Under plans announced in April’s Budget, income tax relief on pension savings for individuals with taxable incomes of £150,000 or more will be restricted with effect from 6 April 2011. In the interim, and to prevent those likely to be affected from front-end loading their pensions contributions/accrual before the measures take effect, the Government also introduced complex “anti-forestalling” provisions, which themselves give rise to issues for both employers and high-earners.
These anti-forestalling measures are set out in Schedule 35 to the Finance Act 2009, which received royal assent on 21 July. Regulations have already made slight changes to the regime, and further regulations are expected. This bulletin examines some of the issues arising out of the anti-forestalling provisions and also considers some possible alternative benefit design options for employers once the 2011 restrictions on tax relief come into effect.
- In broad terms, what are the anti-forestalling measures?
- Who is affected by the anti-forestalling regime?
- How much is the special annual allowance and how is it applied?
- Anti-forestalling: some useful easements (and their limitations...)
- Issues and problems with the anti-forestalling regime
- Erosion of tax relief on pension contributions/accrual of high earners: the 2011 changes
- Alternative benefit designs to mitigate the effect of the 2011 changes
- EFRBSs: how are they taxed?
In broad terms, what are the anti-forestalling measures?
With effect from 22 April 2009 until 5 April 2011, anti-forestalling measures (in the form of a new and additional special annual allowance and an associated tax charge) will apply to high earning members of both defined benefit and defined contribution schemes, to make the following subject to tax :
- Increases in pension contributions made by or in respect of them; or
- Improvements to benefit accrual (in the form of a material change to the scheme rules which govern benefit calculation and which does not affect at least 50 other scheme members); and
- Which, in either case, are in excess (i) of their normal regular savings pattern; and (ii) of the new special annual allowance.
Who is affected by the anti-forestalling regime?
Broadly, the anti-forestalling provisions apply to individuals who have an annual taxable income of £150,000 or more in any of the tax years 2007/8 to 2010/11, and on or after 22 April 2009 change:
In relation to defined contribution arrangements:
- Their normal pattern of regular pension contributions (essentially deviate from the continuation of contributions paid under agreements made before 22 April 2009 which are paid quarterly or more frequently and increase the rate at which they are paid). (Note that (i) pension contributions include both employer and employee contributions; and (ii) irregular pension contributions are protected in certain circumstances – see below); or
In relation to defined benefit arrangements:
- The normal way in which their benefits accrue, where there are not at least 50 members affected by the change.
Individuals must add any income foregone by way of salary sacrifice (under any agreement made on or after 22 April 2009) so that it counts towards the £150,000.
How much is the special annual allowance and how is it applied? For high earners who simply make contributions on a quarterly basis (or more frequently than that), the special annual allowance is £20,000.
However, during the passage of the Finance Bill, the Government introduced an amendment as a partial concession to those who have a history of making irregular contributions. For those who make irregular contributions (that is, less frequently than quarterly) to defined contribution arrangements, and where the average of those irregular contributions is more than £20,000, the special annual allowance will be the average of their last three years’ contributions up to a maximum of £30,000 (inclusive of any regular pension contributions).
All regular pension savings under agreements which were in place before 22 April 2009 are protected and do not fall to be tested against the special annual allowance regardless of their level. However, additional pension savings (as outlined in the bullet points above) will be tested against the special annual allowance and the excess will be liable to a special annual allowance charge of 20%. It is thought likely that this charge will increase to 30% for the year 2010/11, to take account the new 50% top tax rate.
Anti-forestalling: some useful easements (and their limitations...)
- Refunds of contributions: a refund of member AVCs may be possible for the tax year 2009/10 where that member has, for example, inadvertently exceeded the special annual allowance by increasing their AVCs from the pre-22 April level. Certain conditions apply and a refund will only be possible if the pension scheme rules allow it.
- Added years/AVCs: broadly, these will not count towards the special annual allowance provided that the arrangement to buy the added years/make AVCs was in place before 22 April 2009 and the contributions are made at least quarterly.
- Relationship with the annual allowance: the standard annual allowance (£245,000 for 2009/10) will continue to apply as before; the special annual allowance will stand alongside it. Where an individual’s pension savings exceed both allowances, an adjustment is made to the amount subject to the special annual allowance charge.
- Savings in the tax year in which the member retires or dies: these will not usually count towards the special annual allowance. However, where the individual is a member of a small defined benefit scheme (that is, one with fewer than 20 members) and dies or retires (but not due to ill-health), then their pension savings that year will be tested against the special annual allowance (in contrast to the position in relation to the standard annual allowance).
- Additional contributions/accrual made between 6 April 2009 and 21 April 2009: additional contributions/accrual made between these dates will not be subject to the new tax charge, although the value of the additional contributions/accrual will reduce the amount of the special annual allowance available for 2009/10.
- New or restructured pension arrangements: generally, where a member joins or rejoins a scheme, increased contributions/accrual will not count towards the special annual allowance, provided that:
- At least 20 members continue to accrue benefits on the same basis;
- There is no material change in the rules under which benefits are calculated which affects fewer than 50 active members; and The provision of benefits is part of the normal pattern of pension provision by the employer.
- Flexible benefits: in a Q&A, HMRC has confirmed that annual re-elections to contribute to a pension scheme at the same rate (as is often a requirement under a flexible benefits programme) will be protected from the special annual allowance charge.
- What happens if “regular” pension contributions are not equal: where an individual pays regular contributions but those contributions are at different levels, HMRC has confirmed that it will take the median of those contributions (that is, put the contributions in order of value and take the middle (or the average of the two middle) contribution(s)). The excess would count against the special annual allowance.
- Discretionary rules: where the employer/trustees of a pension scheme have an established history of using a discretionary power to augment benefits in a particular way and continue to use that power in the same way after 22 April 2009, then HMRC has confirmed that it will not consider this to be a material change in the rules of the scheme. However, the corollary also applies; namely, the value of benefits derived from novel uses of discretionary powers after 22 April will count as a material change and will count against the special annual allowance.
- National Insurance rebates: these will not count as contributions for the purposes of the special annual allowance.
- Salary increases in defined contribution arrangements: any automatic increase in pension scheme contributions as a result of an increase in salary will be protected (and, therefore, will not be tested against the special annual allowance).
Issues and problems with the anti-forestalling regime
In some cases, the easements outlined above give rise to uncertainties, or anomalies, or do not go far enough to fully offset the problems they are seeking to address. Employers and high earners still face various problems in connection with the anti-forestalling regime, some of which are set out below:
- Bulk transfers on scheme restructurings and mergers: the "new or restructured pension arrangements" exemption applies to bulk transfers on pension scheme mergers (whether to a separate scheme or to a different section of the same scheme). Unfortunately, this also means that the limitations to that exemption also apply. In particular, protection from the special annual allowance charge will only apply to bulk transfers where there are at least 20 members in the receiving scheme who accrue benefits on the same basis as the transferring members. In addition, each employer must employ a minimum of 20 members in the scheme. These restrictions could give rise to problems, for example, on the merger of an executive scheme into a staff scheme which provides less generous benefits. Any increase in pension contributions/material change to benefits in respect of the individual subsequent to the merger may also render that increase subject to the special annual allowance charge.
- Member communications: employers may wish to inform affected high-earners of the existence of the anti-forestalling regime, but in doing so, must be careful not to give the member financial advice.
- Redundancy augmentations: additional payments/increases in value, made by an employer or employee into either a defined benefit arrangement (for example, in the form of crediting the member with additional years of service) or a defined contribution arrangement (for example, in the form of a one-off lump sum payment), even where the payment/augmentation is made in connection with the member’s redundancy, will not be protected; with the result that the additional amounts will be tested against the special annual allowance. Redundancy sacrifice arrangements (where the member agrees to give up a portion of a redundancy payout in favour of the employer paying that amount into the member’s pension scheme) will also be caught.
Redundancy payments in excess of £30,000 will also count as income for the purposes of working out whether an individual is over the £150,000 threshold.
However, it is not clear how HMRC would view the position where there is an established practice of using a scheme’s discretionary power to augment benefits on a member’s redundancy, given their stated position in relation to the exercise of discretionary powers outlined above.
- Age -related contributions bands and matching contributions: where a member ascends age-related contribution bands automatically, then any additional pension contributions will not need to be tested against the special annual allowance. However, the position is not clear where the member must take a decision or make an election in relation to changing bands. Where an employer offers its employees a choice of matching contributions, it appears that only the lowest core contributions qualify automatically for protection (although this is not entirely clear).
- Change of GPP provider: there is presently no exemption in the legislation which covers pension contributions as a result of a change of GPP provider. However, the NAPF understands that HMRC intends to address this in regulations, which will offer protection for regular contributions on a change of pension provider.
- What constitutes a material change? The Finance Act provides that defined benefit accrual is protected (and, therefore, not tested against the special annual allowance) where there has not been a material change in the scheme's rules under which benefits in respect of the individual are calculated (or where there has been a material change which affects at least 50 people). However, whilst certain benefit changes (for example, improving the accrual rate) can clearly be described at material changes, it is not always clear what constitutes a "material change" in this context. For example, would a change to an attaching benefit, such as a spouse's pension, qualify as a material change?
- Executive options: HMRC's approach to the introduction of executive options under a defined benefit scheme (for example, to take unreduced early retirement at age 60) is not clear. Would this count as a "material change" to the basis on which benefits are calculated?
In light of the limitations on the protection offered in respect of post-22 April benefit changes and the uncertainties as to its ambit, employers may wish to consider the risk of the exposure of high earners to the special annual allowance charge when reshaping benefits or reorganising pension arrangements. Whilst the payment of the charge is a matter for the individual, and not for the trustees or the employer, the impact of benefit changes on high earners will be a relevant consideration for employers in many cases.
Erosion of tax relief on pension contributions/accrual of high earners: the 2011 changes
With effect form 6 April 2011, income tax relief on pension savings of individuals with taxable incomes of £150,000 or more will be restricted, with the effect that:
- Those who earn £180,000 per year will receive tax relief on their pension contributions/accrual at the rate of 20%; and
- Tax relief will be tapered in respect of contributions/accrual paid by those who earn between £150,000 and £180,000.
Given that the changes will not come into force until 2011, the restrictions on tax relief are not dealt with in this year's Finance Act, and consequently the detail as to how the new restrictions will apply is not yet known.
The changes will affect tax relief in respect of contributions/accrual in both defined benefit and defined contribution arrangements. The Government has also indicated that employer contributions in respect of high earners may be treated as a benefit-in-kind and subject to a flat rate tax of 20%. The problem the Government faces in this regard is that there is no obvious and convenient way of measuring the value of employer contributions in respect of particular individual members of defined benefit pension schemes. It intends to consult on how the tapering regime will apply and on how defined benefit schemes (and employer contributions towards them) will be dealt with.
Alternative benefit designs to mitigate the effect of the 2011 changes
In light of the impending introduction of restrictions to the tax relief applicable to the pension savings of high earners, many employers will wish to review the post-April 2011 benefit package on offer to its high earning executives. In particular, many are considering unregistered pension arrangements or employee benefit trusts as an alternative to more traditional registered pension schemes. The tax changes announced in the Budget only apply to contributions/accrual in registered pension schemes. One possible such alternative arrangement is an employer-financed retirement benefit scheme (EFRBSs).
EFRBSs: how are they taxed?
In essence, EFRBS is the collective post-A Day term for arrangements which were unapproved before A-Day (that is, funded unapproved retirement benefit schemes (FURBSs) and unfunded unapproved retirement benefit schemes (UURBSs)) – and remain unregistered post-A Day. The broad tax position in relation to these arrangements changed significantly on A-Day and is as follows:
- Corporation tax: a deduction is allowable only when benefits are paid out of the EFRBS.
- Income tax: no tax charge arises on the employee when making the contribution; pensions are taxed as income on payment.
- National Insurance: employer contributions are not liable to National Insurance contributions as they are made; and there is no charge when the benefits are paid provided that they are within benefit limits applicable to registered schemes.
- Investments: investment income and capital gains in trust-based EFRBSs are taxed at the rates applicable to trusts and do not benefit from the reduced rates previously applicable to FURBSs and UURBSs.
- IHT: the specific exemption in relation to inheritance tax previously applicable to FURBSs does not apply post-A Day. However, lump sum death in service benefits can be paid out under a discretionary trust, and, therefore, will not be within the deceased member's estate for IHT purposes.
Notwithstanding the tax charges levied on EFRBSs, it may still be advantageous for high earners affected by the 2011 reductions in tax relief to participate in these arrangements, as opposed to continuing in active membership of registered pension schemes.
After A-Day, unregistered arrangements largely fell into disuse given the simplified tax regime, and, in particular, the introduction of the lifetime allowance in place of the earnings cap. However, EFRBSs may now have a reinvigorated role in pension provision for those whose taxable income is in excess of £150,000.
In addition to EFRBSs, there are other potential options for alternative means of benefit provision, including employee benefit trusts, secured unfunded arrangements and overseas arrangements.