This note which describes changes to the United Kingdom tax regime relating to pensions will be of interest to entities with UK operations and employees.
Background
In spring 2009, the then Labour Government announced detailed and complex changes to the system of tax relief applicable to members of UK pension plans. The changes were to be effective from April 2011. In the interim, an "anti forestalling" regime was introduced which effectively limited pension contributions and accrual for many higher rate tax payers, to prevent higher contributions being made in the two years before the proposed restrictions on tax relief came into force.
Immediately after the spring election the new Conservative/Liberal Democrat Government (the "Coalition") announced that it would scrap the Labour proposals. The Coalition then carried out a consultation, over summer 2010 on the possible approaches to restricting pension tax relief.
Proposals
On 14 October, the Coalition issued its final decision on pension tax relief restrictions.
With effect from April 2011, the maximum amount which can be contributed to a tax-favoured pension arrangement without a member being subject to tax will be £50,000 per annum.
From April 2012 the "lifetime allowance", i.e. the maximum amount which can be accumulated in a pension arrangement without attracting any additional tax charge on the member, will reduce from £1.8 million to £1.5 million. Where an individual already has a sum accumulated greater than £1.5 million the Coalition intends to bring forward legislation which will protect that accumulated pot (and we assume investment growth) from any additional tax, but the individual must then cease any form of pension saving which attracts tax relief.
In defined contribution arrangements, monitoring the amount contributed in any year is relatively straightforward. However, there are obvious problems in monitoring the "attributable" or deemed contributions into defined benefit plans. The Coalition intends to bring forward arrangements under which, in respect of defined benefit arrangements, members' benefits will be valued at the beginning of the year in question and an uplift applied to allow for a deemed (revaluation/inflation) increase which will not give rise to any tax charge. The member will then be subject to a charge on the value of the further deemed increase determined using a formula. For example, if the member's total pensionable accrual in respect of a year increases by £1,000 that will be deemed to have used £16,000 of the yearly annualallowance based on a conversion factor of 16 which will be the factor adopted for converting £1 of pension to a capital value.
To allow for some "spikiness" in actual or deemed contributions, for example where individuals are promoted and/or receive large salary increases in any given year, a form of "carry back" will be permitted so that where the contribution in any given year exceeds £50,000, if the member has unused spare capacity in the previous three years, that can be used to offset the charge, eg, if the member's actual or deemed contribution in a plan is £60,000 but in the previous year the contribution was only £40,000, the member will not be subject to tax because they will be able to use a credit of £10,000 from the previous year.
No charges to tax will arise where a member is subject to a serious ill health retirement, (e.g. where the employer then provides under a defined benefit plan for some form of enhanced early retirement benefit), or in the event of the member's death (e.g. where this gives rise to some form of enhanced spouse's pension). However, no exemptions will apply for redundancy (severance) cases.
Draft regulations which are to be the subject of consultation are expected to be issued during the course of the next six months for review and discussion covering the deeming provisions.
Where contributions exceed the £50,000 annual allowance and there is no "carry back" relief available, the member will be subject to a tax charge at his or her highest marginal rate. The Coalition is to consult on proposals under which, where the tax charge is large and it may not be appropriate to collect it through the income tax system, the charge may be paid out of the member's retirement account perhaps at retirement.
Impact
We anticipate that the change, while welcome, since it removes a great deal of the complexity in the previous tax restriction proposals, is likely to accelerate the growth of defined contribution arrangements and the further decline of defined benefit arrangements. From the perspective of members and employers, it is easier to understand and track contributions to defined contribution arrangements than the deeming provisions and charges applicable to defined benefit arrangements.
The good news is that for members who pay tax at higher rates tax relief will continue to be granted at the highest available rate but only on contributions up to £50,000.
For employers who currently operate defined benefit plans, we anticipate that a considerable of time will now be taken up discussing with the plan trustees mechanisms either for limiting defined benefit accrual and/or managing the new tracking system which will have to be introduced to alert members to deemed tax charges in each tax year.
Where employers provide defined contribution arrangements, we anticipate that a review will be necessary of current contribution levels, and members' employment contracts. We think it likely that most members who would prefer to restrict contributions so that they do not exceed the annual cap rather than pay tax charges at the time the contributions are made or have charges deducted from accrued contributions.
The Coalition has also announced that it intends to review alternative arrangements which have been used for example "Employer Funded Retirement Benefit Schemes" which currently do not qualify for tax approval but where it may have been possible to deliver benefits at a later date a reduced tax rate, to determine whether or not these should be the subject of further scrutiny. We think it possible that arrangements of this nature are likely to be the subject of considerable review and particularly where they are funded the Coalition will consider whether or not some form of tax may be applied to any accruing benefit.
While further details are still being developed, we do not anticipate that there will be further changes to the "base-line" £50,000 restriction or to the £1.5 million lifetime cap.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.