As promised in the 2019 Conservative Party manifesto, the Government is reviewing how tax relief is processed for member contributions to a registered pension scheme.
The driver for this review is the discrepancy that can arise in a low-earning person’s take-home pay depending on which of the two methods is used when applying tax relief.
The ‘Pensions tax relief administration: Call for Evidence’ sought views on how the current system can be adapted to address this discrepancy without having a disproportionate knock-on effect to a system that is otherwise seen as fit for purpose.
Methods of tax relief
When processing pension contributions, there are currently two principal methods used for administering pensions tax relief.
The first method is commonly referred to as the ‘net pay arrangement’ (NPA) and this is usually applied by employers using a trust-based pension scheme as the main vehicle for pension savings.
In this method, a member’s income is only taxed after pension contributions have been deducted thus ensuring that their contributions aren’t taxed.
The second is ‘relief at source’ (RAS) and this is applied by providers of personal pension schemes and a few occupational schemes. For RAS, the employer payroll doesn’t make any adjustment for contributions, so they are taxed and then the amount paid across to the pension scheme provider is calculated assuming basic rate relief will be added (that is, 80p in the £1 is deducted and paid).
The provider must then reclaim the basic rate tax relief (of 20p in the £1) direct from HMRC and those members subject to higher rates of tax must make a claim for tax relief themselves.
Low earners
As already noted, the two tax relief methods provide different results for members whose total earnings are below, or close to, the tax-free personal allowance (currently £12,500).
Under RAS, these members have a payment from HMRC credited to their pension account, equivalent to the basic rate of tax for their contribution. As they don’t pay tax, this is effectively a government top-up paid into their pension.
Conversely, under NPA, members in a similar situation don’t receive that top-up. This is because they wouldn’t have paid basic-rate tax on their pension contributions if their earnings were below the personal tax allowance.
This difference in tax treatment has been criticised recently, especially following the trend for more lower-paid employees to be enrolled into pension schemes.
Potential approaches to fix the system
The call for evidence includes four potential approaches to addressing the issue of tax relief for lower earners:
1. Paying a bonus based on Real Time Information (RTI) data
This would require HMRC to pay a ‘bonus’ to lower earners whose employers use the net pay method of tax relief. The payment would make up for the difference in the amount of tax relief that a comparator in a pension scheme operating RAS would receive.
As this proposal creates additional costs and administration burdens on HMRC, the Government is not looking to adopt this proposal.
2. Standalone charge on RAS schemes
This would see HMRC applying a stand-alone charge to a low earner to recover what it refers to as a ‘top-up’ given under the RAS method of tax relief.
This is essentially the opposite of the first approach, as it’s clawing back the discrepancy in tax relief from those that have benefited from the RAS tax relief approach.
It’s no surprise that this proposal has been pretty much ruled out, not just because of the additional administration but also because it would clearly be unpalatable for the Government to be seen to be taking money from some of those on lower incomes who are saving for their retirement.
3. Employers operating multiple schemes
This requires employers to operate both tax relief methods for their employees. Which process to apply would depend on whether the employee’s earnings would be above the pro-rated personal allowance for that pay period. This method addresses the issues with tax relief for low earners and ensures that higher earners automatically receive full tax relief on contributions when using the NPA method.
The Government sees several advantages for this proposal but suggests that it is only feasible for large employers with a relatively high proportion of low-earning employees and raises issues over fluctuating earnings. It would be interesting to see if there was any take-up of the suggested voluntary adoption of this proposal given the set-up costs and the additional complexity it would bring.
Capita comment
The Call for Evidence provides for an interesting discussion about how to address the inherent differences between the NPA and RAS tax-relief methods, but the Government seems to have talked itself out of all but the last of the four approaches that it put forward.
The costs to business and the Government are clearly going to be the main focus, especially in the current economic climate, and, while some will anticipate that the status quo will be maintained, others may be worried about the risks of increased costs and potential tax changes to DC pension schemes.
We watch this space with interest.
4. Mandating the use of RAS for all DC schemes
If all defined contribution (DC) schemes operated RAS, this would ensure that all low-earning members were treated in the same way.
The Government understands that requiring all DC schemes to transfer to RAS would be a significant change for providers and employers who currently operate net pay.
Thought must also be given to those employers that have schemes with DC and non-DC pension arrangements in place, as they would have to run both methods.
For those with a marginal rate of tax above the basic rate, this would require them to make a claim for any additional tax relief to which they are entitled.