The Finance Act 2011 received Royal Assent on 27 July 2011. The act enacts proposals (aimed at raising revenue) that were proposed by HM Treasury in July 2010 and confirmed on 14 October 2010, following concerns that earlier proposals that had been put forward by the previous Government disadvantaged high earners only and introduced more complexity to the tax system. In this briefing, we look at the implications of the provisions in the Act for registered and unregistered pension schemes.
Reduction in the annual and lifetime allowances
The Finance Act 2011 makes two key changes to the annual and lifetime allowances regime:
- From 6 April 2011, the annual allowance (“AA”) was reduced from £255k to £50k.
- From 6 April 2012, the lifetime allowance (“LTA”) will be reduced from its current level of £1.8 million to £1.5 million.
What is the significance of the AA and the LTA?
The AA refers to the maximum pension saving that can be made in a year without triggering a charge to tax for the member (the “annual allowance (AA) charge”). The effect of the AA charge is to remove any tax relief on pension savings over the AA limit. Any pension saving (in excess of the annual allowance):
- Over the higher rate limit (currently £150k) is taxed at 50%;
- Over the basic rate limit (currently £35k) but below the higher rate limit is taxed at 40%; and
- Below the basic rate limit is taxed at 20% .
The LTA relates to the total amount of pension savings that an individual can make within a registered pension scheme during their lifetime. If the LTA is exceeded, the excess is subject to a tax charge (“the lifetime allowance (LTA) charge”). The rate of the lifetime allowance charge depends on how benefits are taken. Any amount over the lifetime allowance taken as a lump sum is taxable at 55% and at 25% if the excess is retained in the scheme to be paid out as a pension. The pension when it is paid, is subject to income tax.
How are members’ benefits valued against the AA?
- For a defined contribution (“DC”) arrangement, whether or not a member has exceeded the AA (and is therefore liable to an AA charge) is worked out by testing whether the sum of employer and employee contributions made during a period of time known as the Pension Input Period (“PIP”) exceeds the AA.
- For defined benefit (“DB”) and cash balance schemes, the increase in the value of the member’s pension savings during the PIP is tested against the AA.
The Act makes a number of changes to how the amount of pension savings, (the “pension input amount”) for a DB and cash balance arrangement is calculated. The key change to note is that the valuation factor used when calculating the pension input amount for defined benefits has been raised (from 10) to 16. No changes have been made to how the pension input amount for a DC arrangement is calculated.
The Act also introduces a number of exemptions and other measures to ameliorate the impact of the revised regime on scheme members, including the introduction of a new facility (called “Scheme Pays”) under which members subject to an AA charge can require the scheme trustees to pay the charge from the scheme in return for reduced benefits.
Measures to ameliorate the impact of the revised regime on scheme members
The 3 year carry forward rule
Members can carry forward any unused AA from the last three years by adding any unused allowance to the current year’s AA to give a higher AA in the current year. The AA in the current year must be used first then the earlier years, using the earliest tax year first. A member must have been a member of a registered pension scheme to have any unused AA. Members joining a registered pension scheme for the first time will not have any carry forward available in their first year.
The deferred member exemption
The deferred member exemption treats a deferred member as having a nil pension input amount. Schemes closed to future accrual (which, under their rules, will typically treat all active members as deferred members from the closure date) will particularly benefit from this exemption. But note:
- For the exemption to apply, a deferred member’s benefit cannot be increased by more than the consumer prices index or any annual rate “specified” in the rules of the pension scheme as the rules stand at 14 October 2010. “Specified” means a percentage figure or a percentage produced by movement in an index, or a combination of the two and “does not include a percentage produced by the exercise of discretion by any person”. Schemes that provide for the revaluation rate to be determined by the trustees and/or the employer may not, therefore, be able to rely on the exemption.
- Where a deferred member’s benefit has a salary linkage, if the increase in any PIP as a result of a salary increase is more than the revaluation rate specified in the rules or CPI, the exemption will not be available.
Benefits on death and severe ill-health
The AA does not apply to any pension savings for the year in which any benefit or lump sum is paid on death or in circumstances of severe ill-health. Severe ill-health is, broadly, where (1) the pension scheme administrator has received evidence from a registered medical practitioner that the member is unlikely to be able to work until state pension age and the member then becomes entitled to all their benefit; or (2) where a member is paid a serious ill-health lump sum because they are expected to live for less than a year.
Issues for DB schemes
Despite the changes to how DB members’ benefits are tested against the AA, there are still some issues facing DB members. We consider these below.
Spikes in the pension input amount
The way the pension input amount is calculated means that there can be a large one-off spike in the pension input amount resulting in the pension input amount exceeding the AA in that PIP, for instance on redundancy or increase in pensionable pay as a result of promotion. This may be rough justice, particularly if the value of the pension declines in the future or the value is never fully realised – for instance where a temporary promotion ends or the scheme winds up underfunded.
Unless the deferred member exemption can be used, late retirement uplifts are tested against the AA, potentially giving rise to an AA charge.
Application of the N/NS formula
Some schemes (particularly those offering accelerated accrual rates) cap benefits by reference to a maximum number of years of pensionable service or a maximum of 2/3rd of final pensionable salary. For early leavers, the pension is usually calculated according to the formula N/NS x P (“the N/NS adjustment”) where:
N is the member’s actual pensionable service at date of leaving; NS is the member’s actual plus potential pensionable service to normal retirement date; and P is the member’s expected pension.
As the pension input amount in a PIP is calculated using an artificial assumption that the member has, broadly, already reached normal retirement date, no account is taken of a member leaving early and the N/NS adjustment. This can result in members having a higher or lower pension input amount than would be the case if the N/NS adjustment was taken into account. (This is not something new – the reduction in the AA has, however, brought the issue to the surface with HMRC illustrating the anomaly through worked examples in its Pension Schemes Newsletter 47). Schemes can amend their rules so that, effectively, the N/NS formula is taken into account for AA purposes but care must be exercised when introducing this type of change, as it could benefit some members and disadvantage others.
HMRC is unapologetic about the above issues. In its response to its consultation on changes to the annual allowance (March 2011) it has said that the rules around how pension input amounts are calculated have been designed to be simple and that it is not going to complicate the regime by taking into account a plethora of different scheme-specific rules and circumstances. “Employers and pension schemes should consider the implications of the new regime for their scheme rules and remuneration arrangements. Individuals should consider the tax consequences of pensions accural...” In practice, this means employers, trustees and members (as appropriate) looking at the tax implications of any change that is likely to give rise to a large pension input amount for the member (such as a pension contribution on redundancy, scheme augmentation to members’ benefits, pay-rises etc) and considering how these changes may be effected to minimise the risk of an AA charge arising. Employers may increase salary as an alternative or offer an Employer Financed Retirement Benefit Scheme. Schemes may be able to amend their rules to give the member the option of capping their pension savings so that they do not exceed the AA in a PIP.
With many more people now likely to have to pay an AA charge, the Act introduces new provisions allowing members to require the trustees to pay all or part of the AA charge in return for reduced benefits under the scheme. It is mandatory for DB and DC schemes to offer the Scheme Pays facility from 11 August 2011. Key points to note about Scheme Pays are:
- For a member to qualify for it, a member’s liability to AA charge must exceed £2,000 (across all schemes in which he has benefits) and the member’s pension input amount (in relation to the scheme) must exceed the AA.
- Schemes do not have to amend their rules to operate Scheme Pays. A statutory override (“the Scheme Pays Override”) is given.
- The facility has to be offered free of charge.
- Where a member does not satisfy the eligibility conditions for the mandatory Scheme Pays facility, schemes may decide to offer it on a voluntary basis.
Care must be exercised when deciding how to adjust members’ benefits under Scheme Pays. The Scheme Pays Override states that “the rules of the scheme shall be modified so as to allow for a consequential adjustment to be made to the entitlement of the member to benefits under the scheme on a basis that is just and reasonable having regard to normal actuarial practice”. Other than this, the legislation does not prescribe how schemes are to modify members’ benefits; trustees therefore have a wide discretion in this regard. Furthermore, HMRC has stated that only benefits of the member may be adjusted, not benefits payable in respect of the member to his dependants (although there may be a consequential effect on dependants’ benefits where a member’s benefits are reduced).
If the trustees decide to offer a voluntary facility, they can prescribe the circumstances in which they would make it available. The terms of a voluntary facility do not need to be restricted to the narrow circumstances in which the mandatory facility is to be provided. Trustees should also take into account the administrative burden and costs of providing a voluntary facility.
There are a number of other issues which require clarification from HMRC, for instance how the facility may be applied in the year in which benefits are taken. We will report on these in due course.
Before the Act, a PIP began on the date benefits started to accrue and ended on the anniversary of that date – this created problems for schemes that wanted to align their PIPs with the tax year. The Act changes this so that:
- For new schemes and new members of existing schemes, unless a different date is nominated, a member’s PIP will end on 5 April. If a different date is nominated, it must be within 12 months of the date on which a member’s benefits start to accrue under the scheme. Subsequent PIPs will end on a nominated date in the following tax year after the PIP ended, or if there is no nomination, the anniversary of the date the previous PIP ended.
- Members can only change a PIP under a money purchase arrangement. The administrator can change the date of the PIP for any type of pension arrangement. A PIP can be changed by nominating a new end date for the PIP in the tax year immediately after that in which the last pension input period ended. Only one change can be made in a tax year. If more than one date is nominated, the date nominated first applies. Retrospective changes to PIPs are not allowed.
The case of the ‘Straddling PIP’
An individual’s PIP may have started before 14 October 2010 (the date the new rules implemented by the Act were announced) but finishes after 5 April 2011 (the “Straddling PIP”). Transitional rules apply here, so that, broadly, the allowable pensions savings for AA purposes is a maximum of £50,000 in the post-announcement period and an overall maximum of £255,000 in the tax year 2010/11. If the £50,000 limit or the overall limit of £255,000 is exceeded, the member could be saddled with an AA charge.
Once the LTA is reduced to £1.5 million, a new form of transitional protection from the LTA charge called “fixed protection” will be available for those who do not already have either primary protection or enhanced protection, allowing such members to have the current LTA of £1.8 million to be applied to them. An individual must apply for a certificate on or before 5 April 2012 to claim fixed protection.
Members who claim fixed protection should ensure that they are not auto-enrolled by an employer into its own scheme or NEST when the auto-enrolment rules become applicable to their employer. Otherwise, they could end up losing fixed protection.
Relaxation of the requirements to take benefits at age 75
From 6 April 2011, the effective requirement for DC schemes and DB schemes with a DC element to annuitise at age 75 is removed. The drawdown regime that existed before this date (namely unsecured pension and the alternatively secured pension) has been scrapped and replaced with a new drawdown facility which has two elements: a “capped drawdown” element and a “flexible drawdown” element:
- Capped drawdown will allow members from age 55 to take an amount of drawdown pension from the scheme each year, capped at an annual maximum. The maximum amount that members can take is worked out using new tables produced by the Government Actuary’s Department and is, broadly, the amount of annuity that the amount crystallised for drawdown purposes would buy.
- Flexible drawdown is a drawdown arrangement for people who meet a minimum income requirement (“MIR”) of £20,000, excluding any drawdown income. Income that can be taken into account for the purposes of MIR includes pensioner lifetime annuity payments from a registered pension scheme, RPI-linked annuities and state pension benefits.
The relaxation of age-75 restrictions (including providing the new drawdown facility) are not mandatory. Schemes wanting to take advantage of the new regime may have to amend their rules and should consider the administrative burden and costs of doing so.
Age 75 restrictions for lump sums and lump sum death benefits
Also gone from 6 April 2011 are the age-75 restrictions on certain payments of lump sums and lump sum death benefits (such as the pension commencement lump sum, serious ill-health lump sum, the trivial commutation lump sum and the defined benefit lump sum death benefit). These changes apply to both DB and DC schemes.
The tax charge
Where benefits are drawn before a member dies, and the rest of the fund is paid out on death before age 75 in a lump sum form, the tax charge applicable has been increased from 35% to 55%. This 55% charge also applies where death occurs on or after age 75, replacing the previous tax charges (which could give rise to a total potential tax charge of 82% including inheritance tax). No inheritance tax is payable on the remaining sum.
Section 72 of the Act contains provisions preventing tax avoidance through the interaction of relief for pension savings and double taxation arrangements. Broadly, it provides that a double taxation treaty may not apply where (1) a pension or “similar remuneration” arises in another country; (2) a UK resident receives that payment; (3) the payment relates to a transfer from a pension scheme to the overseas scheme; and (4) the main purpose, or one of the main purposes, of that transfer was to secure an income tax advantage under a double taxation arrangement. Appropriate credit is, however, given for a UK tax charge if the individual has paid tax on the benefit in another jurisdiction.
The provision was originally aimed at a clause in a new double taxation treaty with Hong Kong that would, broadly, have allowed UK resident tax payers with a Qualifying recognised overseas pension scheme in Hong Kong to be taxed on pensions at 15% and lump sums to be paid free of tax.
The disguised remuneration rules
Broadly, the “Disguised Remuneration” rules are wide reaching anti-avoidance rules which impose immediate income tax and national insurance contributions charges on any arrangement made by an employer to reward an employee through a third party. A third party for these purposes can include a trustee (but will not normally include the employer or a member of the employer’s group unless they are acting as a trustee). For a charge to arise, among other things, a “relevant step’ must have been taken by the third party in pursuance of the arrangement. Broadly, ‘relevant steps’ are:
- Earmarking any sum of money or asset for the employee. Earmarking would, for example, catch payment of moneys into a trust or notional allocation of monies into a trust;
- Paying a sum of money or transferring an asset; and
- Making an asset available to the employee.
There is also an additional regime which applies specifically where an employer (or other third party) gives an undertaking to pay a contribution to an unregistered pension arrangement and either earmarks or grants security in respect of that undertaking.
Impact of the disguised remuneration provisions on pensions arrangements
The disguised remuneration rules do not apply to benefits payable from, or contributions paid to, a registered pension scheme. However, they can apply to unregistered pension schemes, employer financed retirement benefit schemes (“EFRBS”).
Where the rules apply, the employer will be required to operate PAYE and employer National Insurance Contributions on the amount paid. The charges are harsh, including an income tax charge of up to 50%, given that the charge may arise even if the member has not at that time received any benefit.
What is an EFRBS?
Under an EFRBS, the employer (or a member of the employer’s group) gives an undertaking to some or all of its employees to provide benefits to those employees on retirement (or in other specified circumstances). They are commonly used to provide “top up” benefits for executives and other high earners to compensate them for pension benefits in excess of the AA and the LTA. Such an undertaking can be on a DB or DC basis and can be unfunded, secured or funded.
Implications of the disguised remuneration rules for unfunded EFRBS
Broadly, where an EFRBS is wholly unfunded, the arrangement will not fall within the scope of the disguised remuneration rules. This is because the benefits are paid directly by the employer (or member of the employer group) and as a result, there is no third party involved in the arrangement.
It is not uncommon for security to be granted in respect of an unfunded EFRBS. Providing that the security is granted directly to the employee by the employer, the new regime would not apply, as there would be no third party taking a relevant step. However, there are some outstanding issues relating to the granting of security where the security is granted to a security trustee. We are of the view that the new regime should also not apply to that type of arrangement. However, this is not addressed clearly in HMRC’s draft guidance and clarification of the position is awaited.
Implications of the disguised remuneration rules for funded EFRBS
The position differs in a funded EFRBS. Here benefits will be paid by a third party acting as trustee, so on the face of it, the new rules will apply. However, where the EFRBS provides defined benefits and the assets of the EFRBS are held by the trustees on a “pooled basis” (ie without being able to allocate specific assets in respect of particular beneficiaries) then no tax charge should apply on the funding of the scheme (on the basis that the step cannot be attributed to a particular employee). This view is consistent with the HMRC Frequently Asked Questions (dated 5 July 2011) which state that in relation to a defined benefit EFRBS “so long as the assets and liabilities of a relevant third person providing defined benefits are both genuinely separate and pooled, then it is probable there would be no earmarking”. A charge to tax would, however, arise when the benefit is ultimately paid, as it would be paid by a third party.
In contrast, under a funded DC EFRBS, in the event that the trustees hold separate accounts for each beneficiary, it is likely that a charge to tax would arise when the contributions are paid.