Capping pension funds
What might be thought of as a cap on the amount of tax approved pension funds has been introduced in the Finance Act. It is not a formal cap in the sense that it does not forbid funding of pensions beyond a certain limit, nor does it deny tax benefits for that funding. What it does do it to impose punitive taxation on the pension fund and the pensioner, once any benefits crystallise out of a pension fund that has been funded beyond pre-set limits.
To illustrate how the punitive taxation will work, consider a defined contribution scheme where, on the date the employee becomes entitled to a pension, the fund is E1m in excess of the appropriate threshold. A tax charge of E420,000 will be imposed upon the pension fund. That will leave E580,000 of the excess still in the fund, and available to purchase an annuity for the pensioner. That E580,000 net amount will emerge to the pensioner as taxable income, in all probability subjected to a further 42 per cent tax. The E1m excess will have borne an effective tax of approximately 66.36 per cent. This may be compared with the maximum tax liability that can arise in relation to an individual, which (taking levies into account) is 44 per cent.
If the scheme were a defined benefit scheme, a 42 per cent charge would have arisen on the scheme trustees, thus leaving them under-funded to provide the promised benefits. If the under-funding is made good by the employer, that additional contribution would in turn be charged to tax at 42 per cent, and so on.
In practical terms, the alternative to further funding by the employer is a reduction of benefits for the employee, to reflect the fact that part of the scheme assets have been diverted to the Revenue and are no longer available to purchase an annuity. The effective tax rate on the defined benefit scheme, where the employer does not make an additional contribution, is as outlined for a defined contribution scheme.
The limit over which a tax charge will arise on the fund can be one of two figures. The standard threshold is E5m (indexed). However a higher threshold amount is possible where the pension which an individual would have received had he reached normal retirement age on 7 December 2005, when valued at a factor of 20 times the pension, would produce a higher threshold.
The assumption that a person had reached their normal retirement age on 7 December 2005 is an assumption solely about the individual’s age and does not change the actual years of service they would have accrued at that date, when determining the pension entitlement they would have had at that date.
If for example, an individual would have been entitled to a pension of E300,000 on 7 December, had they reached normal retirement age on that date, their threshold amount would be E6m, and not the standard threshold amount of E5m. The valuation factor used, of 20, is arbitrary and the resulting threshold amount is not necessarily an accurate reflection of the size of pension funding that in practice would be required to provide the pension benefits in a particular case.
This higher threshold amount, is available only when an election is made by the taxpayer to the Revenue not later than 7 June 2006, or before pension entitlements crystallise if earlier. This deadline for notification can be critical for higher paid executives now approaching retirement, or with substantial accrued pension benefits.
The new arrangements have implications not only for those whose pension fund is at or approximating the new thresholds over which the penal taxation applies. It has implications for the remuneration package of any top executive, in so far as pension arrangements that could ultimately produce a fund in excess of E5m are under consideration, or already exist.
What to do?
Firstly, employers and higher paid executives need to check if their personal threshold limit at 7 December 2005 would be higher than E5m. If so, they have a short timescale in which to serve notification to the Revenue of this fact, or otherwise they will lose the benefit of the higher threshold amount. Failure to make that notification on time could cost approximately 20 per cent of the difference between the standard threshold amount of E5m, and what would have been their higher personal threshold amount. That would be a costly error.
For employers and employees already committed to pension arrangement which seem likely to ultimately produce a fund in excess of the E5m standard threshold limit, there may be a need to renegotiate their remuneration package in a more tax efficient manner. It is possible to come up with innovative and tax efficient approaches, but employers and employees should avoid knee jerk reaction such as “let’s look at share options”. Such “first come to mind” solutions may not introduce significantly greater efficiency, at least from an income tax viewpoint.
Double taxation
The punitive taxation on a pension fund that exceeds the threshold amount has been perceived to have involved an element of double taxation. That is valid. What is not generally understood is that the basic rules relating to pensions are themselves fundamentally based on a double charge to tax.
In the ordinary way you would have expected that where an employer promises an employee a pension, the employee will be taxed when he receives the pension, but that otherwise it would not be a matter of concern to him. That is not the way the tax law is structured. Where an employee is entitled to a pension on retirement, unless that pension is to be provided through a Revenue approved pension scheme, a double charge to tax will arise. The first charge will arise on the employee as the employer makes payments to an unapproved pension scheme, or will arise to the employee in each year of service where the pension promise is unfunded. When the pension itself is paid out, a further charge to tax will arise. Furthermore, an unapproved pension scheme is itself liable to tax on its income and on its capital gains.
The escape from this peculiar system of double taxation is provided by means of ensuring that the pension funding is through a Revenue approved scheme. In such a case the employee will face a tax charge only when the pension scheme commences to provide benefits to him. And now, under the new rules, a surplus over the threshold amount will on that occasion, effectively again becomes liable to a double charge to tax.
The background approach to pensions, in setting up a scheme predicated on a double charge to tax, but then reducing it to a single charge to tax if it is funded through a Revenue approved scheme, is bizarre. The changes made in the Finance Act betray the symptoms of tinkering with an ill-designed system that was in need of fundamental reform.
ARF payouts
With effect from January 2008, approved retirement funds will be taxed on the assumption that they pay out 3 per cent of their value each year as a pension payment, whether or not they do so. It is understandable that an ARF, since it is created as a form of pension provision, should be required to provide a pension. What is not readily understandable is that an ARF is required to do so regardless of the amount of the fund. If the fund suffers from the fundamental problem of being inadequate, would it not be more sensible to permit it to grow through capital gains and income being rolled up, before beginning to pressurise it into paying out sums as pensions?
The new regime would have made more sense if it applied only to ARFs to the extent they exceeded a certain minimum figure, but this is not what has been done. Furthermore, the new rules take no account of the age of the owner of the ARF. At a time when thinking in the area of pensions is taking account of increased longevity, and the possible need to lengthen the working life, should an ARF be pressurised to commence pension payments from as early (in some cases) as 55 years of age? Would it not have been more sensible to apply the system only once the owner of the ARF arrived at the age of (say) 70 years?
The 3 per cent deemed payout does not apply to an alternative minimum retirement fund (AMRF). It appears to be the view of the Revenue Commissioners that such funds cannot have an initial transfer to them in excess of E63,750. Whether or not such a cap on the size of the fund exists is questionable in terms of the legislation, and would seem even more questionable in terms of policy. A sum of E63,750 is an inadequate safety net in the case of a person moving his pension funds into an ARF (from which they can be withdrawn subject to tax at any time). It is unfortunate that the opportunity was not taken to substantially increase the minimum amount which must be placed in an AMRF, where funds are to be transferred from an approved pension scheme to an ARF.
Overall, the changes in the area of pensions reflect much tinkering, and inadequate analysis. |
