TAX TREATMENT OF PENSION PROVISION BY F. R. LANGHAM, F.I.A., A.S.A., F.S.S. AND J. D. SPARKS, B.A., F.I.A.

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1 TAX TREATMENT OF PENSION PROVISION BY F. R. LANGHAM, F.I.A., A.S.A., F.S.S. AND J. D. SPARKS, B.A., F.I.A. 1. INTRODUCTION 1.1. The present authors, with G. T. Humphrey and R. E. Snelson, were associated in the preparation of a paper entitled Pensions and Company Finance (J.I.A. 96, 189) which was concerned with many aspects of the financing of company pension arrangements in the United Kingdom. The purpose of this note is to bring up to date those sections of the previous paper which dealt with the different taxation treatments which apply to the various methods of providing pensions. For the sake of completeness, we repeat some of the previous material It is interesting to notice that although a new scheme of corporation tax was introduced with effect from 1 April 1973, many of the conclusions reached by us in February 1970 still hold good. 2. METHODS OF PROVIDING FOR PENSIONS 2.1. There are two methods which an employer can use to provide pensions for his employees: (i) By the establishment of an exempt approved pension fund. (ii) Unfunded pension arrangements. Under these arrangements, either: (a) benefits are paid directly from revenue, or (b) an internal reserve is established within the company so that the cost of benefits is met in advance The normal method used in the U.K. is to provide pensions by means of an exempt approved pension fund. Pension costs are met in advance by contributions to the fund (in many cases using insurance policies) and the assets of the fund (which may include policies) are held by Trustees. It is relatively rare to find formal unfunded pension arrangements in the U.K. except in the public sector. Such liabilities do exist, however, very often in the form of guarantees to supplement benefits from a pension scheme up to some specified level. In addition, companies pay ex gratia pensions to former employees. These arise, for example, as a company pension supplementing funded rights in respect of an employee who has been retired early, or in the form of pension increases to retired employees where a decision has been made to meet the cost from company revenue rather than through the pension fund Whether an unfunded or a funded approach is adopted, it is essential to obtain Inland Revenue approval to any formal arrangement as an approved retirement scheme. If a fund is established it is essential to obtain approval 323

2 324 Tax Treatment of Pension Provision as an exempt approved scheme. Either way such approval will mean that the employee will not be taxed on the actual or notional employer s contributions. An employee will receive tax relief only on contributions to an exempt approved scheme. See Inland Revenue practice notes ( ). External fund 2.4. Company contributions to an exempt approved pension scheme are deductible for corporation tax and the pension fund itself is able to reclaim any income tax deducted at source from its investment income. In addition, a pension fund is not subject to capital gains tax. Income from investments, deposits or other property held for the purposes of an exempt approved pension scheme is exempt from the investment income surcharge on certain trusts. Exempt approved schemes are not exempt from development land tax. Pension funds are not exempt from VAT, i.e. pension funds cannot recoup any VAT that is included in any charges to the pension fund. Unfunded schemes 2.5. Under an unfunded arrangement the company pays benefits directly from revenue either with no reserves set up in advance or by setting up in advance an internal reserve in the books of the company which will eventually be debited with the cost of the emerging pensions. It is clearly prudent accounting policy to provide in advance for promised retirement benefits if they are unfunded, and this is one of the points made in Recommendation N.21 on retirement benefits issued by the Council of the Institute of Chartered Accountants in As pointed out in 2.4 of our previous paper, the tax consequences to the company of either approach are the same (unless one obtains tax relief on allocations to reserve as discussed below) and for the rest of this note we will deal only with the situation where a reserve is set up each year If a company does establish an unfunded approved pension scheme for the benefit of its employees and it makes an allocation out of profits to an internal reserve, this allocation can be treated as a deduction for corporation tax, provided that certain conditions are fulfilled As pointed out in our previous paper ( 3.1) the only case on this is the case of Owen (HM Inspector or Taxes) v. The Southern Railway of Peru Limited, which went to the House of Lords in In this case the company contended that upon proper principles of commercial accountancy amounts of compensation calculated to have accrued to each employee from year to year as deferred remuneration should be allowed as a deduction for tax. Three of the Law Lords were of the opinion that where a number of similar contingent obligations arise from trading there is no rule of law which prevents the deduction of provision for them in ascertaining annual profits if a sufficiently accurate estimate can be made but the provisions claimed by the company throughout the proceedings was not permissible by reason of the absence of discount and other factors. In our previous paper we concluded that this case appeared to

3 Tax Treatment of Pension Provision 325 establish that tax relief on an allocation to provision for pensions may be made provided that the allocation is calculated on an actuarial basis. During the discussion on our paper, the opener mentioned that he had recently received a letter from the Board of Inland Revenue on this subject. This stated that in their view a company would be entitled to a deduction against its profits for corporation tax purposes in respect of sums allocated to expected pension liability provided that the amount was assessed actuarially, was commercially justifiable in relation to the services rendered, and that the pension liability was contractual. However, the amount deductible for any accounting period would be limited to the sum appropriate to the services provided in that accounting period It is believed that relief on an allocation to an internal reserve has been claimed and granted for very few schemes. One reason for this is that the usual method of pension provision, although, as we shall see, a more expensive one from a tax point of view, has been by means of an external fund. Another reason is that, even had this method been considered, there would have been practical difficulties about reopening the tax assessments of previous years because it is appropriate to charge to any particular accounting year only the amount by which the actuarial liability at the end of the year exceeds the actuarial liability at the beginning of the year. Over the years the very nature of the contractual obligation to provide pensions has also changed, so that now an employee s pension rights must be referred to in his contract of employment and after he has reached age 26 and completed 5 years of qualifying service he has rights to preserved benefits. It now seems, therefore, even less arguable than formerly that the value of commitments entered into to provide employees pensions should not be allowed in computing the amount of the company s profits or gains to be charged to corporation tax. We should point out that in a number of countries, notably Germany, pension arrangements are generally unfunded and tax relief is obtained on allocations to reserve If tax relief is not granted in respect of an allocation to an internal reserve, it would usually be available on any pension payments made from the reserve in the particular accounting year in which they had been made. Lending-back If assets of an external fund are lent back to the company, the tax position of the company is very similar to that which would have applied under an unfunded arrangement under which allocations are eligible for relief. However, several of the conditions referred to in 2.7 do not apply with respect to lending back. 3. COMPARISON OF METHODS 3.1. The object of this note is to see to what extent the effects of tax (corporation and income) have a bearing on the question of funding or not funding. We are

4 326 Tax Treatment of Pension Provision not concerned with the general economic effects of pension funding on the country as a whole, nor on the financial effect of an individual company in so far as it might be able to obtain a greater or less return on retained money compared with money invested by the pension fund. It is not our object to advocate one method as opposed to another and we must emphasize that the tax position is only one of the many factors that should enter into a decision as to whether to fund or not. In particular, for private companies it is desirable (and many would believe essential) that pensions should be funded in order to protect members against a deterioration in the fortunes of the employing company. In some countries, notably Sweden and Germany and to some extent (and in a slightly different context) the U.S.A., there are forms of credit insurance to cover unfunded pension commitments If a company obtains tax relief on an allocation to reserve for pensions, this tax relief will be greater than the tax relief obtained on contributions to the pension fund. The reason is that the annual allocation to the provision in the company s books will be equal to the build-up on a year-to-year basis of this provision, i.e. equivalent to contributions plus investment income. In other words, for funded and unfunded arrangements tax relief is obtained on amounts equal to the contributions, but for unfunded arrangements tax relief is also obtained on the notional investment income allocated to the provision The company may invest in ordinary shares or fixed interest securities like a pension fund. Suppose, for the sake of argument, that one particular investment has been made directly by the company and indirectly through the company s pension fund. It is now to be considered whether investment returns by the pension fund will be greater, the same, or less than the company s return net of corporation tax. The conclusion differs according to the type of investment and whether the return represents income or capital A dividend received by a U.K. resident company from another U.K. resident company will already have suffered corporation tax in the hands of the first company and is not subject to further corporation tax in the hands of the receiving company. For corporation tax purposes the dividend is treated as franked investment income. The tax credits attaching to the dividend can be used to offset advance corporation tax (ACT) payable by the receiving company, but this relief is normally temporary in that less ACT paid means less ACT credit available against the mainstream corporation tax liability. On the other hand when a pension fund receives the dividend it can obtain cash in respect of the tax credit. Therefore, with regard to dividend income a pension fund is at an advantage vis-à-vis the investment income in respect of an unfunded reserve by an amount currently equal to 35/65ths of net dividends If a company does not obtain tax relief on an allocation to reserve for an unfunded scheme but on the pension payments themselves, the cost is higher in each year compared with an external fund by an amount equal to 35% of the gross franked investment income. On the other hand if a company does obtain tax relief on an allocation to reserve then, as mentioned in 3.2, the company

5 Tax Treatment of Pension Provision 327 effectively receives tax relief at the full corporation tax rate on the investment income which is allocated to the reserve, i.e. currently 52% of gross franked investment income. Thus, where tax relief is obtainable on an allocation to reserve there is a positive gain to the company compared with an external fund of 17% of the gross franked investment income The above points are illustrated in Tables 1 3. In these tables a simple example has been chosen. A company earns trading profits, before tax and pension costs, of 2,000 per year and decides to retire one of its employees in 3 years time and grant him a pension of 1,000 per year payable annually in arrear for 3 years, the pension to cease thereafter. If the pension fund, or investment by the company, can earn 6% per annum, the annual contribution payable 3 years in arrears would be 840. The three tables illustrate the three situations. Table 1 refers to the case where an external fund is established. Table 2 is where an internal reserve is established, but where allocations to reserve are not allowed for tax and in this case only the net reserve is set up. Table 3 illustrates the situation where an internal reserve is established but allocations to reserve are allowed for tax. In all three tables it is assumed that either the pension fund or the company invests in the same ordinary shares. For illustration purposes it has been assumed in each case that dividends will be paid of 325 in each of the first 3 years and of 650 in each of the second 3 years. It is the final column of each table, i.e. profits retained, that should be compared. It will be noticed that where an allocation is made to reserve and tax relief is not obtained until the pension payments are made, the retained profits are lower in each year except the first than for the external fund. The difference is equal to 35% of the gross dividends, i.e. the tax credit attributable to dividends received by the company equal to 35/65ths of column (7) in Table 2. When Table 3 is compared with Table 1 it will be seen that in all years except the first profits retained are higher for the unfunded scheme than for the funded scheme. As mentioned in 3.5 this is equal to 17% of the gross franked investment income, 17/65ths of column (6) in Table The position with regard to fixed interest and other unfranked investment income is different, because this income (gross) is subject to corporation tax at the 52% rate in the hands of the company. Where tax relief can be obtained on an allocation to reserve the corporation tax payable on the investment income exactly balances the corporation tax deduction allowed on this investment income as an allocation to reserve so that the position is neutral vis-à-vis a pension fund. This is illustrated in Table 5. Where no tax relief is obtainable on an allocation to reserve, the position is worse vis-à-vis a pension fund by an amount equal to corporation tax on the investment income. This illustrated in Table Where capital gains are considered the position is advantageous where an allocation to reserve is allowed for tax purposes, but disadvantageous where it is not. The two positions are illustrated in Tables 6 and 7. The capital gain is tax free to the pension fund but is subject to corporation tax (at a rate of 52% on 30/52nds of the gain, effectively 30%) by a company. Where an allocation

6 328 Tax Treatment of Pension Provision to reserve is allowed for tax in respect of this capital gain (effectively the investment income earned by the reserve) then compared to a pension fund the advantage to a company would be that it would gain tax relief equal to 22%, i.e. (52% 30%) on the capital gain The position on lending-back is that the company not only obtains tax relief on the contributions to the pension fund but also on the interest paid on the amounts borrowed provided that the loan is required for business purposes. However, had the loan not been made but retained in the pension fund, the investment income or profit would not be subject to income tax or capital gains tax. A comparison of the relative positions can be made by postulating that an amount equal to that of the loan is applied to secure the same portfolio of ordinary shares or fixed interest securities as might otherwise have been the result of direct investment by the pension fund. For the sake of simplicity we assume that the interest on the loan will be equal to the return which would have been secured by direct investment. In the case of franked investment income, the tax relief of 52% on the loan interest has to be offset by the income tax of 35% withheld from the dividend received by the company, leaving a balance of advantage to the company of 17%. In the case of unfranked investment income the position is neutral whereas, in respect of capital gains, the advantage to the company in lending back is 22%, representing the difference between the tax relief of 52% on the loan interest and corporation tax at an effective rate of 30% borne on direct capital gains. The three cases to which we have referred in this paragraph are illustrated in Tables 8, 9 and 10; for each table, we have assumed that the contributions and interest received by the fund are immediately lent back to the company. In no case does any extra tax burden outweigh the advantage of full corporation tax relief on loan interest payable to the pension fund It can be seen that the lending-back method obtains all the tax advantages of the unfunded approach where relief is obtained on allocations without many of the disadvantages. Small actuarial surpluses can be carried forward and it is unnecessary to apportion liability between accounting years. However, we would emphasize that the favourable tax position of lending-back must be set against the prejudicial effect it will often have over the security of members pensions and other benefits. The method can sometimes be used where members security would otherwise be less; to quote from our reply to the discussion of the previous paper: We find it surprising that while speakers were unanimous in deploring lending back, although very reputable financial institutions actually do borrow from their pension funds, no one mentioned that it was common practice for actuarial deficiencies to be spread over a long period of years. Members of a pension fund would enjoy greater security if a past service deficiency was met by the fund receiving a lump sum contribution from the company which was lent back to the company on the security of a 10 to 15-year debenture stock on which the interest was well covered, rather than by level annual contributions from the company payable over a 25-year period. Any delay in meeting an actuarial deficiency may be more prejudicial to members interests than the practice of lending back.

7 Tax Treatment of Pension Provision For ease of reference we summarize the results in Tables 1 10, showing for the company referred to in 3.6 the total profits retained over the 6 years in question. External fund Tax Relief on Allocations to Reserve Franked investment income only Unfranked investment income only Capital gains only Tax Relief on Pension Payments Franked investment income only Unfranked investment income only Capital gains only Loan Back to the Company Franked investment income only Unfranked investment income only Capital gains only 1,626 Table 1 1, , , , , , , , , It has been assumed in this note that corporation tax and income tax will remain unchanged at their current rates. To illustrate the principles involved we have had to ignore certain factors which will be relevant in particular cases. For example, the precise incidence of tax varies from company to company and this will have an effect upon the relative advantages of each method of providing pensions. Just recently, several companies have not had a mainstream corporation tax liability. Small companies pay corporation tax at a special reduced rate. 4. TAX FROM THE POINT OF VIEW OF MEMBERS 4.1. A member of a pension scheme, provided it has been approved by the Inland Revenue, is not subject to tax on the employer s actual or notional contributions. In addition, if he pays contributions to an exempt approved scheme then these contributions are tax deductible in the year that they are paid (subject to certain limits laid down by the Inland Revenue). Benefits when payable are taxable except that part of the benefits can be commuted for a taxfree lump sum and lump sum death benefits are normally arranged so as not to be subject to capital transfer tax It must be pointed out that the immunity from tax of lump sum retirement benefits does not depend on pension fund tax legislation but is of much longer standing, and Section 14 of the Finance Act 1973 confirms the position As far as the individual members are concerned the tax position is logical in that the inputs to the pension fund are tax free, i.e. the member does not pay tax on employer s contributions, he obtains tax relief on his own contributions, and the build up of the Fund is tax free, whereas the outputs in the form of

8 330 Tax Treatment of Pension Provision pension are subject to tax. Some members would obtain a marginal tax advantage if the tax rates payable on their pension were lower than the rates at which relief was obtained on contributions. All individuals can gain a tax advantage if they take part of their benefits in the form of a tax-free lump sum (but this does not rest on pension fund legislation as mentioned above) and the dependants of other members might obtain a tax advantage in that capital transfer tax might not be payable on any lump sum death in service benefit. 5. GENERAL REMARKS 5.1. From time to time statements are made about the tax advantages of pension funds. If there are tax advantages they cannot lie with the pension fund, which is only the medium used to provide pensions, but must lie either with the beneficiaries or with those that provide the means of paying the pensions (the individuals concerned and their companies). In this paper we hope that we have established the relative tax position with regard to the different methods which may be adopted. Although the change in corporation tax in 1973 placed an external fund at a tax advantage over on unfunded approach, under which no relief is allowed until pensions are paid, it is still the case that the pension fund is in a disadvantageous position with regard to other methods. If it is desirable for pension promises to be funded then additional taxes on pension funds, such as VA? or development land tax, can only militate against this and make unfunded scheme arrangements or lending back, which are frequently less satisfactory for other reasons, appear more attractive.

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