The Bank of England cut the base rate on 4 August for the first time since March 2009. Does this mean companies can borrow more cheaply now from small self-administered schemes (SSASs) as the minimum interest rate set by HM Revenue & Customs (HMRC) is linked to base rate?
The answer is 'possibly'.
Whilst there is a minimum interest rate set in the pension rules, business owners borrowing capital from their pension should be paying a commercial rate of interest and, for those who have already taken out a loan, the chances are that it is on a fixed interest basis in any event.
The Prescribed Minimum Interest Rate
To be an Authorised Employer Loan, the rate of interest payable on the loan cannot be less than the rate prescribed by regulations made by the Board of Inland Revenue. This is set out in The Registered Pension Schemes (Prescribed Interest Rates for Authorised Employer Loans) Regulations 2005 [SI 2005/3449].
"Loans already advanced which are linked to base rate may be subject to a more immediate drop in the interest rate."
This minimum rate is generally described as being 1.0 per cent over base rate and whilst this is a useful description, it generalises the more accurate position which is replicated at the end of this blog. The regulations use a 'relevant interest rate' which is worked out with reference to the six base rates of high street banks. This is generally the same as the Bank of England base rate.
However, there is also a lag similar to the lag on maximum pension drawdown rates when the gilt yield changes. So a drop in base rate by the Bank of England does not equate to an immediate fall in the minimum interest rate set by HMRC. As the recent change in base rate occurred on 4 August, the change in the prescribed minimum won’t happen until 8 September.
Loans already advanced which are linked to base rate may be subject to a more immediate drop in the interest rate. The terms would be set out in the loan agreement. Where a drop occurs, it should not cause the interest rate to fall below the prescribed minimum noted above for risk of an unauthorised payment being triggered.
A Commercial Interest Rate
The Prescribed Minimum Interest Rate is low even when you consider that the loan has to be secured by a 'first charge' (more accurately, a charge that takes priority over any other charge) over the asset(s).
There are more general provisions within the pension taxation rules that require transactions between trustees of SSASs and connected parties to be conducted on commercial terms. In the context of an Authorised Employer Loan, this would mean that the interest rate charged by the trustees should be in the corridor of interest rates that an arms’ length lender might charge.
In the current environment, agreed interest rates are typically higher than the prescribed minimum in any event and so a reduction in the prescribed minimum resulting from the quarter percent drop in base rate may not automatically translate to a drop in the commercial rate of interest that should be charged. We would, though, expect commercial rates to fall in due course. And many commercial rates of interest are linked to base rate and so an immediate reduction for loans in the process of being agreed could be adopted (taking care to amend the loan agreement and any repayment schedules).
Fixed Rate Loans
Fixed rate loans seem more easily compatible with pension legislation which broadly requires there to be equal repayments (of interest as well as capital) throughout the term of the loan. HMRC confirm in their Pensions Tax Manual that:
"A registered pension scheme may make a loan at a fixed rate of interest as long as that interest rate is at least the rate specified. As long as the terms of the loan remain unchanged there will be no requirement to alter the interest charged on the loan during its life."
So, to state the obvious, the reduction in base rate will have no impact on loans that have already been advanced on a fixed rate basis, other than perhaps if there are penalty interest charges linked to base rate.
In summary, the reduction in base rate will, sooner or later, make borrowing cheaper from SSASs. Loans in the process of being agreed may or may not benefit, and loans already advanced on a fixed rate basis will have to keep up with their existing level of repayments.
More explanation on the minimum rate of interest can be found in HMRC's Pensions Tax Manual under the section headed Interest rate.