09 July 2015 - Post by:Helen Powell
An ISA-style system of pensions taxation, as suggested by the Chancellor in his Summer Budget yesterday, is conceptually quite straightforward. Currently the UK Government provides tax relief (subject to the annual allowance) on pension contributions as they are made, exempts investment roll-up during the accumulation phase and taxes the end product (known as an Exempt, Exempt, Taxed system or EET). It would be entirely possible to turn that around and require pension contributions to be made from taxed income, continue to allow tax-free investment roll-up and make pensions and lump sum payments tax-free (a TEE system).
It would, however, be a mistake to think that those two systems are equivalent from a Treasury perspective:
- The marginal tax rate applicable to an individual is generally higher while they are earning than during retirement. It is estimated that only one in seven workers receiving higher rate tax relief during their working life will ever pay higher rate income tax during retirement. The tax payable on pre-contribution salaries under a TEE system could therefore be substantially higher than the tax payable on pension income derived from those contributions under an EET system.
- Currently, the ability to take a tax-free lump sum means that 25% of a worker’s pension savings are currently exempt both on the way in and on the way out of the pension vehicle; a side-effect of moving to a TEE system is likely to be the disappearance of this additional benefit.
Another major bonus for the Treasury would be to bring forward tax income from later years, which is clearly a concept favoured by the Chancellor. The April 2015 DC flexible access changes look set to net the Treasury an extra GBP700 million in this tax year by bringing forward tax revenues and consumer spending which would otherwise have been spread over future decades. Similarly, the Government estimates that moving to a TEE system could bring an estimated GBP50 billion into its coffers, based on 2013/14 figures, although tax income in future years would be reduced. Tax income from pension payments in 2013/14 was 13.1 billion.
Note that the GBP50 billion figure not only takes account of higher receipts from taxing working incomes compared to retirement incomes, but also of the impact of National Insurance. In a TEE system, there would be no obvious reason for pension contributions to be exempt from NI, which could effectively make salary sacrifice redundant in relation to pensions.
Why would individuals save into a pension (with age restrictions on access) rather than an ISA (with no such restrictions) under a TEE system? The suggestion is that the Government would offer some form of top-up to contributions to incentivise retirement saving – but there is no indication of what the level of that top-up might be, and based on past experience, the likelihood is that it could be whittled away over time.
One of the reasons the Government gives for looking at reform is that constant tinkering and extra layers of restriction on tax relief have added complexity to the system and reduced transparency, but it seems unlikely that a TEE system would be any less subject to political intervention – or that TEE might not (at least to some degree) become TET over time. From a demographic perspective, as the population ages, income tax receipts are likely to decline in later years; the impact of bringing forward the tax take by up to a generation could be felt more severely by future governments.
Other significant questions include:
- How would employer contributions to defined benefit arrangements be quantified for individual taxation purposes under a TEE system? Would sponsors of DB schemes still obtain tax relief on deficit recovery payments?
- How would any change be implemented? Would it be gradual (increasing complexity through incremental change) or would treatment change on A-Day 2.0, with separate systems being required to apply EET to pre-implementation savings and TEE post-implementation? Would workers be able to pay (or be required to pay) some form of tax-equalising amount and rollover their EET savings into a TEE system?
It’s worth noting that almost all EU Member States tax occupational pensions on an EET basis, so change on these lines would run counter to the EU’s strong desire for harmonisation in the pensions arena. The Chancellor may not be unduly distressed by the prospect of ploughing a slightly different path to the rest of Europe, but there will be implications for cross-border pension contributions. Depending on a worker’s direction of travel between Member States, their pension savings could be taxed at both ends of the process, or escape taxation altogether. Would different treatment be established for UK workers in cross-border schemes, and how would the potential for cross-border pension arbitrage be avoided?
As the Chancellor noted in his Budget speech, ‘This idea, and others like it, need careful and public consideration before we take any steps.’ That, at least, will be a relief to a pensions industry still dealing with the fallout from his March 2014 Budget announcements. You have 12 weeks to make your views known: As the Chancellor noted in his Budget speech, the consultation document can be found on this link.
Helen Powell is a PSL Counsel at Allen & Overy LLP