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A New Lifetime Allowance Test
Andrew Roberts, an actuary in our Amersham office, explains the concept of "double jeopardy" as it applies to pension schemes in the post 5 April 2006 world, with the Revenue seeking to impost a further test against the Lifetime Allowance at age 75. Article first appeared in Taxation Magazine, 17 November 2005.
The application of the lifetime allowance has to be one of the simplest aspects of pensions tax simplification. It is therefore quite surprising that the recently issued HMRC guidance on this subject is one of the longest chapters of their Registered Pension Schemes Manual. Yet disturbingly there is no reference to the proposed, and almost rubber-stamped, new instance of testing against the lifetime allowance. I am referring to the test for members in drawdown at age 75 who would have already been tested at the point of retirement - surely a case of double jeopardy!
In December 2002, the Government and the Inland Revenue issued proposals for a simplified pension taxation régime. At the heart of this was the lifetime limit, a ceiling on the amount of tax-relieved pension that an individual may accumulate. This limit was instrumental in harmonising the plethora of benefit and contribution limits that governed the existing eight pension régimes. Limits would be replaced by 'one single test against the lifetime limit', performed when benefits are triggered, or crystallised.
A more detailed technical document was issued the following December. The lifetime limit was subtly re-branded as the lifetime allowance and the mechanism for how the one-off test would function was described. These eventually became enshrined in the Finance Act 2004, which is the main home of the pension tax simplification rules.
Once in a lifetime?
To understand the concept of double jeopardy, it is important to understand how the lifetime allowance test operates. A test is conducted whenever there is a benefit crystallisation event (BCE). Currently, there are eight such events set out in the legislation, as summarised in Table 1.
Each event has an associated method for assessing the amount to be compared with the lifetime allowance. For example, BCE 1 occurs when funds are used to provide income drawdown. The amount tested against the lifetime allowance is, unsurprisingly, the value of those funds (called 'unsecured funds' under the new legislation).
The initial portrayal of pensions being subjected to a one-off test should fall foul of the Trade Descriptions Act. Under the terms of FA 2004, unsecured funds already tested against the lifetime allowance under BCE 1 are then potentially subjected to a further test on the purchase of an annuity, which is caught under BCE 4. So unsecured funds can, in fact, be tested twice.
In acknowledgement of this, the legislation allows credit to be taken for amounts that have already been tested. This should be sufficient in most cases, but as there is no revaluation applied to the amounts tested, HMRC are effectively seeking to tax any increase in the size of funds in drawdown.
It is important to note that credit appears to be given only for events that fall under BCE 1 and does not, for example, include the tax-free cash sum of £375,000 in Example 1. Note also that the credit given is not revalued in any fashion.
Getting away with it
Once a member reaches age 75, however, the Act provides that there will be no further tests against the lifetime allowance (except in relation to BCE 3). Crucially, a member who triggered income drawdown could thus avoid a second test if annuity purchase was delayed beyond age 75 or avoided completely, as is allowed under the new regime.
It is natural to assume that people in income drawdown would wish to continue with income drawdown beyond age 75, as not many defer annuity purchase as a tactical decision, holding out for improved rates. The decision usually focuses on avoiding loss of capital and retaining control of investments.
Therefore advisers were relatively relaxed about the concept of a theoretical second lifetime allowance test that could apply were a client actually wanting to purchase an annuity before age 75.
Spoiling the party
HMRC soon noticed the discrepancy between an individual purchasing an annuity just before age 75 from unsecured funds and one who did so just after age 75. On 16 February 2005, HMRC confirmed in 'Pensions tax simplification - technical note' that:
'There will be a new benefit crystallisation event for individuals who reach age 75 with an unsecured pension fund. The amount crystallised will be the value of the fund less the amount crystallised when the fund was first created. This rule will equalise the position between these individuals and those who use their unsecured pension fund to purchase a lifetime annuity or scheme pension, who are already, under FA 2004, subject to a benefit crystallisation event on the purchase.'
What a great way to ruin a 75th birthday party, i.e. by being assessed for tax if your investments perform too well!
Draft wording, expected to form the basis for the statutory instrument introducing the new benefit crystallisation event, is hidden away in the annals of the HMRC website:
'In section 216(1) (benefit crystallisation events and amounts crystallised), below, after the entry relating to benefit crystallisation event 5 insert -
"5A. The individual reaching the age of 75 having designated sums or assets held for the purposes of a money purchase arrangement under any of the relevant pension schemes as available for the payment of unsecured pension to the individual.
"The aggregate of the amount of the sums and the market value of the assets representing the individual's unsecured pension fund under the arrangement less the aggregate of amounts crystallised by benefit crystallisation event 1 in relation to the arrangement and the individual".'
This appears to clarify the intention only to allow credit for funds crystallised under BCE 1, and therefore does not include retirement lump sums. See Example 2.
This potential second tax charge could be construed as one of two proposed stealth taxes that are being considered to dissuade individuals from drawing little or no pension. The other stealth tax being considered is the application of inheritance tax on pension funds; see Update, Taxation, 28 July 2005 and 12 August 2005. HMRC are concerned that a pensioner would choose to leave monies invested in the tax-efficient environment of a pension arrangement even beyond age 75, rather than to receive taxable monies which would the form part of his estate.
The application of a second test against the lifetime allowance would encourage the drawing of pension so as to control the risk of a second lifetime allowance charge becoming payable. Similarly, the threat of an inheritance tax charge, particularly on death after age 75 when there has been little or no pension payable, could provide similar encouragement. It is a shame that a more practical approach was not taken at the outset of simply requiring a minimum level of drawdown, as operates currently.
Individuals can avoid the lifetime allowance charge completely by registering for enhanced protection. This is one clear way of avoiding the second lifetime allowance charge but may not always be suitable as the protection is lost if pension contributions are made after 5 April 2006. Furthermore, registration must take place by 6 April 2009 and so this protection will not be possible for future generations of pensioners.
It is expected that members with all of the pensions in payment by 5 April 2006 will automatically be protected from the age 75 test and this would be a welcome administrative relaxation.
For others, it will be important that they understand the potential for further tax once benefit drawing has commenced and factor this in when planning their pension withdrawals. If not, the main beneficiary of their frugalness could be the taxman.
Andrew Roberts, November 2005.