator will have no way of knowing what funds are available under other schemes, nor what the individual's intentions might be.
16.23 The legislation that existed before 6 April 2006 imposed specific restrictions on the investments that could be held by schemes such as small self-administered schemes and self-invested personal pension schemes, where the members were able to direct the way the funds were invested. Those restrictions have been removed in the new legislation from 6 April 2006, and there is now a single set of investment rules for tax purposes applying to all types of registered pension schemes. However, as explained later, certain investments held by certain types of registered pension schemes will attract tax charges.
Schemes will still be subject to any relevant restrictions arising from DWP legislation, or other general restrictions outside tax law. The scheme trustees have a duty under general trust law to act prudently, conscientiously and honestly when making decisions in respect of the scheme. Trustees must always act in the best interests of the scheme members.
The tax legislation does not impose any restrictions on the investments that may be made by registered pension schemes. Instead, everything is regulated by the imposition of unauthorised payment tax charges if certain conditions are breached. The conditions which may be breached are:
Any loan made by a scheme to an employer who is connected with the member will give rise to a tax charge on the member. But a registered pension scheme in the form of an occupational pension scheme can make a loan to the sponsoring employer without incurring any tax charges providing the loan does not exceed 50% of the fund value and it is done on specified terms.
Any loan to a scheme member will give rise to a tax charge.
Schemes can borrow funds for any purpose – for example, to assist with the purchase of an asset, or to meet a short-term liquidity problem. But the borrowing must not exceed 50% of the fund value (less any amounts previously borrowed), otherwise tax charges will arise.
There is a limit on the amount which a registered pension scheme in the form of an occupational pension scheme can invest in the shares of the sponsoring employer, without giving rise to tax charges. The market value of the shares must be less than 5% of the fund value.
Certain types of registered pension schemes are categorised as 'investment-regulated pension schemes'. Under these schemes tax charges will arise when the scheme holds assets, either directly or indirectly, that are classed as 'taxable property' (5).
16.24 The following tax exemptions apply to registered pension schemes:
(a) income derived from investments or deposits held for the purposes of a registered pension scheme is exempt from income tax (section 186 of the Finance Act 2004);
(b) underwriting commissions applied for the purposes of a registered pension scheme are exempt from income tax if they would otherwise be chargeable to tax under Case VI of Schedule D (section 186(1)(b));
(c) income from futures contracts and options contracts are deemed to all be from investments as is any income derived from transactions relating to futures contracts or options contracts (section 186(3));
(d) profits or gains arising from transactions in certificates of deposit are exempt from income tax (section 56 of the Income and Corporation Taxes Act 1988);
(e) profits from sale and repurchase agreements (repos) and 'manufactured payments' are exempt from income tax (SI 1995/3036, as amended by SI 2006/745));
(f) a gain arising from the disposal of investments (including (c) above) held for the purposes of the scheme is exempt from capital gains tax (section 271 of the Taxation of Chargeable Gains Act 1992).
The exemptions above do not apply to income derived from investments or deposits held as a member of a property investment limited liability partnership.
There is nothing to prevent a registered pension scheme entering into trading activities. But as income derived from trading is not investment income or income from deposits, the tax exemptions (including those relating to capital gains on assets used by a scheme for trading purposes) do not apply. So, a registered pension scheme would be liable to pay tax on any income derived from a trading activity.
16.25 Because the legislation does not impose any restrictions on the investments that may be made by registered pension schemes, there is potential for schemes to invest in assets which may provide the opportunity for private use by the members. The government is keen to prevent tax-advantaged pension funds being used in that way, So, the legislation contains special provisions for certain types of registered pension schemes (referred to as 'investment-regulated pension schemes') which remove the tax advantages where the investments may create an opportunity for private use.
The term 'investment-regulated pension scheme' is used in the legislation to describe a registered pension scheme where the member, or a person related to the member, can self-direct the investments held by the scheme.
A registered pension scheme that is not an occupational pension scheme will be classified as an 'investment-regulated pension scheme' where a member (or person related to the member) is able (whether directly or indirectly) to direct, influence or advise on the manner of investments held for the purposes of the member's arrangement under the scheme. This encompasses registered pension schemes in the form of self-invested personal pension schemes, and fully insured personal pension schemes where a personal managed fund facility is made available.
A registered pension scheme that is an occupational pension scheme will be classified as an 'investment-regulated pension scheme' where the scheme has fewer than 50 members and has at least one member who meets the 'self-direction' condition, or the scheme has 50 or more members and has at least 10% of members who meet the 'self-direction' condition. The 'self-direction' condition is met if the member (or person related to the member) is able (whether directly or indirectly) to direct, influence or advise on the manner of investments held for the purposes of the scheme. This will encompass registered pension schemes in the form of small self-administered pension schemes and possibly some large self-administered pension schemes.
Whenever an 'investment-regulated pension scheme' holds assets, either directly or indirectly, that are classed as 'taxable property' there will be tax charges.
'Taxable property' consists of residential property and most types of 'tangible moveable' property.
Residential property can be in the UK or elsewhere and is:
(1) a building or structure that is used or suitable to be used as a dwelling;
(2) any related land that is wholly or partly the garden for the building or structure;
(3) any related land that is wholly or partly grounds for the residential property and which is used or intended for use for a purpose connected with the enjoyment of the building;
(4) any building or structure on any such related land;
(5) ground rents (long leaseholds) held in respect of residential property;
(6) hotel or similar accommodation where ownership is conferred via timeshare rights.
Tangible movable property comprises things that can be touched or moved such as art, antiques, jewellery, fine wine, boats, classic cars, stamp collections, rare books.
16.26 It is important to note that the legislation refers to 'taxable property' that is held 'directly or indirectly'. The reference to 'indirectly' ensures that 'taxable property' held by companies and other vehicles owned by pension schemes is also caught. That acts as a deterrent to the pension scheme owning, for example:
(1) 100% of the shares in a company that owns a flat in a desirable holiday resort which could be used by a member;
(2) 100% of the shares in a trading company that deals with, for example, fine wines or antiques, that could be available for the private use of a member.
Unfortunately, the scope of this part of the legislation also catches investments in companies involved in trading activities for which there is no possibility of private use. This could have the effect of stopping schemes holding unquoted company shares, which has traditionally been a popular form of investment for small self-administered schemes.
Where an 'investment-regulated pension scheme' holds an interest in 'taxable property', whether directly or indirectly, the value of the interest will be treated as an unauthorised payment, and the following tax charges will arise. The value of the interest would be 100% of the value of the property if held directly by the scheme. If held indirectly, the value would be based on a percentage, to take into account the fact that only a part of the interest in the taxable property is held by the investment-regulated pension scheme.
(1) The member will be subject to the unauthorised payments charge at 40% of the value placed on the interest.
(2) If certain limits are exceeded, the member will also be subject to the unauthorised payments surcharge at 15% of the value placed on the interest.
(3) The scheme administrator will be subject to the scheme sanction charge, normally at 15% of the value placed on the interest.
(4) Income or deemed income received in relation to the 'taxable property' will be subject to the scheme sanction charge at 40% of the value placed on the income.
(5) Any capital gain on the disposal of the 'taxable property' will be subject to the scheme sanction charge at 40% of the value placed on the capital gain.