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IN THE BOOK 1066 and All That, everything was either 'A Good Thing' or 'A Bad Thing'. Until recently, recycling was invariably 'a good thing', encouraged by government. But last year's Pre-Budget Report contained a Technical Note on pensions recycling, clearly 'a bad thing'. The Note (on the Internet at www.hmrc.gov.uk/pbr2005/pensions-simplification.pdf) said that 'The [pensions recycling] device works by the scheme member withdrawing a tax-free lump sum which is reinvested back into a registered pension scheme, automatically generating further tax relief on the amount reinvested. This in turn allows a further tax-free lump sum to be paid out, so that the cycle can be repeated'.
HMRC recognised that this 'device' actually provides limited scope for tax minimisation. 'Given that pension income is taxed at a member's marginal rate, anyone re-cycling in this way is effectively exchanging a tax-free lump sum for a future stream of taxed income and therefore the potential benefits are unlikely to be large.'
Nevertheless, it was 'abusive' and new legislation would 'remove tax advantages in relation to lump sums which are artificially recycled in this way', where the 'sole or main purpose' of taking the lump sum was to reinvest it in another scheme. However, the Note also sought to reassure, saying that 'this legislation will not affect cases where a person withdraws a tax-free lump sum as part of the normal course of taking pension benefits'.
New guidance
On 3 February 2006, HMRC published detailed guidance explaining how the new avoidance rules will work, along with an amendment to the pensions legislation. The next Finance Bill will insert a new provision, paragraph 3A ('Recycling of lump sums') into Finance Act 2004, Part 4, Sch 29. The new paragraph can be found at www.hmrc.gov.uk/pensionschemes/j1027.pdf and the guidance is at www.hmrc.gov.uk/pensionschemes/recycling-guidance.htm. At the time of writing, both are in draft form; the legislation will be effective from 6 April 2006.
The key question is whether the rules have succeeded in targeting only the abuse, while leaving ordinary taxpayers safe from unexpected and inappropriate attacks on their pension provision. At first glance, it looked as if HMRC had unleashed another raft of complex rules which taxpayers and agents would struggle to understand and apply. However, more detailed examination suggests that this may be unfair. The following paragraphs summarise the position as I understand it, and hopefully will provide some pointers to practitioners trying to find their way through the new rules. All legislative references (subparas), unless otherwise stated, are to new paragraph 3A, and all paragraph and example references are to the guidance.
Motive test
The first, and perhaps the key point, is that the rules contain a motive test (subpara 2(b) and paragraphs 4.1 and 4.2 of the guidance). For the avoidance rules to bite, the pension scheme member must have 'pre-planned' to recycle the pension lump sum. This pre-planning must take place at 'the relevant time', which is normally when the lump sum is taken. However, if the individual tries to avoid this by paying increased contributions ahead of receiving the lump sum (e.g. by obtaining a loan) and then using the lump sum to repay the loan, then the 'relevant time' is the time he makes the increased contribution, see subpara 6(b).
Thus, the avoidance rules explicitly do not apply where (my italics):
'the member receives a pension commencement lump sum, and after receipt of that lump sum, the member decides to increase, significantly, contributions to a registered pension scheme or contributions that are paid in respect of the member are significantly increased.' (Guidance paragraph 13.1, final bullet)
It is for the reader of the guidance to remember that this motive test is one of the keys to understanding the rules, as some of the later examples forget mention it. For instance, Examples 3 and 9 in the guidance describe transactions caught by the new rules, and which thus must have involved pre-planning, but neither refer to this key pre-condition.
Reinvestment amount derived from the lump sum
There is also an overriding rule that, to be caught, the reinvestment must be possible because of the lump sum. New subpara 2(a) confirms that the provisions will apply when 'because of the lump sum, the amount of the contributions paid by or on behalf of, or in respect of, the member to the pension scheme, or to any other registered pension scheme, is significantly greater than it otherwise would be .…'
Again, the reader has to remember this principle as he or she reads through the guidance.
In Example 15 an individual inherits money at the same time as taking his lump sum and, because of the inheritance, makes an extra contribution into his pension scheme.
In Example 16 an increase in the individual's business profits provides the source of the extra pension contribution; in Example 17 the individual has a 'genuine windfall' when his numbers come up in the National Lottery; and in Example 18 he receives a financial settlement on a divorce.
In none of these cases are the anti-avoidance rules triggered, although each time significant extra contributions are made to the individual's pension funds at the same time as a lump sum is taken. It would be helpful if HMRC could remind the reader why this is, by referring back to the legislation.
No material changes
The principle that, to be caught, the reinvestment must occur 'because of the lump sum' means that, where there have been no material changes to the contribution pattern, HMRC will accept that the rules do not apply.
In Example 5, the contributions have increased significantly at the same time as a lump sum is taken, but the percentage of salary contributed remains the same as in previous years. What has changed is the salary itself. HMRC say that this is not caught by the avoidance rules 'because the basis on which the contributions were paid remained the same'. However, this point appears only in the examples; it would be helpful if the guidance was explicit about HMRC's 'no material change' interpretation in its opening paragraphs.
Material change, externally driven
Example 7 contains a further useful extrapolation from the 'because of the lump sum' rule. Here, the contributions are again significantly increased at the same time as a lump sum is taken, but the reason for the increase is:
(a) because the employer ends its pension holiday; and
(b) simultaneously increases the required employee contribution.
HMRC say that this is not caught by the avoidance rules, again because 'the basis on which the contributions were paid remained the same'.
As a question of fact, this is not the case — the basis on which the contributions have been paid has materially changed, but the change has been caused by factors wholly external to the member and without any intervention by him — i.e., the increase is not 'because of the lump sum'. Again, the guidance would be easier to use if this interpretation had been included in the opening paragraphs.
The financial limit and 20% tests
If a lump sum followed by a reinvestment does not satisfy the above requirements, so that the reinvestment is both pre-planned and 'because of the lump sum', there are still two further tests, both of which must be satisfied before the avoidance rules bite. These are the £15,000 limit and the 20% tests, see subparas 3 and 4. Under these provisions, the lump sum only falls within the avoidance rules if:
- when taken together with any other lump sums within the last twelve months, the total is more than £15,000 (subpara 3); and
- the amount reinvested is more than 20% of the lump sum (subpara 4).
It should be noted that the first test relates to the whole of the lump sum(s) received, not the amount reinvested; whilst the second test applies to the reinvestment amount.
This means that an individual taking a lump sum of £200,000 could reinvest up to £40,000 without triggering the rules because, whilst the £200,000 breaches the £15,000 rule, the £40,000 contribution is not more than 20% of the lump sum. However, an individual with a lump sum of £29,000 who reinvests £14,500 is caught by the rules. Although the reinvested amount is less than £15,000, that limit relates to the lump sum received, which here is (as was the £200,000) more than £15,000, and there is no 'escape' under subpara 4 because the reinvested amount (£14,500) is now more than 20% of the £29,000 lump sum.
Table 1
Year 1: Lump sum taken of £20,000; pension payments increased from £10,000 pa to £10,500.
Year 2: Contributions increase by a further 5% to £11,000.
Year 3: Contributions increase by a further 5% to £11,500.
Year 4: Contributions increase by a further 5% to £12,000.
Total contributions have now increased by £5,000 (500 + 1000 + 1,500 + 2,000) which is 25% of the lump sum, and so the avoidance legislation is triggered.
Cumulative periods
In calculating the 20%, the guidance states that it is not enough to look only at a twelve-month period. Examples 8 and 9, taken together, are set out in Table 1 above.
This is extremely unsatisfactory. Clearly, if a time line is continued for long enough, most people will fail this numerical test. It is unfair to give taxpayers these apparently helpful limits and then stretch them into an unknown future so that they become meaningless.
A four-year period is very long, particularly in the context of the normal self assessment enquiry deadlines. And four years is not necessarily the end of the story — it simply happens to be the year, in Example 9, that the individual's relatively small increases in investment tip him over the limit. The guidance nowhere gives a time limit beyond which the reinvestment amount can be regarded independently of an earlier lump sum.
Question 4 (Q4) at the end of the Guidance Note (see section 15, 'Questions and answers') asks 'What information must be kept to satisfy HMRC that the payment of a pension commencement lump sum is not being used as part of recycling?' and answers that 'individuals should already keep documentation for self-assessment purposes'.
This adds weight to the view that taxpayers should only be required to consider their reinvestment position within the normal self assessment time limits for enquiry.
The structure of the guidance
Despite the existence of key principles which have to be satisfied before the avoidance legislation is in point, the text of the guidance often seems to forget them and instead concentrates on the more concrete £15,000 and 20% tests.
Example 3 does not mention pre-planning, or the need for the funds reinvested to be 'because of the lump sum'. Example 18 appears to put the onus on the taxpayer to prove a negative (my italics). 'The contribution by the employer for the annuity is not a recycled contribution provided it can be shown that the amount of the intended contribution towards the annuity awarded by the employer has not been increased to any extent as a consequence of any agreement between the individual receiving the annuity and the employer that would have involved the individual using the pension commencement lump sum as means of increasing the employer's contribution towards the annuity the employer is to provide for the individual.'
Example 13 is even more worrying. In substance it reads as follows (my italics): '… The member crystallises half of the value of [his £1 million money purchase] arrangement, taking a pension commencement lump sum of £125,000, and putting the balance into an unsecured pension arrangement. The member then loans £125,000 to [his controlled family] company, which then makes a contribution of £125,000 to another registered pension scheme on behalf of the member (in addition to the usual £10,000 it pays to the company scheme). HMRC would look to establish that there was the intention at the time the lump sum was taken for the additional £125,000 contribution to be paid and it will be regarded as caught by the recycling rule. I should be more comfortable with the guidance if this final paragraph read that 'HMRC would consider whether there was the intention at the time the lump sum was taken for the additional £125,000 contribution to be paid and if this is the case and there is no other source for the money it will be regarded as caught by the recycling rule.'
All or nothing
If the lump sum is within the avoidance provisions, then the whole of the sum will be regarded as caught — there is no exemption for the first £15,000 or 20%. This is made clear by paragraph 10.4.2 of the Guidance Note.
Mechanics of the rules
If the avoidance rules are triggered, then the lump sum is deemed to be an 'unauthorised member payment'. The individual then suffers an income tax charge of 40% of the sum (the 'unauthorised payments charge'). There may also be a 15% unauthorised payment surcharge, depending on the percentage of the member's fund that has been accessed. The charge (and any surcharge) must be reported on the individual's self assessment tax return.
An individual intending to use a lump sum as part of a recycling device is required to inform the scheme administrator of his intention within 30 days of taking the lump sum (see Question 2 of the guidance).
In addition to the penalties on the individual, the pension scheme administrator may also suffer a scheme sanctions charge. This can be as high as 40% of the lump sum, but reduces to 15% if an unauthorised scheme charge has been paid by the individual.
However, the guidance offers some comfort to administrators: 'Scheme administrators are able to apply to HMRC to ask it to discharge their liability in respect of a scheme sanction charge. Such an application can be made where the scheme administrator considers that the grounds for such a discharge are just and reasonable'.
Presumably, failure by the individual to notify the administrator of his nefarious intent may constitute a just and reasonable basis for avoiding a charge.
More details of these various charges can be found in HMRC's Registered Pension Schemes Manual, which is published on their website at www.hmrc.gov.uk/manuals/rpsmmanual/index.htm.
A good thing?
It is clear from the above summary that these rules are aimed at structured, marketed, avoidance. They should prevent pensions advisers from sending mailshots to customers, recommending that they take a lump sum today and reinvest it tomorrow. Such advice, followed by action, will trigger these avoidance provisions unless the sums involved are relatively small — and it will normally be uneconomic to advise in relation to such modest amounts.
Equally, the rules should prevent the innocent being inadvertently caught up in draconian anti-avoidance provisions. An ordinary taxpayer who increases his pension provision close to the time he takes a lump sum, but who has another source of funds, or who did not pre-plan, should not be affected. Even those who do plan to use the rules to recycle funds can do so, as long as the amounts do not breach the £15,000 and 20% tests.
Thus, and contrary to initial impressions, this legislation, together with the HMRC guidance, may have succeeded in dividing 'tax-avoiders' from ordinary taxpayers, which is no mean achievement. However, this plaudit comes with the following caveats.
First, HMRC must remember, when they come to enforce the law, that it applies only if there is pre-planning and no other source of funds; they should not become fixated on the £15,000 and 20% tests (as seems to be the case in parts of the guidance).
Secondly, in an enquiry, taxpayers who have not pre-planned should not be required to prove a negative. HMRC should acknowledge that the legislation only applies if there is positive evidence that pre-planning existed.
Thirdly, the time cumulation issues are wholly unsatisfactory and need to be dealt with.
The guidance would thus benefit from being amended to cover these points — in other words, it could do with a little recycling of its own.
Anne Redston CTA (Fellow), FCA is Chair of Personal Taxes at the Chartered Institute of Taxation and a Visiting Professor in Law at King's College London. The views expressed in this article are her own. Anne can be contacted by e-mail via the CIOT at: technical@ciot.org.uk.
