Many scheme rules provide for interest to be payable on a contribution refund where a scheme member leaves service with less than two years’ qualifying service. Pre-A-Day this was not a problem, as the total payment was made net of 20% tax. However, it has come to our attention that HMRC is taking the view that, under the Finance Act 2004 regime, the interest and investment growth element may not necessarily constitute an authorised payment.
It is clear from the Finance Act 2004 that a refund of contributions constitutes a short service refund lump sum, taxed at 20% on the first £10,800 and at 40% on the excess. This is payable by the scheme administrator. To qualify as a short service refund lump sum the refund must not exceed the actual amount of contributions paid by the member, i.e. excluding any interest or investment growth.
The tax treatment of the interest and investment growth, however, is less certain, in relation to both short service refund lump sums and refunds of excess contributions lump sums (refunds of contributions exceeding the maximum amount on which tax relief can be obtained in any tax year). It is not clear whether they fall within the Finance Act definition of “scheme administration member payment”. HMRC’s interpretation is as follows:
- interest paid on an arm’s length, commercial basis, i.e. at no more than a reasonable commercial rate, will be a scheme administration member payment (payable gross by the scheme administrator to the member, with tax payable by the member)
- any excess will be an unauthorised member payment and taxed accordingly.
HMRC makes no direct reference to investment return, but in practice actual investment return should normally constitute a payment made on an “arm’s length, commercial basis” and hence be treated as a scheme administration member payment.
This interpretation of the legislation has implications for many schemes, especially money purchase and AVC schemes. These schemes often provide for a return of the part of the member’s fund which represents employee contributions; by implication this includes any investment growth.
We await further clarification from HMRC on these issues, but the consequence of its approach, both for scheme rules and for scheme administration, is that refunds will have to be treated – and paid - as two distinct and separate elements:
- the amount of the contributions actually paid by the member (tax deductible and payable by the scheme administrator) and
- the amount of any interest/investment growth (payable gross to the member, who must account for the tax on a self-assessment tax return).