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MUCH HAS BEEN written about the detail of the pension changes from A-day, 6 April 2006, and I do not intend to repeat them here; instead, I will concentrate on the main change announced in the 2005 Pre- Budget Report. The proposed tax changes in relation to residential property and other specific assets are somewhat unusual. Readers must decide for themselves what to make of them, especially, perhaps, their timing. Gordon Brown does have advisers who guide him in making his decisions but, as Chancellor, he is fully responsible for the strange announcements that are emerging.
The important aspect of the Pre-Budget Report announcements as far as pension planning is concerned, is the ability of pension funds through the medium of a self invested personal pension (SIPP) to be able to invest in residential property after A-day.
The history
It helps to look at the history of residential property being allowed to be used as such an investment.
Under the eight current pension régimes, there are only extremely limited situations where a pension fund can hold residential property as an investment; for example, a flat attached to a commercial property for the use of staff.
In December 2002, the first indication that pensions were going to be simplified was released in a draft of a consultation paper. The full consultation was published in December 2003 in a HM Treasury document entitled 'Simplifying the taxation of pensions: the Government's proposals'. Chapter 4.2 of this document states that 'The new régime will, subject to Department for Work and Pensions requirements, allow pension funds to invest in all types of investments, including residential property'. REV BN 39, the notice following Budget 2004, reiterated in the same terms as in the December 2003 document that residential property would be allowed as a pension fund investment. There was no hint, at any of these stages, of the totally draconian tax and other charges that were going to be announced at what is, in real terms, the eleventh hour on such investments.
The pensions industry and the general public became very excited by the proposed new freedom of investment for pension funds in residential property and much national press coverage was given to it. The prospect of one's pension fund being able to purchase a buy-to-let property with no tax on income or realised capital gains within the fund was felt to be extremely appealing. This was especially so in view of the way that property prices were increasing.
Much was written and many documents came from HMRC and HM Treasury, although nothing, sadly, emerged from the DWP as to their 'requirements'. Still no hint of the draconian charges was given.
The next important link in the paper trail was Pensions Tax Simplification Newsletter No 1 issued by HMRC in June 2005. This promised the chapter of the new pensions simplification bible, the Registered Pension Scheme Manual, on 'Investments — this describes various methods of investing scheme funds and some of the consequences' by the end of September 2005.
This chapter was duly published. However, in view of what was contained in the Pre Budget Report statement just over two months later, I will quote the most important extract from the chapter, RPSM07101060 — Technical Pages: Investments: Overview: Residential property, the sixth bullet point:
'Although any rental income or capital gains from the disposal of the property will be tax free in the pension fund when the money is paid as a pension it will be taxable at the member's marginal rate.'
This is how the pensions industry and the world at large understood the situation to be. In my view, this is what HMRC, the Treasury, Gordon Brown, the pensions simplification team, etc. had led the world to believe in spite of early warnings to them that they may be being too generous with this approach.
Much action!
So the pensions industry, including the major insurance companies, financial advisers, the national and trade financial press, etc. have spent substantial amounts of money, possibly millions of pounds, in developing new products suitable for the new developments, publicising pensions simplification including the potential for residential property purchase, advising clients who have expressed an interest in the residential property situation — all, to what turns out now, to absolutely no avail.
Government intervention
It seems that the Government has become completely paranoid about pension scheme members, directly or indirectly through their self invested personal pension, purchasing a residential property and actually enjoying some benefit from it themselves. This is in spite of already announcing severe tax charges on the enjoyment of any such benefit.
A statement in the HMRC technical note accompanying the Pre-Budget Report reads:
'This is to prevent people benefiting from tax relief in relation to contributions made into self-directed pension schemes for the purpose of funding purchases of holiday or second homes and other prohibited assets for their family's personal use.'
It can be seen that there is no mention of, for example, buy-to-let properties in this statement but the new measures will also make them totally unviable for pension funds, SIPPs in particular. Yes, this is the sledgehammer to crack a nut yet again!
New draconian charges
So, how are residential properties held by SIPPs going to be taxed in the future? You may have thought that, as these are now referred to as 'prohibited assets', pension funds would not be able to invest in them at all, but that is not the case. Presumably it would have been too much of a political climb down to ban pension funds from investing in residential properties altogether, having made such a big thing of allowing them from A-day for such a long period. In view of the monumental tax charges that will be incurred on such an investment, they would have been better referred to as prohibitive rather than prohibited assets. The effect is, in any event, that surely no-one will invite their pension scheme administrator to consider residential property as an investment, so they may as well have been totally prohibited anyway.
The best way to describe the tax charges so that no confusion arises is to quote direct from the HMRC technical note:
'The legislation will be designed to remove all tax advantages from holding prohibited assets directly or indirectly in self-directed pension schemes and will broadly mean that it is at least no more advantageous to hold such assets in a pension scheme than it is to hold them personally.'
In the event, it is likely to be much less advantageous to hold them in a pension scheme. The technical note continues:
'If a self-directed pension scheme directly or indirectly purchases a prohibited asset, the purchase will be subject to the unauthorised member payments charge in FA 2004, s 208. This will recoup all tax relief given on the amounts used to purchase the asset.
'This means that:
- The member will be subject to an income tax charge at 40% on the value of the prohibited asset.
- The scheme administrator will become liable to the scheme sanction charge in FA 2004, s 239, which is a further charge on the scheme member of 15% of the value of the prohibited asset.
- If the set limits are exceeded, the cost of the asset may also be subject to the unauthorised payments surcharge in FA 2004, s 209, which is a further charge on the scheme member of 15% of the value of the asset.
- If the value of the prohibited asset exceeds 25% of the value of the pension scheme's assets, the scheme may be de-registered under FA 2004, s 157, which would lead to a tax charge on the scheme administrator on the value of the scheme assets at the rate of 40% under FA 2004, s 242.
'If the new rules dealing with the investment in prohibited assets are applicable to a particular investment, the pension scheme will also be denied the benefit of tax exemptions on income and gains generated by the directly or indirectly held prohibited assets. Such income and gains will be subject to the scheme sanction charge in FA 2004, s 237, which imposes tax at a rate of 40%. If the prohibited assets produce no, or low levels of, income, the above charge will apply to an amount of deemed income. This will ensure that pension schemes and their members cannot avoid the charges by investing in prohibited assets for personal use which do not generate any income.'
First, how does this final quoted paragraph square with the September 2005 HMRC publication RPSM 07101060 as above which, as stated, says 'Although any rental income or capital gains from the disposal of the property will be tax free in the pension fund …'? Amazingly, this publication was still available on the HMRC website on 12 December, a full week after Gordon Brown's pronouncements.
So, what could the worst case charge be on any pension fund naughty enough to purchase a prohibited asset in spite of the fact that it will be an allowed investment?
The member pays 40% of the value of the asset, plus, if the set limits are exceeded, a further 15% of the value of the asset, plus 40% on the commercial rent and any realised capital gains of the pension fund, presumably after taper relief (the technical note is silent on this) or will it be indexation? Or will it be neither? The Government is straining any credibility over pensions simplification already so nothing would now be a surprise.
The scheme usually pays 15% of the value of the asset, plus, if the value of the asset exceeds 25% of the scheme's total assets and if this leads to scheme de-registration, the total scheme assets would be subject to a 40% charge.
At worst case level, this could net the Government a total of just under 215% of the value of, say, the residential property, the 'prohibited asset', plus 40% of the commercial rent and realised capital gain, which is not a bad deal.
Prohibited assets
The new and unusual legislation will apply to direct investment in residential, and in most forms of tangible moveable, property. These will be collectively referred to as 'prohibited assets', although pension fund investment in them will, as intimated, not be prohibited.
This means that many other assets which would have enjoyed tax free rent or capital gains under pensions simplification, as investments of pension funds, are useless in that regard. Such investments include fine wines, works of art, antiques, classic cars, etc.
The new legislation will also apply to indirect investment in prohibited assets that are a 'close proxy' to direct investment and to other forms of indirect investment that could be used to circumvent the new rules for prohibited assets. The example given is that of a residential property owned by a company in which a SIPP held 100% of the shares.
A twist in the tale is, however, that the Government states that certain products offering indirect investment in prohibited assets will not be subject to the new rules and will obtain pension scheme tax advantages. It seems that genuinely diverse commercial vehicles holding residential properties, such as the new real estate investment trusts, or other prohibited assets will be tax efficient. So, why will not buy-to-lets let to unconnected third parties at a commercial rent?
Protection
The Government has also announced that there may be some protection for pension funds against the new legislation if the assets are purchased before either 5 December 2005 or 6 April 2006 depending on circumstances. The protection is fairly restrictive and, in the main, relies upon not improving or developing the asset. The HMRC note 'Pensions tax simplification — Pre-Budget Report technical note' gives further details.
Planning gain supplement
The Pre Budget Report also announced consultation on a new planning gain supplement, which would apply to both residential and commercial situations. It would not be implemented until 2008 at the earliest but it is set to capture a proportion of the value uplift achieved on land when planning permission has been granted. The question is, would this new tax apply to pension funds? My initial reaction to this is that it must do, but we will just have to wait and see.
Fiasco
So, what is to be made of all of this? Pension simplification has been a Government aim for a considerable period. It is, sadly, no longer simple. As to the promised freedom for members to direct the SIPP administrators to invest in whatever they like, subject of course to Department for Work and Pensions requirements, it has delivered on this, but the severe tax and other charges on substantial classes of assets, including residential property investment, mean that, effectively, it has not.
What a fiasco! Can we trust the Government on anything anymore? Readers must decide for themselves.
As a parting shot, this is all very disappointing but readers should not lose sight of the huge tax and National Insurance savings that pension planning can bring. We all need something to live on when we retire; planning for this via a pension is still, by far, the most tax-efficient way and pension funds can still be directed to invest across a wide range of assets, including commercial property.
Do not miss these opportunities!
Brian Lawless is business development director, Jelf Private Clients.
