| Prejudicial pensions regime? |
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| Some important changes were made to the taxation of pensions in recent years. Other changes have been contemplated. Brian Daly argues that these changes have served to further penalise high achievers in a system biased by fundamental misconceptions about pensions taxation. |
An article by Frank Monks in the June edition of Finance Dublin provided some interesting food for thought regarding the pensions regulatory environment. Frank’s article mentioned how financial services employees have limited pension options compared to self employed individuals or proprietary directors who own more than 5 per cent of the voting shares in the employer company.
In the tax system, there seems to be a bias against high achievers in the private sector generally, founded to some extent on a misconception about the nature of pensions and their tax treatment. The 2006 Finance Act introduced several punitive tax measures, presumably as a result of the findings of the internal review of tax schemes which was published by the Department of Finance in February 2006.
Department review
The Department’s report expressed concern regarding the use of pension funds by high earners. It concluded that reliefs were too generous in relation to individuals whose employers were in a position to make substantial tax deductible contributions, particularly in circumstances where the individuals were in a position to influence the level of employer contributions and their remuneration levels. The type of influence envisaged is not prevalent in the case of employees who are not controlling shareholders of the employing company, such as the vast majority of financial services executives. Yet the measures which were introduced impinge on such employees if they are high earners.
The report emphasised the ‘cost’ of income tax relief relating to both employer and employee contributions amounting to a tentative figure of €1.4 billion in 2001 as compared to ?783.3 million in the tax year 1997/98.
The report attacked the gross roll up regime for ARFs stating that ARFs have not yet been used substantially to fund income streams in retirement and that the rules were encouraging the build up of large funds with limited taxation on transfer on death.
Department recommendations
The Department review looked at a number of options for dealing with the perceived shortcomings of the current situation, such as limitation of employer contributions, placing a cap on the maximum final salary for pension purposes, deeming a notional annual distribution to be made from an ARF, placing a cap on the size of the maximum tax-relieved pension fund and placing a cap on the level of tax free lump sum from a pension scheme. As discussed further below, the latter three were implemented in Finance Act 2006.
Comment
A number of points need to be made in relation to the above.
The first is that tax relief for pension provision is primarily in the nature of a tax deferral. While the gross roll up of income and gains free of tax in a Revenue approved pension fund is undoubtedly of major benefit, pensions are ultimately taxable upon payout.
The second point is that there are more people in the workforce paying tax now so the increase in tax relief is proportionate to the increase in the tax take. Increases in remuneration levels and the fall in the value of money between 1997/98 and 2001 are also relevant.
Thirdly, employer pension contributions are a legitimate business expense just like wages and salaries, so tax relief should be available under first principles. Employers would be entitled to tax relief on additional salary paid in lieu of employer pension contributions. Why then are deductions for employer contributions often referred to as tax breaks? The only real tax break is the tax free cash lump sum that can be withdrawn at retirement age. Finance Act 2006 placed a cap on this.
It is worth noting that while income tax relief at 41 per cent is available for a pension contribution, all returns from the investment, as well as the original amount invested, are subject to tax at the marginal tax rate on pension payment. Conversely investment of after-tax salary in a gross roll-up fund would result in only the actual income or gain being subject to tax at 23 per cent. Assuming the same charges, investment returns etc, the lower overall tax profile of a pension fund would yield a better return but the margin of advantage is smaller than many may expect. In particular for a financially literate investor with significant sums to invest, it is worth weighing up all comparative advantages and disadvantages, for example accessibility etc.
The above suggests that the Department’s conclusion that pension related tax reliefs were being abused did not take account of all the relevant factors.
In relation to the Department’s comments on ARFs, the report ignores the impact of the restrictions on access to ARFs. ARFs are primarily available to self employed individuals and to directors who own more than 5 per cent of the voting shares in the employer company. Given this and their relatively short time in existence, the low level of withdrawals is not surprising and should logically increase if the availability of ARFs was extended given their many commercial advantages.
The report fails to acknowledge that the treatment of an ARF on death is broadly in line with the treatment that generally applies to assets passing on death, i.e. no tax event for the holder with the beneficiaries liable to tax at up to 20 per cent.
Implemented measures
The 2006 Finance Act measures have been well documented, including a special tax charge at 41 per cent on the excess in value of a pension fund over €5 million or, if higher, the value of the funds on December 7th 2005 (provided that a detailed notification was made to Revenue by 6 June 2006). The standard €5 million threshold has now been increased for inflation to €5,165,000.
Tax free pension scheme lump sums were capped at 25 per cent of the above cap, i.e. €1.25 million (now indexed to €1,291,250) with no transitional arrangements to deal with cases where the value of funds in a pension fund exceeded ?5 million in December 2005.
The third change is that there is now an annual imputed distribution from the value of the assets held in the ARF by individuals over age 60 at December 31st each year. The imputed distributions are 1 per cent of the value of the assets at December 31st 2007, 2 per cent at December 31st 2008 and 3 per cent in each subsequent year.
There are several unjust aspects to these provisions.
The special tax charge at 41 per cent on the excess of the value of an individual’s pension fund over the above mentioned thresholds can result in an effective tax rate of over 65 per cent ultimately applying to the excess when further tax (at 41 per cent) is applied to the pension purchased with the remaining 59 per cent. An effective tax rate of over 65 per cent is totally penal and disproportionate.
The provisions are clearly discriminatory against the private sector. In the case of defined contribution schemes (which will be the norm in future), employees carry all of the investment risk but could ultimately be deprived of over 65 per cent of the excess over the threshold.
If through wise investment decisions an individual manages, despite the limits on contributions and market conditions, to exceed the indexed ?5 million threshold he is to be penalised for doing so – it is difficult to see the logic in this or what public policy is being served. Surely this is nonsensical in an age where the government is trying to encourage entrepreneurship and risk taking?
At a minimum, double taxation should be removed and the overall tax on the excess should not exceed the marginal tax rate, currently 41 per cent. If the government is to insist on some form of pensions limitation for tax purposes, perhaps a better alternative would be to give employees and the self employed the option of a scheme which is limited by reference to contributions only. Contribution limits could be set at amounts which actuarially would put a medium performing scheme at the adjusted €5 million limit. Such schemes could then take market risk without any penalty for good investment decisions.
The retrospective nature of the cap on the level of tax-free lump sums from pension schemes was very unfair to high achievers who had funded their pensions in good faith based on existing legislation.
The new ARF deemed distributions rules apply regardless of the value of assets in an ARF. Retention in an ARF is penalised, even where the assets in the ARF are falling in value and the holder wishes to defer withdrawing in order to preserve income for the future. This further demonstrates the lack of commercial rationale behind these rules. The fact that the provisions apply where the ARF investor is 60 years or over also runs contrary to current focus on extending working life.
Financial services impact
The financial services industry has a high concentration of very highly paid employees. The bulk of this population was already unfairly denied full access to ARFs.
The introduction of these penal rules will be relevant to many of these employees. It will have a further impact upon competitiveness in the sector, which has also been adversely impacted upon by the abolition of the remittance basis.
The industry should consider making strong representations to government to ensure that the competitiveness of Irish financial services sector is not further eroded. Some relaxation of recent changes would be welcome. |
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| Article appeared in the August 2007 issue.
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