Better Business:Taxing pensions

Paul Burgin looks at the new Special Annual Allowance Charge on pension contributions.

The latest incarnation of the Special Annual Allowance Charge rules cuts the relevant income threshold to £130,000 from 9 December 2009. The tax penalty applied from April 2011 will be set at the ‘appropriate rate’, allowing the tax man to increase it from 20% to 30% to reflect the new 50% income tax band.

John Lawson, head of pensions policy at Standard Life, is concerned with the final legislation, which will come into force by 6  April 2011. Once all higher rate allowances disappear, he expects high earners to withdraw from employer schemes, particularly defined benefit structures. In the public sector, Lawson estimates as many as 100,000 employees will be caught, including doctors, dentists, GPs and senior teachers.

“When they suddenly get a tax demand for tens of thousands of pounds in 2012, there will be a backlash from this very influential group of people,” he predicts.

Last April, the Chancellor announced plans to reduce the relief available to these ‘high income individuals’ from April 2011. Relief will be tapered for incomes between £150,000 and £180,000 and set at the basic-rate limit of 20% on gross incomes over £180,000.

D-day for A-day

The plan created a potential problem for HM Revenue & Customs. The Government said high earners would bring forward their pension contributions by using the generous annual allowance introduced in the A-day simplification, resulting in a relief loss to tax coffers of £2bn.

To compensate, a Special Annual Allowance Charge was introduced to catch those who increase their contributions solely to benefit from higher-rate relief. The ‘anti-forestalling’ penalty cancels out additional relief on increased contributions that stray from previous payment patterns, effective from 22 April 2009, known as the ‘relevant date’ for calculating what tax charge, pension contribution level and income apply.

The 20% penalty is to be collected through self assessment. In original form, it applied to people whose income is over £150,000, who change their normal ongoing regular pensions savings and whose total pension savings exceed £20,000. It does not apply to those earning less than £150,000 per year in the last two tax years. Those with higher earnings and pension contributions that do not increase or remain within the £20,000 limit are also exempt. Relevant income for the current tax year allows deductions such as business loss write-offs and Giftaid.

Personal pension contributions to £20,000 can effectively be deducted too.

But employer contributions are caught by the rules. They include salary sacrifice applied to pension contributions or additional pension benefits put in place after 22 April 2009. For money purchase schemes, total contributions are counted. For DB schemes, the tax man counts any increase in the value of accrued rights during the period. The Pre-Budget Report tightened the rules and increased the tax penalty.

Under the Pre-Budget amendments, the Special Annual Allowance tax charges will be in future set at the ‘appropriate rate’. This will allow the rate to increase in tax year 2010/11 from 20% to 30% to reflect the new top rate of income tax. The floor at which the anti-forestalling rules apply was dropped from £150,000 to £130,000, with effect from 9 December. For those whose income lies between the two bands, the tax charge will apply only to additional pension savings above the normal level from the new ‘relevant date’. Any individual whose gross income minus employer pension payments is less than £130,000 will continue to benefit from full tax relief.

Additional allowances up to a total £30,000 exist for those who make infrequent pension contributions (less than once per quarter). Pre-determined increases, such as those linked to salary or average earnings, that take contributions above the £20,000 limit, will continue to attract additional relief.For all other regular contributors who used to pay in less than £20,000 per year and increase them, the penalty still applies to payments over the £20,000 limit.

If regular pension payments already exceed £20,000, the charge will apply only to any additional payments in excess of the current level at the relevant date.

Tom McPhail, head of pensions research at Hargreaves Lansdown, believes the new rules are overly complex and will likely cost more to administer than they save in tax relief. He says: “They will certainly cost UK plc far more as companies change remuneration policies, close final salary schemes quicker and company directors become disenchanted with long-term savings.”

Establishing regular contribution patterns makes the process bureaucratic. Each high-earner tax submission affected by the rules will have to be dealt with on a case-by-case basis.

McPhail says: “The move breaks the principle that you only pay tax once on pensions. The system takes money when you earn it, gives it back when you defer consumption, then taxes your income at the end.”

Lawson thinks the interim rules are confusing but not onerous on higher income earners who maintain their regular contribution patterns. But irregularities in last year’s legislation need to be addressed. “As it stands, you can lose your protection on contributions over £20,000 if you move employer or scheme. Those moving to a smaller scheme with less than 20 employees are particularly at risk,” he says.

Financial secretary to the Treasury Stephen Timms was inclined to agree with Standard Life and others in the industry who lobbied for change. Amendments are expected within one month.