Treasury sticks to its lifetime limit
After a long delay the government has finally published its detailed proposals on simplifying the tax regime for pension schemes. While most of the original ideas have been retained, some changes have been made to take account of comments received. We examine the latest discussion paper in detail.
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Summary of key points The government is proposing to replace all current tax regimes applying to pensions by one regime, which will apply to all types of pension arrangements. There will be a single lifetime allowance, starting at £1.4 million and indexed from "A-day" that will apply to pensions from all sources. Complex transitional arrangements will protect existing pension rights and lump sums in excess of the new lifetime allowance at A-day. For the purposes of assessing DB benefits against the lifetime allowance, a standard factor of 20:1 will be used. Up to 25% of each member's fund (subject to a maximum of 25% of the lifetime allowance) may be taken as a tax-free lump sum. The government has given in to pressure and reduced the recovery charge on benefits in excess of the lifetime allowance from 331/3% to 25%, in addition to any income tax. There will also be a limit on annual accruals to pension funds, with DB benefits valued using a factor of 10:1 for this purpose. It will be possible to contribute a total of 100% of earnings, or £3,600 a year if greater, to any number of pension arrangements. |
For the secondyear insuccession, the government has dashed the hopes of the pensions industry that it could enjoy a quiet Christmas. The Treasury and the Inland Revenue published a joint discussion paper* on the simplification of the taxation of pension arrangements just before the start of the holiday season.
The latest paper fleshes out the proposals contained in a consultation paper published at the same time as the Green Paper at the end of 2002. At the time of its publication, the first tax paper was broadly welcomed for its genuinely radical approach. However, the proposed changes were not explored in depth because the government stated it wanted people to concentrate on the broad principles first. It has now set out its detailed proposals, including the transitional arrangements.
Comments taken into account
The broad approach is still that set out in the original consultation paper, which is that the eight current taxation regimes covering pension arrangements will be replaced by one set of tax rules that will apply to all types of registered scheme. The government is still intending to introduce a lifetime limit (referred to as a lifetime allowance in the new paper) on the value of benefits, initially of £1.4 million, and an annual limit (again now referred to as an allowance) of £200,000 on increases to the value of funds.
There have been some significant changes to the proposed regime resulting from comments received during the original consultation. These are set out in box 1. The reduction in the proposed recovery charge from 331/3% to 25% is likely to be welcomed, as is the decision not to apply the annual allowance in the year that benefits are taken in full.
It was hinted that the original implementation date for the new regime would be April 2004 but that has been delayed for 12 months. More worrying for pension professionals is the throwaway line in the report that an announcement will be made in the 2004 Budget as to whether or not the regime will be introduced at all. The Faculty and Institute of Actuaries points out that this question mark over the implementation of the proposals makes it difficult for pension funds and their advisers to make concrete plans.
Lifetime allowance
In spite of claims that the initial allowance of £1.4 million was too low, the government is pressing on with its intention to have a single allowance on pension benefits, which will be a limit on funds accrued over a lifetime. The allowance will be increased in line with retail prices. Members' benefits will be tested against the allowance when they come wholly or partially into payment, or in the case of older members with benefits not yet in payment, at age 75. Further tests will be applied in certain circumstances when discretionary increases are granted to pensions in payment.
While testing defined-contribution (DC) funds against the allowance should be relatively straightforward, a lump-sum equivalent value will have to be calculated for defined-benefit (DB) pensions. Originally, the government intended that tables would be used, based on age and the different types of benefits provided by DB schemes. Conceding to criticisms that this would be too complicated, it is now proposing that a standard factor of 20:1 is used to convert benefits for valuation purposes (so an accrued pension of £1,000 is valued as £20,000). This factor would be the same for everyone and assumes that members' pensions will be increased in line with the retail prices index (RPI) and that total dependants' pensions do not exceed the amount of members' benefits. Schemes may be able to negotiate different factors if their benefits differ widely from this. An illustration of the operation of the lifetime allowance is contained in box 2.
If a member's benefits are found to be in excess of the lifetime allowance, a recovery charge will be applied. The government has acceded to criticisms that the rate originally suggested (331/3%) was too high and is now proposing that it should be 25% of the excess amount. In response to further comments, the government has stated that any funds in excess of the lifetime allowance may be taken as a lump sum taxed at 40% after the recovery charge has been applied. This will result in benefits that exceed the lifetime allowance being taxed at 55%. While the recovery charge will be assessable on the member, schemes will be required to withhold benefits to cover the charge.
Transitional arrangements
The first tax paper was vague about the transitional arrangements that would apply where the value of members' benefits is close to, or exceeds the lifetime allowance before the planned changes come into force ("A-day") but is within existing Inland Revenue limits. The new tax paper contains detailed proposals concerning the arrangements but the government has admitted that they are more complicated than originally envisaged.
It is now suggesting that there should be two types of transitional protection from the recovery charge:
Primary protection - this will only be given to the value of benefits built up before A-day in excess of £1.4 million. These benefits will be indexed in line with the statutory lifetime allowance. If they increase by more than the increase in the RPI, they may become subject to the recovery charge. Therefore a higher level of protection is also proposed.
Enhanced protection - where people cease active membership of pension arrangements before A-day, all benefits coming into payment after that day will be exempt from the recovery charge.
To prevent abuse of these concessions, there will be a ceiling on pensionable pay, the level of which will depend on whether or not the member is subject to the current capping regime. Enhanced protection is lost if the member joins any DB plan after A-day. Box 3 illustrates how the two different types of protection will work. In order to benefit from the transitional arrangements, such rights need to be registered within three years of A-day.
The original consultation paper made no reference to the position of funded and unfunded unapproved retirement benefit schemes (FURBS and UURBS). It is now confirmed that benefits paid under these schemes do not need to be taken into account when calculating the value of members' benefits. However, such schemes will no longer be able to claim any tax advantages.
Payment of benefits
The new tax paper considers the best way for benefits to be delivered and develops some of the ideas discussed in earlier consultations on annuities. For many people, the limit on tax-free lump sums has been increased. It will be possible to take up to 25% of the total fund as a tax-free lump sum, subject to a maximum of 25% of the lifetime allowance. Again, there will be transitional arrangements. The paper deals with two possible scenarios that may exist on A-day:
where the value of pension rights is less than the lifetime allowance but the tax-free lump sum is greater than 25% of the value of the fund, and
where the value of pension rights at A-day is greater than the lifetime allowance but the tax-free lump sum is within the lifetime allowance.
The method of protecting the lump sum depends on the method chosen to protect pension rights. Examples are set out in box 4 to illustrate this.
Pension benefits must provide an income for life for members. It is proposed that there will be three main ways of providing such income:
secured - income that is promised by a pension scheme and is backed by the sponsoring employer or guaranteed by the purchase of an annuity;
alternatively secured - where limits on income and annual reviews stop the funds from being depleted too rapidly; and
unsecured - this method is available up to age 75 and is similar to the present income-withdrawal arrangements. The maximum income allowed will be 120% of the amount that could have been provided had the funds been used to purchase a flat-rate annuity on the open market. Unsecured pension may also be provided through limited-period annuities for no longer than five years.
Annual allowance
Although some commentators on the first tax paper felt that the imposition of an annual allowance was unnecessary in view of the lifetime allowance, the government is still proposing that there will be an allowance of £200,000 to prevent tax avoidance. However, the present restrictions on individual contributions will be removed and people will be able to contribute the greater of £3,600 and 100% of earnings. As long as this limit is not breached, it will be possible to have concurrent membership of different pension schemes.
The allowance will cover all contributions allocated to provide members' benefits under DC schemes but not to investment growth, as some had originally speculated. It also applies to increases in the capital value of DB benefits and lump sums. Growth in the capital value of deferred DB benefits in excess of the RPI will be included in the allowance. It is proposed that a factor of 10:1 will be used to value DB benefits for this purpose. Benefits that are transferred during the relevant year will not count towards the allowance.
Concern was expressed during the first consultation that people on relatively low incomes, who are given enhanced benefits if retiring on account of redundancy or ill health, could be adversely affected by the annual allowance. Accordingly, the government has decided to exempt contributions and benefit growth from the allowance in the year in which benefits are taken in full.
Death and divorce
The latest paper sets out in some detail the application of the lifetime allowance to death benefits, paid on death both before and after benefits become payable. While there are to be no restrictions on the amount or form of benefits paid on death in service, the lump sum counts towards a member's lifetime allowance. Any excess over the allowance is effectively taxed at 55%, in the same way as benefits on retirement. However, schemes will not have the responsibility for withholding the tax. The benefit will be paid gross and the member's legal personal representatives will be responsible for paying the charge. This may give rise to problems where the benefit is paid on discretionary trusts as the personal representatives will either have to reclaim the money from the recipient or pay it out of the member's estate to the detriment of other beneficiaries. The value of dependants' benefits in payment will not count towards the lifetime allowance.
Where a member dies with some or all benefits in payment, the rules governing the payment of a guaranteed amount (in addition to a dependant's pension and any death-in-service lump sum) will depend on whether or not the member's income was secured. If the member's pension was secured, there can be a guaranteed minimum payment period of up to 10 years starting from the date on which the pension commenced. If the member was under 75 at the date of death, this may be paid as a capital sum, subject to a 35% tax charge.
Where benefits were unsecured at the date of death, any undrawn benefits may either be paid as a lump sum, subject to tax at the rate of 35%, or may be used to provide dependants' benefits.
The government's original proposals on the treatment of benefits subject to a sharing order on divorce were that pension rights from spouse A that were transferred to spouse B on divorce would not count against spouse B's lifetime allowance but would continue to count against spouse A's allowance. This seems nonsensical to many commentators and the government now agrees that the lifetime allowance should be based on the position of each spouse after the sharing has occurred. In addition, neither credits nor debits under pension sharing orders will count towards the annual allowance.
Flexible retirement skirted over
Both the Green Paper and the first tax simplification paper promoted the concept of flexible retirement by enabling members to draw benefits from their pension schemes while continuing to work part time for the same employer. This is not permitted under current rules. Only one short paragraph covers this issue in the new tax paper. No information about how the change will operate or be introduced is provided, which is surprising given the level of detail in the rest of the report.
More explanation is provided about the raising of the earliest age at which a pension may be taken from 50 to 55 by 2010. The first tax paper asked for views on the best way of introducing this change. It has been decided that schemes will be free to decide how to move to the new minimum retirement age. This means that schemes will be able to maintain a minimum age of 50 right up to 2010 if they choose. The minimum retirement age will apply to all schemes including those that currently have normal retirement ages of less than 50, such as those for professional sports people.
Certain public sector schemes, including the police and fire service schemes, will be affected by this provision, and the government is conducting separate consultation exercises in respect of amendments to those schemes (see our next issue and OP, September 2003). Raising the minimum retirement age will not affect schemes' ability to allow people to retire earlier than 55 in cases of severe ill health or disability. Certain protections are also given to members who currently have a right to retire at age 50 or earlier.
New registration requirement
If the simplification of the taxation of pension arrangements proceeds, schemes will no longer have to apply for exempt approval from the Inland Revenue in order to obtain tax advantages. Instead, they will go through a registration process, which the government hopes can be delivered electronically. Unlike at present, there will be no interim procedures so tax relief will not be allowed on scheme contributions until the Inland Revenue issues an acknowledgement that the registration is valid.
Instead of schemes having to submit everything to the Inland Revenue, they will self-certify that they are complying with the rules. The Revenue will carry out spot checks to ensure this is the case. It will be the responsibility of schemes to keep the Inland Revenue informed of any changes to key information. All existing exempt approved schemes will be automatically registered.
Other changes
The paper also contains the government's proposals in respect of pension scheme investments that apply principally to small self-administered schemes (SSASs). In future, there will be a limit on holding shares in the parent company or connected companies of 5% of fund value. Loans to members will not be permitted and scheme borrowing will be restricted to 50% of a fund's assets at the date a loan is taken out. The Inland Revenue is also consulting on whether the requirement for SSASs to have pensioneer trustees should be abolished.
Other changes proposed by the paper include increasing the tax deducted from refunds of contributions that are greater than £10,800 where members have less than two years' service (though the two-year vesting period is set to be reduced). The new rate would be 40% on the amount of the refund above that level and refunds of less than that amount would continue to be taxed at 20%.
The need for schemes to carry out funding reviews to reduce surpluses will also be abolished from A-day. Instead, the Department for Work and Pensions will set out rules to determine when a surplus arises under a DB scheme.
A question mark over progress
The government believes that simplifying the tax regime applicable to pensions will remove a barrier to saving for retirement. It accepts that there will be a one-off transitional cost to the pensions industry of implementing the new regime but believes that this will be outweighed by savings made once the system is in place. However, it seems that it is not prepared to proceed with the changes if the cost to the Exchequer in lost revenue is too great.
Hence it is likely that the major debate about the proposals will concern the starting figure for the lifetime allowance and the number of people who will be affected by it. The government stands by its contention that £1.4 million represents the value of the maximum pension fund under the current capping regime. It also insists that no more than 5,000 people are presently affected by the proposal, with approximately another 1,000 a year reaching the lifetime allowance in future. However, it is asking the National Audit Office to report on the validity of its numbers before the 2004 Budget. The paper implies that the decision whether or not to proceed hinges on its findings.
The closing date for comments on the proposals is 5 March 2004 and, if the government decides to proceed, legislation will be enacted during this year and the new system will commence the following April.
* "Simplifying the taxation of pensions: the government's proposals", available by telephoning the Treasury public enquiry unit on 020 7270 4558, or the Inland Revenue's pension simplification team on 020 7438 8374, free, and from the Treasury and Inland Revenue websites (www.hm-treasury.gov.uk via "Pre-Budget Report"and "Associated documents" and www.inlandrevenue.gov.uk via "Pre-Budget Report" and "supplementary documents").
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Initial reactions to the government's proposals on tax simplification
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Our research This feature is based on the latest tax simplification paper published jointly by the Treasury and the Inland Revenue, the partial regulatory impact assessment and, to an extremely limited extent, commentaries produced by various law firms and pension consultants. |
