Complexity is price of tax simplification
After a three-year gestation period, and at least one scare that the plug might be pulled, the new simplified tax regime for pensions is on the statute book. We examine the main features of the system, which takes effect on 6 April 2006, and discuss some of its complexities.
Summary of key points
With effect from 6 April 2006 (A-day), eight existing tax regimes
covering pensions will be swept away and replaced by a new "simplified"
system.
The Act introduces a number
of new sanctions for schemes that do not comply with the rules.
The central feature of the
new system is a single lifetime allowance (LTA) against which the value of
the individual's total pension scheme benefits from all sources will be
assessed.
There will also be an annual
allowance to ensure that individuals do not try to evade the rules by
investing large sums in their pension funds over short periods.
The Act permits flexible
retirement, allowing members to draw a pension and continue to work for the
same employer, but raises the minimum retirement age to 55 from 2010 for most
members.
There are complicated
transitional arrangements for people whose benefits are valued above, or
close to, the LTA on A-day.
In April 2001, Melanie Johnson, who was Economic Secretary to the Treasury at the time, announced that a review team was being established to examine the tax rules applying to defined-benefit (DB) pension schemes. On 22 July 2004, the Finance Act*, implementing the outcome of that review, received Royal Assent. The changes have turned out to be far more radical than anyone envisaged at the time of the initial announcement. They relate to all types of pension arrangements and replace all existing tax regimes with one that is, allegedly, simplified.
Although the tax regime for pensions has been simplified, the new rules applicable from "A-day" (the day when the pension provisions of the Act come into force), which is 6 April 2006, are complex. One reason for this is that the Inland Revenue is endeavouring to close all loopholes to ensure that individuals and organisations do not abuse the tax reliefs granted. The main features of the new tax system are set out in box 1, and below we examine some of them in more detail. Examples of the application of the new rules are set out in box 3, box 4 and box 5 .
Back to basics
Rather than building on existing pensions tax legislation, the Finance Act has started from scratch. Therefore, it begins by defining basic terms, such as "member" and "pension scheme".
A key section defines the various types of benefits that may be provided by pension arrangements. These are as follows:
money-purchase benefits - calculated by reference to the amount of money available for benefits to, or in respect of, the member;
cash-balance benefits - although these are calculated by reference to the amount of money available for the provision of benefits, that amount is not determined solely by reference to contributions paid by, or in respect of, the member;
defined benefits - calculated by reference to the earnings or service of the member, or some factor other than the amount of money available for their provision; and
hybrid benefits - calculated in accordance with any two or all three of the above, depending on the member's circumstances at the time of calculation.
It is important that schemes identify the type of benefits they provide correctly, as different valuation methods apply to each to determine whether the lifetime allowance (LTA) or annual allowance have been breached.
New scheme sanctions
To obtain tax relief, schemes currently have to seek Inland Revenue approval. In most cases, this is discretionary and can be withdrawn if the scheme does not continue to meet the Inland Revenue's requirements for approval. Under the new regime, in order to receive the tax reliefs, pension schemes will simply have to register with the Inland Revenue by providing such information and declarations as it requires. The Inland Revenue must register the scheme unless any information in the application is incorrect or false declarations have been made.
Schemes that are exempt-approved immediately before A-day will be registered automatically unless they make a request to opt out. If schemes choose to opt out, a tax charge of 40% of the value of their assets will be imposed. One big change introduced by the Act is that schemes will no longer have to be established under trust. This meets one of the criticisms of the EU regarding the availability of UK tax reliefs to overseas schemes (see EU takes a tough line on pension tax discrimination).
The Finance Act introduces a number of new sanctions for schemes that do not meet its requirements. The ultimate sanction is deregistration, and the grounds on which this may be invoked by the Inland Revenue are set out in box 2 . For these purposes, the Act contains detailed provisions distinguishing between authorised and unauthorised payments, both to employers and individuals.
The other new sanctions introduced by the Act are:
an unauthorised payments charge of 40% on any scheme member or employer that receives an unauthorised payment from the scheme;
an unauthorised payments surcharge of 15% imposed on top of the unauthorised payments charge if a payment exceeds 25% of the value of the fund;
a scheme sanction charge of 40%, which may be imposed on the scheme administrator if the scheme has made a "scheme chargeable payment", such as an unauthorised payment or borrowed an unauthorised amount; and
a scheme deregistration charge of 40%, imposed on the total value of the scheme's funds if the Inland Revenue withdraws the scheme's registration.
Tax relief on contributions
Under the new regime, members will be able to belong to more than one pension arrangement concurrently, as long as their total contributions to all schemes do not exceed 100% of their earnings, or £3,600 a year if greater. Tax relief on members' contributions will be obtained as at present, that is, through the net pay system, or relief at source, or by claiming relief.
Employers' normal pension contributions will also continue to attract tax relief as at present. However, the Act significantly changes the rules relating to exceptionally large contributions made by employers. At present, relief is given for these on a discretionary basis by the Inland Revenue, which usually requires the relief to be spread over a number of years.
The provisions for spreading relief have now been codified by the Act and apply to the total contribution and not to the amounts for individuals. A contribution will only have to be spread if it is greater than 210% of the employer's contribution in the previous year, and the amount of the excess is greater than £500,000. Some payments, such as those to fund a cost-of-living increase for pensioners, are exempt from these provisions.
Any contributions that are over and above the limits will have to be spread for tax relief purposes as follows:
£500,000 or more but less than £1 million - the relief is spread over two years;
£1 million or more but less than £2 million - the relief is spread over three years; and
£2 million or more - the relief must be spread over four years.
Lifetime allowance
The central plank of the new simplified tax regime is a single lifetime allowance (LTA) that applies to all types of pension arrangements. This has been set at £1.5 million for the 2006/07 tax year and, although the Act provides for the LTA in subsequent years to be specified by Treasury Order, the chancellor announced the rates for the subsequent four years in his Budget speech. Consequently, the LTA will rise in steps until it reaches £1.8 million in 2010. The Act makes no specific provision regarding how this amount is to be reviewed thereafter, but the government has said that it will be reconsidered every five years.
Although the concept of the LTA is simple, the rules are complicated. The Act introduces a new term into the pensions lexicon, which is "benefit crystallisation", and lists eight crystallisation events. In most cases, these relate to when a benefit comes into payment - including on the death of a member in service - but also include when an individual reaches age 75 and is still prospectively entitled to a benefit, and when a transfer of assets to a recognised overseas scheme occurs.
Benefits have to be valued at the time of crystallisation to determine whether they exceed the LTA. If they do, an LTA charge is imposed of 25% of any amounts taken as pension and 55% of any excess taken as lump sum. Scheme administrators and members are both liable for the tax. In practice, the administrator will deduct it and the member will declare the excess benefit on his or her tax return and offset the tax paid by the administrator. Where lump-sum benefits paid on death in service exceed the LTA, the recipient is solely liable for the tax owing.
The value of DB benefits is calculated by multiplying the amount of pension by a factor of 20 (or some other factor agreed with the Inland Revenue) and then adding on any lump-sum benefit to which the member is entitled other than by way of commutation. The value of money-purchase benefits, including cash-balance benefits, is the market value of the assets available to purchase an annuity. Complications arise in a number of situations. One common one could be where a member staggers retirement. Box 3 sets out in detail the calculation that would apply in this situation.
Annual allowance
Although having an annual allowance in addition to the LTA was criticised by some organisations as an unnecessary duplication, the Inland Revenue has proceeded with its introduction to prevent tax avoidance over short periods by highly paid individuals. It is the maximum amount by which an individual's pension accruals can increase in a particular 12-month period. The limit on A-day will be £215,000 for the first tax year and accruals in excess of that amount will be taxed at the rate of 40%. While the chancellor's Budget statement made it clear that the annual allowance will increase over the next five years until it reaches £255,000 in 2010, as with the LTA, the Act is silent on the review process thereafter.
In order to determine whether the annual allowance has been exceeded, schemes have to test the "pension input" in each year against the allowance. For this purpose, it is very important to know exactly how the benefits provided by the scheme will be classified. The Act contains detailed provisions regarding the calculation of the pension input amount for each of the four types of pension benefits it identifies. Examples of the calculations can be found in box 4 and, in brief, they are as follows:
defined benefits - the value of the member's benefit is calculated at the beginning and end of the input period by multiplying the pension by 10 and adding any lump sum to which the member is entitled other than by way of commutation; the opening amount is then increased by the greater of 5%, the increase in the retail prices index or some other percentage set out by the Inland Revenue and contained in Regulations, and the adjusted figure is deducted from the closing amount;
money-purchase benefits - the pension input amount is the total of the tax relievable contributions, other than national insurance rebates, paid by the individual and the individual's employer during the year;
cash-balance benefits - the pension input amount is the closing value of the member's benefits less their value at the beginning of the year (opening value), which is adjusted in the same way as the value of a member's DB pension before being deducted. For the purpose of this calculation, the value of the member's benefits is the amount available for the provision of those benefits; and
hybrid scheme benefits - the pension input amount is whichever is the greater or greatest of those of the three calculations above that are relevant to the scheme structure.
Benefits do not have to be tested against the annual limit in the tax year in which the member dies or the benefit becomes fully payable.
Retirement and pension
The Finance Act confirms the introduction of flexible retirement, enabling people to continue working for their employer, while drawing all or part of their pension from the employer's scheme. Box 3 illustrates how benefits are tested against the LTA in these circumstances. All benefits still have to be drawn by age 75, despite the attempts of the Conservatives to have the maximum age raised to 80 when debating the Finance Bill at Committee stage.
Schemes must increase the minimum age at which benefits may be taken to 55 by 2010. This does not apply to members who joined schemes on or before 6 April 2006 and had the right to earlier retirement, provided the scheme rules permitted earlier retirement on 10 December 2003 (see Government gives ground on increase to minimum pension age). It will still be possible for schemes to pay benefits at an earlier age in cases of serious ill health.
The Act also sets out detailed rules relating to the payment of pensions. Most of these relate to the age at which pension may commence or the manner in which it is to be paid. For this purpose, the Act identifies three main methods:
scheme pension - this is either payable from the scheme's own resources or by an insurer. It must be non-assignable, paid for life and commence by age 75. The Act requires schemes with fewer than 50 members to provide pensions through an insurance company. If they do not, they will be deemed to be making unauthorised payments. While there is protection against this for schemes whose numbers fall below 50, there are no transitional arrangements for schemes that currently have under 50 members and pay benefits from their own resources. Some commentators have expressed concern that the insurance requirement will increase the costs of such schemes to an unacceptable level;
lifetime annuity - this is payable by an insurance company selected by the member and may be level, increasing or investment-linked. It must commence by age 75, unless alternatively secured pensions are paid instead, and be paid at least annually until the member's death; and
unsecured pension - this is paid either as a short-term annuity or as income withdrawal. The former must cease at age 75. The Act sets out detailed conditions regarding the amounts and timing of both types of pension and also covers the payment of alternatively secured pension.
Both annuities and scheme pensions may continue for a period of up to 10 years after commencement, even if the member dies during that period. However, no other payments may be made after the death of the member (other than certain specialised protection benefits) so the current five-year guarantee provisions operated by many schemes, whereby a tax-free lump sum equal to the balance of unpaid pension instalments is paid if the member dies within five years of retiring, will not be permissible. The same rules apply to payments of dependants' pensions, except that children's pensions must cease at age 23 by the latest, rather than 25 as at present.
Authorised lump sums
The Act contains detailed provisions relating to the circumstances in which schemes may pay lump sums to members. The main lump sums permitted under the Act are:
"pension commencement lump sum", which is effectively the lump sum to which the member becomes entitled when the pension comes into payment, either by commutation or as a standalone benefit;
refund of short-service contributions, where the member has completed less than two years' service; and
trivial commutation lump sum.
While the main details concerning other benefits are contained within the body of the Act, the lump-sum calculations are found in Schedule 29. The amount of tax-free lump sum that may be taken on retirement is 25% of the value of the fund, subject to a maximum of 25% of the LTA (amounting to £375,000 on A-day). This may result in some people being able to take a higher lump sum than under the existing regime. It is also possible for schemes to value funds in excess of the LTA as a lump sum, but that will be subject to a 55% tax charge.
The Act brings in changes to the rules covering the refund of short-service contributions. Currently, such refunds are subject to a 20% tax charge. In order to prevent pension scheme members contributing very large sums, on which 40% tax relief is given, and then withdrawing them within two years and only paying the lower rate of tax on the refund, the Act provides that any refunds in excess of £10,800 will be taxed at 40%. This will be deducted by the scheme administrator before paying the refund.
The rules relating to the commutation of trivial pensions have also been modernised. Where the total value of a member's benefits, whether already in payment or uncrystallised, is less than 1% of the LTA in force at the time, all the benefits may be commuted. This must be completed within a 12-month period but can be at any time between the ages of 60 and 75. Up to 25% of the amount may be taken tax-free (depending on whether any lump sums have already been taken) and the remainder is taxed as earned income.
Transitional arrangements
As expected, much of the detail of the pension tax simplification provisions of the Finance Act is concerned with the transitional arrangements. These are broadly as set out in the consultation paper. Operating them is likely to take up a disproportionate amount of pension scheme resources.
There are two types of transitional protection - primary and enhanced. Members have three years from A-day in which to register a claim for transitional protection. They may register for both. If only one is chosen, individuals may have one opportunity to switch protection. Members may not use the transitional arrangements to obtain benefits greater than those to which they are entitled under the present Inland Revenue limits that apply.
Primary protection
Primary protection applies where the value of a member's pension benefits exceeds the standard LTA in force on A-day. To obtain this protection, the member's benefits have to be valued at A-day, including the value of any benefits in payment. Originally the Finance Bill provided that uncrystallised benefits had to be valued as if the member had retired on the earliest possible day on which pension could be taken. However, this provoked criticism as under most schemes, early retirement factors would be applied on the earliest date on which a member could retire (OP, July 2004). The Act, therefore, provides that the pension is to be calculated as if the member had reached the youngest age under the scheme rules in force on 10 December 2003, at which no early reduction factors would be applied (or age 60 if no such provisions are in place).
Individuals who register for primary protection will be able to continue to accrue pension, which will be tested against their individual LTA. This is calculated using an "enhancement factor" (somewhat confusingly named, as it is not used when claiming enhanced protection). To determine an individual's enhancement factor, £1.5 million is deducted from the value of the individual's rights on A-day and the result is then divided by 1.5 million. This will provide the percentage by which the LTA in force at the date of crystallisation of the member's benefits may be enhanced in order to determine if any tax is payable. Box 5 contains examples of the calculation.
Enhanced protection
Enhanced protection only applies if the member has given notice of the right to enhanced protection and has ceased to accrue benefits before A-day. However, the member does not have to have benefits in excess of the LTA on A-day to register for this protection.
The Act imposes restrictions on the salary growth that may be taken into account if enhanced protection has been claimed. For members who are currently subject to the earnings cap, pensionable earnings may not be more than either the best 12 months' earnings in the three years before taking the benefits, or 7.5% of the LTA, if lower.
Where members are not subject to the earnings cap, pensionable salary must not exceed:
the best 12 months' salary in the three years before taking benefits, if this is less than 7.5% of LTA; or
their salary averaged over the three years immediately before the benefits are paid, if this is greater then 7.5% of LTA.
If a member starts earning pension after A-day then enhanced protection ceases to apply. Members with benefits in excess of £1.5 million on A-day can then fall back on primary protection. Otherwise, the transitional protection will be lost.
Lump sums
The change in the limit on tax-free sums will mean that some people will be entitled to higher lump sums than under the present regimes. However, others will have pre-A-day rights to lump sums that are either greater than 25% of the value of their funds, or are more than £375,000 (the maximum lump sum for the 2006/07 tax year) or both. The value that is protected under the transitional arrangements depends on a number of circumstances. The flowchart in box 6 below explains how the protections work in various situations, but careful consideration will have to be taken of each individual's circumstances.
Taking
simplification forward
Although the Finance Act contains a lot of detail, some matters have been left to Regulations. The Inland Revenue has published 18 sets of draft Regulations† on its website on which it is consulting. These cover a wide range of matters from the arrangements for overseas schemes, certain notice and information requirements and details of the occupations that will entitle individuals (including badminton players and trapeze artists) to some transitional protection against the increase in the minimum retirement age, given the unusually young retirement ages currently enjoyed.
The consultation period ends on 5 November 2004. Once the final Regulations have been made, the Inland Revenue plans to issue new guidance for pension arrangements next spring. This will not give schemes long to set up new systems and amend their rules, although the draft Regulations include an overriding power to protect schemes from having to make payments under the provisions of their pre-A-day rules that would be unauthorised under the new regime. However, this protection will only last three years.
The Inland Revenue is also taking action to prevent individuals manipulating the existing rules in order to maximise their benefits under the new regime. So far it has issued Update no.147, which deals with split transfers and requires tax-free cash to be apportioned where the member has transferred benefits in respect of one employment to more than one scheme, or is entitled to benefits from more than one scheme in respect of the same employment.
As more information becomes available, pension advisers will be detailing their ideas on how schemes should proceed to handle the changes. The National Association of Pension Funds (NAPF) has beaten everyone off the mark, having already published its guide** to the Act, which sets out a brief description of the main provisions, and more importantly, suggests the action that schemes should be taking now in order to have the correct procedures in place by A-day. It also contains a helpful glossary explaining some of the new terminology that will apply under the simplified regime.
The next few months will be extremely busy for pensions professionals as everyone struggles to assimilate new concepts, get to grips with the many formulae contained within the Act and establish new systems. It remains to be seen how genuinely "simple" the new regime is in practice.
* Finance Act 2004, available from The Stationery Office (TSO), PO Box 29, Norwich NR3 1GN, tel: 0870 600 5522, fax: 0870 600 5533, email: book.orders@tso.co.uk or via its website (www.tso.co.uk/bookshop), price £43.50 inc. p&p, or it can be downloaded from the HMSO website (www.legislation.hmso.gov.uk/legislation), although not in pdf format.
† Copies of the draft Regulations can be obtained from the Inland Revenue's website (at www.inlandrevenue.gov.uk/pensionschemes/index.htm) via "Pensions tax simplification".
** "NAPF guide to the tax regime", available from the National Association of Pension Funds, Publications Department, NIOC House, 4 Victoria Street, London SW1H 0NX, tel: 020 2808 1300, fax: 020 7222 7585, or by ordering from its website (www.napf.co.uk) via "publications", price £7 inc. p&p to members (£14 to non-members).
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Our research This feature is based on a detailed examination of the Finance Act 2004 and the explanatory notes to the Finance Bill. We have also drawn on a client newsletter produced by Hewitt Bacon & Woodrow and the NAPF's guide (see footnote ). We are grateful to our technical advisers Aon Consulting for checking our worked examples and to Watson Wyatt Worldwide for allowing us to reproduce its flowchart. |
