An important facet of the new rules is that contributions by an employer
need no longer bear any relation to or link with salary. The only effective
restriction on an employer’s ability to obtain tax relief for contributions
to a pension scheme will be the annual limit (the initial figure for 2006/2007
is £215,000, although this will rise annually). This limits the amount by which
the capital value of a member’s pension fund may rise as a result of
tax-relieved contributions without a personal tax charge being imposed on the
member.
An employer is fully entitled to make contributions that exceed the annual
limit, and will obtain Corporation Tax relief for doing so. However, exceeding
the annual limit will cause the employee to be taxed on the excess as though it
was income. Intriguingly, neither the 2002 and 2003 discussion documents, nor
the 2004 Budget proposals, speak of a National Insurance charge on excesses.
This could open a useful avenue for profit extraction from owner-managed
businesses:
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Example
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Veronica is the owner/director of ABC Ltd. She
arranges for herself a pension contribution of £200,000 and a
bonus of £100,000.
Veronica is taxed on £100,000 of income. The company pays
Class 1 NI contributions on £100,000 (£12,800 at current rates),
and obtains tax relief on the full £312,800. Assuming Corporation
Tax at the 30% rate, the cost to the company is £218,960.
Alternatively, the company pays £300,000 into the pension.
Veronica is taxed on the £100,000 excess. The company obtains
CT relief on the full contribution, but pays no NI contributions.
The overall cost is £210,000.
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For contributions by the scheme member himself, whether an employee,
self-employed or unemployed, the annual limit will not be the sole restricting
factor. Contributions by a scheme member which exceed the higher of £3,600 or
the member’s UK earnings will not qualify for any tax relief.
If a member’s income is below the annual limit, he can make contributions in
excess of income, but these will not obtain tax relief.
If the member’s income exceeds the annual limit, he will be able to obtain tax
relief on a contribution in excess of the annual limit. He will, however, be
subject to a tax charge (the “recovery charge”) on the excess.
Contributions which exceed both the annual limit and the member’s income can
still be accepted into the pension scheme. They will, however, be entirely
tax-neutral: they will not attract tax relief, but they will not be subject
to the recovery charge.
Since the bulk of the tax relief is given at source, at the time contributions
are made, while the tax charge is only made as part of the self assessment tax
return some time later, this can give rise to a slight but significant cash-flow acceleration for someone seeking to make substantial increases to the pension fund:
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Example
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Tarquin is self-employed, and his profit is £315,000. He decides
to top up his pension fund by making a contribution of £315,000 on
7 April 2006, while the annual maximum is £215,000.
The full contribution is eligible for tax relief. The basic rate
relief is given at source, so that Tarquin only needs to pay 78%
of the contribution, or £245,700, on 7 April 2010.
When he submits his tax return on 31 January 2012, Tarquin is able
to claim higher rate tax relief (18% of the contribution, or £56,700). He is also taxed at 40% on the excess over the annual maximum. This gives a charge of £40,000. Shortly after 31 January 2013, Tarquin will be eligible for a tax refund of £16,700.
Taking the entire transaction as a whole, Tarquin has placed £315,000
into his pension scheme at a cost of £229,000. This is the equivalent
of obtaining 40% tax relief on £215,000 and no relief on the remaining
£100,000.
However, Tarquin obtained 81% of this tax relief as early as April
2010, with only a small proportion being delayed until the tax return
is submitted.
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The annual limit applies to all contributions, both employer and employee.
If both parties plan to make contributions, care needs to be taken to ensure
that the limit is not exceeded.
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