Pension compensation

For many years I have been diligently paying retirement annuity premiums into a collection of policies which had guaranteed annuity rates in the region of 10%.

I was given advice by my financial adviser to cash in the policies and to place the funds into a self-invested personal pension (SIPP) as he considered he could improve on the poor performance of the existing policies.

His recommended investments have not performed well and the matter was referred to the Ombudsman, who awarded compensation to be paid to the pension scheme.

The professional indemnity insurers for my financial adviser have paid the compensation directly to me, despite my request that the payment should be made to my SIPP.

The financial advisers have told me that the payment is tax free in my hands as it is compensation for investment loss. The award was for the capital lost plus indexation of approximately £10,000.

Do readers agree that the compensation payment is not taxable in its entirety or should I declare a capital gain on the indexation element of the compensation?

As my income is a basic salary at the National Insurance contributions threshold, with the balance by way of a dividend, there has been no scope to make additional payments to the SIPP.

I would welcome readers’ comments on the status of the payment paid to me. In the event I retire shortly, I do not want to have a nasty shock from HMRC opening an enquiry into my return.

Query 17,998 – Old Man

Reply from Ishtar

FA 1996, s 148 exempts compensation including any interest element. If it applies, the payment will be exempt from tax and so will the interest element arising from mis-selling of personal pensions to people who were in occupational pension schemes.

This does not sound like the situation here. If these awards were wholly exempt in any event then it is not immediately clear why that exemption was needed in relation to occupational schemes.

It is well established that a payment of compensation may include an element of taxable interest. The leading case was Riches v Westminster Bank Ltd 28 TC 159.

Although it is described as ‘indexation’, this nevertheless sounds like interest. It is understood that (assuming s 148 does not apply), when an award contains interest, the payer is required to deduct tax at source and account for it.

There is a helpful Tax Bulletin article from 2004 in Tolley’s Practical Tax (10 September 2004, page 152a). But I recommend the article by Mike Truman entitled Gourley surely.

This also appears to be a case covered in the Registered Pension Schemes Manual at RPSM3104511. If the compensation is now used to make a payment into the pension pot it will be a relievable pension contribution according to the manual.

If relevant, the loss of enhanced protection could be triggered. Enhanced protection rights would have included relief from the lifetime allowance charge prior to 2011/12, but the protection does not extend to the annual allowance charge from April 2011. This is all far more complicated than is really necessary in a civilised society.

Reply from Southern Man

My understanding is that where compensation is due to a pension scheme member, the payment will normally be made directly to the member rather than the pension scheme.

However, if the Ombudsman ruled that the compensation should be paid directly to the pension scheme, it might be worth investigating why this was not done.

Unless the compensation actually represents lost pension income – say, previously unpaid arrears – then the compensation itself should not attract an income tax charge.

However, I would expect that the interest element accruing on a compensation payment to be subject to income tax.

TCGA 1992, s 22 (‘Disposal where capital sums derived from assets’) states that just because no asset is acquired by the payer of consideration, does not mean that an asset is not being disposed of for capital gains tax purposes.

In principle, a capital gains tax liability could arise. So what is the asset being disposed of?

This would be the right to take court action for compensation or damages and HMRC’s Capital Gains Manual at CG12040 confirms that these ‘Zim-style rights’ (following Zim Properties Ltd v Proctor [1985] STC 90) are assets.

I note that SIPPs were introduced in 1989, so the provisions of FA 1996, s 148 (‘Mis-sold personal pensions, etc.’) may apply here.

This states that compensation will not be subject to income tax or capital gains tax if it related to bad investment advice given (or at least partly given) between 29 April 1988 and 30 June 1994.

If s 148 does not apply, the Extra-statutory Concession D33 (‘Capital gains tax on compensation and damages’) may be in point.

This notes that TCGA 1992, s 51(2) states that ‘sums obtained by way of compensation or damages for any wrong or injury suffered by an individual in his person or his profession or vocation’ are not subject to capital gains tax; but ‘in his person’ is distinct from ‘in his finances’ so s 51(2) would not apply here.

However, D33 does allow cases where compensation is received from a right to be treated as received in respect of the underlying asset instead (so that normal part-disposal, exemption, etc, rules can apply) and section 11 of D33 confirms that no capital gains tax liability will arise where the right of action relates to property that is not normally an asset for capital gains tax purposes and misleading financial advice is given as an example.

If the compensation is paid (as in this case) to the scheme member and they then make payment to the pension scheme, that payment will be treated as a ‘relievable pension contribution’ if paid before their 75th birthday with the normal implications as regards the available annual allowance and lifetime allowance charge.

If the compensation action was initiated by the scheme trustees/administrator on behalf of the member, then payment could be made to the scheme rather than the member.

There is no tax relief for the scheme member, but the other implications as above will apply.

Generally speaking, it may best if payment can be made to the member, so they can decide on the benefits or otherwise of making a contribution.

Some further number-crunching may be in point in this case. I have not done the calculations but, for instance, would there be an advantage in the client using the compensation as income in place of company dividends (on which the company would presumably have paid tax (plus potentially higher rate income tax) and the company making an equivalent (tax-deductible) pension payment into the SIPP on his behalf?
 

Issue: 4355 / Categories: Forum & Feedback