Pensions

KEITH GORDON MA, ACA, CTA examines the tax rules relating to contributions to personal pension plans.

SOME YEARS AGO, the BBC used to have a pronunciation department, whose task was to ensure that all of the Corporation's newscasters and journalists dealt correctly with foreign names. A particular example was an African tribal leader whose name caused particular difficulty. Eventually, the employees managed to pronounce his name with confidence, only to report the next day that he had been assassinated.

Many readers will recognise the parallels with tax law: as soon as one set of provisions has been settled, the rules change. Sometimes this amounts to a simple tweaking of the old rules, but often it is easier (and safer) to forget the old completely and learn the new afresh.

One good example concerns the rules for pension contributions. In my articles 'Acceptable Provisions - I and II', Taxation, 22 and 29 October 1998 at pages 85 to 88 and 110 to 111, I set out the rules determining the maximum contributions that could be made to a pension scheme, how relief was given for such contributions, how relief could be claimed in a year other than that in which it was paid and how to deal with excessive contributions. Many of these issues have been superseded by the legislative changes made in Finance Act 2000 which, in the main, took effect from 6 April 2001.

This article considers the rules currently applying to personal and stakeholder pension schemes with reference to the differences from the old rules. All statutory references are to the Taxes Act 1988 unless stated otherwise.

Background to the changes

The changes coincided with the Government's introduction of stakeholder pensions, the low-cost pension scheme designed to encourage workers on lower incomes to start contributing towards their retirement. One of the selling points of the stakeholder régime was its relative simplicity. Following consultation, it was decided that it would be better for these simpler rules to be adopted for personal pension contributions so that there were not different sets of rules being applied in broadly similar cases. The changes did not, however, extend to retirement annuity plans. Although new retirement annuity plans cannot be commenced, they can continue to be relevant in cases where the plan was started before 1 July 1998 (section 618(1)).

For simplicity, this article will refer to personal and stakeholder schemes as personal schemes.

Tax relief on contributions

Provided that all the conditions are met, tax relief is available on contributions made to a personal scheme.

First, virtually all contributions are now made after the deduction of basic rate tax (section 639(3)). Previously, those making contributions in relation to income from self employment were required to make gross payments to the pension scheme. There are rules to prevent abuse of the rules (SI 1988/1013, Regulation 4), and these broadly ensure that the person making contributions net has some affiliation to the United Kingdom (section 632A(3) to (9)).

Secondly, once the net contribution has been paid, the individual does not have to account for the tax deducted (section 639(4)(b)). In particular, notwithstanding the individual's tax position for the year, that money does not have to be paid to the Revenue. The basic rate tax relief is automatic and the individual does not need to have other tax liabilities to be set off against it. So, with the current basic rate of 22 per cent, it only costs £78 to invest £100 in a pension plan.

Thirdly, higher rate relief is maintained for those with higher incomes provided that a claim is made (section 639(5B)). Under the old rules, relief was technically calculated by deducting the gross contribution from an individual's income.

As that method is now inappropriate for non higher rate taxpayers, the legislation uses a different method. It provides the additional relief by extending the basic rate threshold by an amount equal to the gross contribution (section 639(5A)). See Example 1.

Example 1

This method works equally well even if the gross pension contribution exceeds the amount of income otherwise exposed to higher rate tax. See Example 2.

Example 2

Age allowances

Pension contributions have been taken outside the mainstream calculation of a taxpayer's total income, as relief is given automatically. One unintended consequence of this was that the tapering of age allowances (sections 257(5) and 257A(5)) could not be avoided by the taxpayer making pension contributions. The marginal rates of income tax payable by such individuals would have exceeded the tax savings on the pension contributions.

In order to rectify this, the Revenue announced Extra-statutory Concession A102 in October 2001, which states that gross contributions may continue to be deducted from total income for the purpose of applying the taper.

Maximum contributions

There is a limit on how much may be contributed to a pension scheme. However, as part of the policy to encourage contributions, the rules limiting contributions were relaxed to allow payments to be made even though the individual has no earnings for the year.

In any year, the maximum contribution for an individual is the higher of:

• £3,600 (sections 639(1B)(b) and 630(1)), the earnings threshold; and
• P × NRE where P is the relevant percentage for the year and NRE is the individual's net relevant earnings after applying the earnings cap (sections 639(1B)(a) and 638(4)).

The £3,600 earnings threshold may be increased by Treasury order (section 630(1A)).

The relevant percentage for a year depends on the individual's age at the beginning of the tax year (section 640(1)(b) and (2)). These are shown in Table 1.

Table 1

By basing the percentage on an individual's age at the beginning of the tax year, an individual whose birthday falls on 6 April will often be entitled to more relief than someone who was born a day later.

Pension contributions may be made by non-taxpayers (including children) and still qualify for basic rate relief, since contributions are permitted even where an individual has no earnings, subject to the £3,600 limit.

Relevant earnings

One of the limits on the amount that may be contributed to a personal pension scheme is the individual's net relevant earnings for a year. This is defined as the individual's relevant earnings for the year less a number of deductions.

Relevant earnings are defined as any of the following taxable sources of income:

• employment income (subject to exceptions below);
• income from a trade, profession or vocation (whether or not carried on alone or in partnership);
• patent income relating to an invention devised by the individual.

Employment income is not included, however, if any of the following applies:

• the employment is pensionable, i.e. the employee is a member of the employer's superannuation scheme (section 644(3));
• the income is assessable as employment but arising in connection with the acquisition or disposal of shares or share options (section 644(4)(a));
• the income is only taxable under section 148 (section 644(4)(b));
• the employment comes from an investment company of which the individual (together, if necessary, with any past or present directors) has control (section 644(5)).

There are also complex rules excluding income in cases where:

• the individual is a controlling director of a company, or has been in the previous ten years; and
• there has been some previous superannuation scheme which makes a payment of benefits to the individual during the year or has been subject to a transfer payment to a personal pension scheme which has made a payment of benefits to the individual during the year; and
• the income relates to past service (section 644(6A) to (6F)).

However, paragraph 83(2)(b) of Schedule 8 to the Finance Act 2000 ensures that deductions from assessable employment income for the purposes of relieving employees who purchase partnership shares under a share incentive plan do not apply when calculating the employee's relevant earnings.

While one can understand the Government's enthusiasm to ensure that one relieving provision did not necessarily preclude another, one is left wondering how many employees, or their tax advisers, will remember to add back (thereby increasing the relevant earnings) the cost of the partnership shares.

Net relevant earnings

To obtain net relevant earnings, the relevant earnings are reduced by the following:

• patent royalty payments, annuities and other charges on income that would be deducted from trading income (but for the exclusion in section 74(1)(m) and (p));
• deductions from employee's income under sections 197AG (mileage rates), 198 (expenses), 201 (fees paid to professional bodies) and 332(3) (expenses deductible by ministers of religion);
• losses, if the loss arises from an activity such that any profits from the activity would give rise to relevant earnings; and
• capital allowances relating to income treated as relevant earnings (section 646(2)).

It was confirmed in Taxline 1991/17 that deductions under section 201A (fees to agents of actors, etc.) need not be deducted from relevant earnings.

There is a minor error in the legislation relating to the charges on income. It refers to 'section 74(m) [and] (p)', when it should in fact refer to 'section 74(1)(m) and (p)'. There is therefore the argument that individuals do not actually need to make the deduction intended.

If an individual is to make contributions based upon net relevant earnings, i.e. they exceed the earnings threshold applicable for the year, the pension company will require evidence of the individual's earnings (SI 1988/1013, Regulation 5(2)(e) and (2C)).

Deductions

In most cases, the deduction from relevant earnings should be made in the tax year to which it relates. However, in some cases, the deduction is deferred to later years. This will arise if:

• the deduction relates to a loss or a capital allowance; and
• the individual is a higher rate taxpayer in the tax year in which the loss or capital allowance is taken into account when determining the individual's taxable income for the year; and
• the loss or capital allowance is deducted from income other than the relevant earnings to which it relates (section 646(5)).

In these circumstances, when calculating net relevant earnings, the loss or capital allowance is only deducted from the relevant earnings. If there are excess losses or capital allowances, these are carried forward and deducted from future relevant earnings irrespective of the individual's pension contributions or whether he is a higher rate taxpayer in that later year. Again, any surplus is carried forward until exhausted (section 646(6)).

This provision ensures that losses and capital allowances are not completely ignored if tax relief, for example, under section 380, is obtained by setting them against general income of the year. It should be noted, however, that:

• the losses and capital allowances can be effectively ignored if they are used to reduce net relevant earnings in a year which is not used for pension contributions; and
• there is no equivalent rule for losses that are set off against capital gains under section 72, Finance Act 1991, although the rule will apply to the part of the loss that is subject to the related section 380 claim.

Cap on net relevant earnings

The figure for net relevant earnings used in the calculation of the maximum contribution that may be made in any tax year is capped in line with the maximum used for final salary pension schemes (section 640A). The current cap is £97,200 (2002-03). This increases annually in line with inflation and is rounded up to the nearest multiple of £600 (section 590C(5)).

Employer contributions

Some employers choose to make contributions directly into their employees' personal schemes. Such payments escape income tax (section 643(1)) and National Insurance contributions (SI 2001/1004, Schedule 3, Part VI, paragraph 2) and are therefore attractive to employees and employers alike.

The following, however, should be noted:

• contributions by employers are made gross (section 639(3)); and
• the limit on contributions for the year is reduced by the amount paid by an employer.

Furthermore, employer contributions can have an indirect effect on the contribution. Since the contributions are not subject to income tax, they do not count as relevant earnings and therefore do not increase the maximum. See Example 3.

Example 3

Interaction with retirement annuity plans

Although retirement annuity plans, to the extent that they remain open to previous investors, do not allow such high percentages of income to be contributed, the earnings cap does not apply to such schemes. As a result, some very high earners are able to benefit from continuing to keep their old schemes open.

Contributing to a retirement annuity plan does not preclude contributions to a personal pension or stakeholder scheme. However, complex rules define the maximum aggregate contributions that may be made.

First, the maximum contribution to a personal pension in any year is reduced by the amount contributed to a retirement annuity plan in that year, and qualifying for relief under the rules for retirement annuity plans (section 655(1)(a)). Therefore care needs to be taken in years where the maximum contribution to a retirement annuity plan exceeds the maximum contribution under the personal pension scheme rules. See Example 4.

Secondly, while unused relief can still be carried forward under the retirement annuity plan rules (section 625) the amount of unused relief carried forward is reduced by any amount contributed to a personal pension scheme (section 655(1)(b)). It was made clear by the Special Commissioners' decision in Brock v O'Connor [1997] SpC 118 that this applies to unused relief originating from previous years as well as unused relief arising in the year to which the personal pension scheme contribution relates.

Example 4

Excess contributions

Excess contributions were briefly alluded to in Example 4, where it was stated that the excess should be repaid. This repayment should be made to the individual, or to the individual's employer if the employer has made the excess contributions (section 638(3)(b)).

There is, however, a moot point concerning the interaction of this rule with the earnings cap. Section 638(3)(a) provides that the scheme must not allow the total contributions to exceed the greater of the earnings threshold (currently £3,600) and the permitted maximum. The permitted maximum is subsequently defined as 'the relevant percentage of the member's net relevant earnings for the year' (section 638(4)). At first glance, this is the maximum amount on which tax relief can be given (under section 640). However, section 640 alone is subject to the rule in section 640A limiting an individual's net relevant earnings by the earnings cap.

It therefore appears that the earnings cap does not apply to section 638(3), and so additional contributions may be made to a scheme although they will not qualify for immediate tax relief.

Part II of this article will look at the new rules dealing with the relating back of contributions and allowing one year's earnings to be used as the basis of contributions for future years.

Keith Gordon is a director of ukTAXhelp Ltd, a company specialising in providing tax advice to other professional businesses. He can be contacted by e-mail on keith.gordon@ukTAXhelp.co.uk. The views expressed in this article are those of the author.

Issue: 3885 / Categories: Comment & Analysis