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THE DEDUCTIBILITY, OR potential lack of it, for corporation tax purposes of company contributions to pension arrangements for directors, particularly shareholding directors, of private limited trading companies was the subject of my article 'Be Warned!', Taxation, 25 August 2005, page 576. The 'new' rules regarding deductibility of such contributions are such that, instead of the automatic deductibility that pertained, within limits, before 6 April 2006, to be deductible from this date, the contributions have to be expended 'wholly and exclusively' for the benefit of the company's trade, the provisions of TA 1988, s 74(1)(a) are to be applied.
The situation was extremely unsatisfactory inasmuch as HMRC seemed reluctant to produce any form of proper guidance as to how they will apply these provisions to company contributions. I have had protracted correspondence with HMRC to urge them to produce clear and transparent guidance since March 2005 with little success, that is, possibly, until now. I say possibly because you will have to make up your own minds as to how clear and transparent the guidance actually is.
The only real guidance given prior to the new attempt was to refer to the general guidance on the topic of 'wholly and exclusively' given in HMRC's Business Income Manual at BIM 37000 onwards. A close examination of these paragraphs revealed that the only case that seemed to have any bearing on the situation was that of Samuel Dracup v Dakin 37 TC 377 which intimated that there may well be no deductibility of company contributions for controlling directors from A-day. A look at this case may pay dividends: a good outline of the facts and reasoning is given at BIM 37745.
Latest development
We now have some draft guidance. This was issued in January 2006, and far too late for companies with an accounting period ending after 5 April 2006. Comments on the draft guidance should be submitted to HMRC by 17 February 2006. I strongly advise that readers consider doing so if they feel that the draft guidance is lacking in any way. The full draft guidance can be found on the HMRC website by typing into their search engine 'Employers' contributions to registered pension'.
It is all company pension contributions that are covered by the draft guidance as they are now all subject to the provisions. I will concentrate on the contributions made in respect of, as HMRC put it, 'controlling shareholders or employees who are close relatives or friends' as this is the area that my previous article dealt with.
In HMRC's defence, I would suggest that they have been under immense pressure to produce material on pensions simplification for a long time. They are very well advanced with the Registered Pension Scheme Manual, a substantial tome that does give great assistance to those involved in giving advice on pensions. They have also had to deal with implementing the Government's change of heart with respect to pension funds investing in residential property after A-day; see my article 'Home, not so sweet home!', Taxation, 12 January 2006, page 351. In addition, they have to devise a way of preventing the recycling of tax free cash sums from pension funds into further pension contributions to generate more tax relief, which was another last minute introduction by the Government.
Draft guidance
The draft guidance should form BIM 46025; note that it is going into the Business Income Manual as opposed to the Registered Pension Scheme Manual. It is headed 'Specific deductions: Registered pension schemes: Controlling directors and shareholders' and begins:
'A pension contribution to a registered pension scheme in respect of any director or employee will be an allowable expense except where there is a non-trade purpose for the payment.'
This indicates that there may be a trade purpose and a non-trade purpose for the payment, i.e. a duality of purpose. If this is the case, perhaps none of the payment should be deductible, as in its entirety it cannot be said to be 'wholly and exclusively' for the purposes of the trade. A reference to BIM 37707 indicates that it is only the excess, i.e. the portion of the payment that is not for a trading purpose, that is not deductible, but there is a form of contradiction in BIM 37745 where the whole payment was disallowed in spite of the judge in Dracup v Dakin stating 'You were laying out the money for your own advantage and not for that of the company, or, at any rate your own advantage came into it …' (my italics). Also, the heading of BIM 37745 includes the words 'Duality of, or non-trade, purpose' which is all very confusing.
The draft guidance covers Dracup v Dakin by saying that 'where there is a non-trade purpose for the payment, then the payment is disallowable'. An analysis of the actual words used suggests that there could have been some trade purpose in the payment but, in the event, it was all disallowed.
It is also in this part of the draft guidance that the reference is made to a 'director who is also a controlling shareholder or an employee who is a close relative or friend'. What is meant by this statement?
Looking at the remainder of BIM 46025, the references seem to indicate that a spouse is the close relative that HMRC are worried about. It may be that 'close friend' may include a partner or common-law spouse. Presumably a civil partner would be included. There may well be other close relatives or friends who would be relevant.
The example
In my view, the main reason for needing guidance is to establish the corporation tax treatment of company contributions to pension arrangements for controlling shareholders/directors.
Sadly, the example given seems to relate in its entirety to a company's only shareholder's spouse who, by definition, is not a shareholder. There are five bullet points that relate to the example: some of the factors could also relate to the shareholder himself but there are difficulties with this that I will deal with later. The example states:
'For example, a small company may employ the only shareholder's spouse. The company pays him ['him' presumably being the spouse and not the only shareholder] a salary of £40,000 and contributes to a registered pension scheme that is to provide him with pension benefits.
'The type of additional evidence to look for to be satisfied that the contribution to the scheme is paid wholly and exclusively for the purposes of the trade would be:
- Are there any comparable third party employees? If the spouse works alongside an unrelated third party and they have comparable salaries, pension contributions, terms and conditions, this would indicate that there is not a non-trade purpose [why the double negative?] for paying the contribution.
- If the pension contribution paid on behalf of the spouse is greater than that for an unrelated third party, then is there any business reason for this? Or is this an indication that there was a non-trade purpose for the payment?
- Additional information could indicate that there are special reasons for the size of the pension contribution. For example, the pension fund may have a funding deficit as a result of losses on its investments.
- It is possible that the right question is not so much the level of pension contributions, as the level of salary. Does the level of salary reflect the value of the work undertaken by that individual for the employer. If not, then it is likely that there is also a non-business purpose for the payment of the pension contributions.
- Where the salary is less than the commercial rate and the size of the pension contribution appears to have been inflated, you will need to establish why this has been done and whether any tax or National Insurance planning for the employees was one of the purposes for the size of the pension contribution rather an incidental benefit arising from it.'
And that is it.
Analysis — spouse employee
As far as the spouse is concerned, in the example the husband, the criteria seem reasonable: he is solely an employee, there is no hint that he is a director and because he has no shares in the company he cannot be remunerated by dividends. It is also odd that, although HMRC identify the amount of the salary, they do not identify the amount of the pension contribution.
I will deal with each bullet point in turn. With regard to comparable third party employees, it is probably reasonable to draw a comparison with other employees as far as the employee spouse is concerned but many small companies may not have other employees where salaries of £40,000 are being paid.
As far as the second bullet point is concerned, I wonder what type of business reason HMRC has in mind. Perhaps the unrelated third party works part time?
The special reason given in the third bullet point is rather strange; funding deficits usually only occur in defined benefit schemes and these are very rare in what looks like a rather small company. The new concept of a cash balance scheme may be relevant here although, again, I think these will be rare for this type of company.
With regard to the fourth bullet point, it may be reasonable for the employee spouse to relate the amount of the salary to the value of the work undertaken, although it will be interesting to see how HMRC intend to measure the value of that work. This becomes very relevant for the actual shareholder (see below) but this has not really been dealt with in the draft guidance.
The fifth bullet point does cause concern. For an employee with no shares, spouse, friend or otherwise, if the salary is less than the commercial rate (we are back to looking at the value of the work undertaken here to establish what the commercial rate should be) and the pension contribution appears to have been inflated, HMRC may be entitled to ask why. The problem is that virtually all pension planning, perhaps other than a company pension scheme for employees, tends to have tax and National Insurance contribution planning as a motive rather than just an incidental benefit.
Analysis — shareholder
This, I am afraid, is where the wheels seem to come off as far as draft guidance for controlling directors and shareholders is concerned. You will recall that these classes of individuals are those in the title of this part of the draft guidance, not their non-shareholding spouses. They are also the individuals about whom the market is most concerned: how are HMRC going to view company pension contributions on their behalf? Are we any further forward in understanding this? Again, I will leave it to you to decide.
I will attempt to analyse the bullet points in the example as if they referred to a controlling director/shareholder. It is difficult to take each bullet point separately as it is really the overall picture that should be looked at for what I will refer to as the 'controller'.
Can there be any comparable third party employees against whom a measure can be made? My view is that the answer in the vast majority of small company situations is 'no'. The controller director invariably runs the business, as the whole enterprise is his responsibility. He will usually work very long hours and will put in effort that is above and beyond the call of duty. Where would you find an employee with no, or even a little, stake in the business prepared to put in so much effort? The controller may, for example, have had to give personal guarantees for business borrowing; he stands to lose much more than just a job if the business goes under. As a corollary, he is trying to make a success of the business so that he can enjoy capital value from it on ultimate disposal, or pass it down through the family. Neither of these aspects will have any relevance to a third party employee.
The controller, in today's high National Insurance contribution environment, will tend to only take a low salary and will try to take his other remuneration by way of declared dividends. If an attempt was made to find a third party employee to do work to a similar value, that employee would want a much higher salary and would be quite likely to want substantial pension contributions from the company as well, and these would probably be deductible. Does this mean that high company pension contributions on behalf of the controller could also be deductible in spite of only taking a small salary? The answer is probably no, but why not? The controller is, as stated, invariably undertaking high value work within the context of the business so, in the context of the 'wholly and exclusively' provisions, should the company pension contribution not be looked at in isolation to the amount of salary taken?
It seems to me that the introduction of 'wholly and exclusively' provisions into the company pension contributions arena, specifically as it refers to controllers, is really only to try and combat the fact that salaries have been lowered and dividends increased to reduce National Insurance contributions. The Government should just admit this.
Many of the owners of small businesses have had one kick in the teeth already recently with the announcement of the abolition of the starting and lower marginal rates of corporation tax from financial year 2006, this looks like another one.
Search for a conclusion
It is difficult to reach a conclusion. If you are an accountant or a pensions adviser, and the draft guidance becomes actual guidance, would you be confident that you would always be able to calculate the amount of company pension contribution that would be deductible in respect of the company controller?
From another part of the draft guidance it is apparent that HMRC are prepared to split a company pension contribution between a trade and non-trade purpose, so some of it could be deductible, even for a controller.
Good luck in trying to advise relevant clients on this knotty issue!
Brian Lawless LLB(Hons), FCII, Dip PFS, FRSA, TEP, chartered insurer is business development director of Jelf Private Clients.
Editorial note: HMRC have now also issued their guidance on the way that the lump sum 'recycling' provisions, announced in the pre-budget report, are intended to operate. They can be found at http://www.hmrc.gov.uk/pensionschemes/recycling-guidance.htm. At first sight, it appears that there are many problems with these proposals as well, and the idea that pensions were to be 'simplified' is becoming laughable. An article by Anne Redston on the recycling provisions will appear in a future issue of Taxation.
