A recent report suggests that only 12% of firms are ready for the new pension regime, to be introduced in April 2006 – known as A Day.
One of the most important changes for those saving for their retirement will commence in April 2006. The changes have been planned for some time, and have been widely consulted on, but recent reports indicate that many employers and current members of schemes are not ready for the changes.
Simplistically, every current member of a pensions arrangement, whether personal or employer funded, should review their position with an expert before the new regime commences on 6 April 2006.
Realistically, many current members will not need to take any specific steps before the new regime commences, but some will; for those who will need to take steps to protect their rights under the new regime, not considering their options now could result in significant financial consequences as we move forward into the new rules.
The key area for advice, and an aspect of the new regime which are unclear is set out here. For those who need to familiarise themselves with the basics of the new rules, the Registered Pension Schemes Manual is an excellent resource. Although incomplete it contains a significant amount of detail and can be found at http://www.hmrc.gov.uk/manuals/rpsmmanual/index.htm .
There are many aspects to the transitional rules, most of which seek to protect rights which members of current schemes have accrued under the existing rules, and which may be lost under the new rules, which in many respects – and particularly as regards benefits – are more restrictive.
However, the most important aspect of the transitional rules affects those with significant pension savings accrued to date who may be affected by the new lifetime limit under the new regime. This is initially set at £1.5 million, but will rise over the first few years of the new regime.
The lifetime limit does not, as the name suggests, limit the amount of input into a fund during the lifetime of the member, but it restricts the amount of capital produced by a pension arrangement. The value of the fund at maturity (the date that the benefits are taken) is compared to the lifetime limit. If the fund exceeds the limit, the excess is taxed at a rate of 25%. This rate can rise to 55% if the excess is taken as a lump sum on retirement.
To mitigate the effect of this on those who have considerable savings under the current regime, where such a limit does not apply, members will be given the choice of two types of protection: Basic protection, which will be available to all, and enhanced protection which is only available to those who elect for it, and then only under certain circumstances.
It is very important that those who will be affected by the lifetime limit consider their options carefully before 5 April 2006, and make a decision about their options, as contributions into a pension after that date will affect their ability to elect for enhanced protection.
You should therefore advise all clients with substantial pension savings (and not only those with funds currently in excess of the limit) to seek advice in the next few months. They may wish to cease paying into a pension from the end of March 2006, and need to make that decision in advance.
Contributions by employers
One aspect of the new rules which is still not clear is the availability of tax relief on employer contributions. The pensions rule is that the “total input” into a scheme in a year must not exceed the annual limit, which is initially set at £215,000, but which will rise steadily over the first few years of the new rules.
Under this rule, the total of employer and employee contributions to a scheme may not exceed the annual limit in any tax year. Contributions in excess of this amount will be taxed on the member at a rate of 40%.
However, this rule does not relate to tax relief on the employer in the Schedule D or trading profits calculation. The new rule for employer contributions will be to adopt the “wholly and exclusively” rule included in S74 TA 1988 (and now for unincorporated businesses in S34 ITTOIA 2005)
Currently contributions to approved schemes are allowable as paid. In future, contributions paid will be tested against the wholly and exclusively rules, whether made by companies or unincorporated employers.
It is not clear how the new rules will be applied by HMRC. Directors of companies drawing a modest salary of, say £5,000 per annum would only be permitted to pay contributions of up to £5,000 themselves and obtain tax relief on them, but the employer could pay in up to £215,000.
The question is, would the employer obtain tax relief on this contribution? The new Registered Pension Scheme Manual is being published in piecemeal fashion, but unfortunately the chapter concerning this aspect remains unavailable to date.
Those with small companies which they control may be very happy to pay substantial pension contributions from the company if they can get full tax deduction for these contributions, as this will enable them to build up a sizeable fund very rapidly.
Also, for those companies which have surplus cash, this would be a very effective way of “slimming down” the balance sheet to eliminate any possible problems with business asset taper relief should the company eventually be sold. The opportunity to store surplus cash in the pension will be attractive to many directors, and particularly those over the age of 40, as the waiting time to obtain the benefit of their investment will be shorter.
So is a £215,000 pensions contribution in respect of a director drawing a salary of £5,000 an expense laid out wholly and exclusively for the purpose of the trade? Does it make any difference if the director is drawing substantial dividends from the company? What if the pension contribution generates a substantial loss?
We do not know HMRC’s position on this, and it could range from limiting the allowance to the contribution which would be payable by the employee and attract full tax relief – that is 100% of his pensionable income – or £5,000 in this example – to allowing the contribution in full. There might be a restriction to current profits, or to total income drawn by the employee, taking salary and dividends into account.
If we consider that the pension contribution would be allowable to the extent that salary payments of the same amount might be allowable, this would seem to place very little restriction on the payments by a profitable company.
There would seem some merit in this approach, as in larger businesses pension contributions would be part of an agreed salary package. So, if salary of this amount would be allowed, then pension contributions of a similar amount would be similarly allowed.
This would generally leave ample scope for payment of substantial contributions by companies in profitable years, but also provide an added “brake” on contributions in respect of a less active spouse director and family members, in that salary payments to these individuals might be challenged. Traditionally there have been very few challenges to the allowance for directors remuneration in profitable private companies, so the pension contribution might equally be acceptable.
However, there remain some key differences between pension contributions and salary. First, as regards the recipient, of course the money is not available to him to pay for his lifestyle needs.
Thus payment in pension rather than salary or dividend, while tax efficient, may not provide an adequate income stream for the individual. Secondly, National Insurance contributions would be borne on salary payments, making this an inherently more expensive way of rewarding the individual. These two lead to a natural tension which is resolved by careful thought and appropriate advice. We await more information from HMRC with interest!
Article by Rebecca Benneyworth