COMPENSATION PAYMENTS FOR LOSS OF PENSION RIGHTS. 2. A trading company agrees to contribute 10,000 per annum to a registered

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1 COMPENSATION PAYMENTS FOR LOSS OF PENSION RIGHTS 1. This article summarises the main tax issues concerning compensation payments for loss of pension rights. Example 2. A trading company agrees to contribute 10,000 per annum to a registered pension scheme for the benefit of an employee. It subsequently wishes to cease these contributions and offers him 50,000 as compensation. Corporation tax 3. The company will be able to deduct the compensation payment in the calculation of its profits for corporation tax purposes provided that the payment is (a) a revenue and not a capital payment and (b) made wholly and exclusively for the purposes of its trade. 1 Capital or revenue? 4. In Vodafone Cellular Ltd and Others v Shaw 2 a company paid a lump sum to cancel a fee agreement under which it was obliged to pay a percentage of its consolidated pre-tax profits to another company in return for the provision of future know-how. After noting that there is no single infallible criterion for distinguishing between capital and revenue, Millett L J said: Two matters are of particular importance: the nature of the payment; and the nature of the advantage obtained by the payment. The fact that the payment is a lump sum payment is relevant but not determinative. In a case such as the present, where the payment is made in order to get rid of a liability, a useful starting point 1 See s. 46(1) CTA 2009, s. 53 CTA 2009 and s. 54(1)(a) CTA TC 376 1

2 is to inquire into the nature of the liability which is brought to an end by the payment. Where a lump sum payment is made in order to commute or extinguish a contractual obligation to make recurring revenue payments then the payment is prima facie a revenue payment. 5. Contributions to a pension scheme are of course revenue payments 3, and so a lump sum paid to extinguish a contractual obligation to make contributions is prima facie a revenue payment. 6. In Hancock v General Reversionary and Investment Company Limited 4 a company paid a pension to a former employee and then the pension was commuted by the purchase by the company of an annuity for the former employee s benefit. The pension had been treated as a business expense and deducted from profits. The company argued that the purchase of the annuity should be treated in the same way. The Revenue argued that it was an outlay of capital and therefore not allowable as an expense. Lush J held that the price paid for the annuity: should be treated, as the pension was treated, as an ordinary business expense and that the deduction should be allowed. It is the pension in another form; it is actuarially equivalent in value and it is identical in character. It was paid to meet a continuing demand which was itself an ordinary business expense as the surveyor had treated it. 7. He also said: It seems to me as impossible to hold that the fact that a lump sum was paid instead of a recurring series of annual payments alters the character of the expenditure as it would be to hold that, if an employer made a voluntary arrangement with his servant to pay the servant a year's salary in advance instead of paying each year's salary as it fell due, he would be making a capital outlay. 8. However, in Vodafone, Millet LJ went on to say: 3 With the possible exception of the very first contribution: British Insulated and Helsby Cables v Atherton (1929) 10 TC. Although see s. 196(2)(a) FA [1919] 1 KB 25 2

3 But the principle that a payment made in order to commute or discharge a liability to make recurring revenue payments is itself a revenue payment is subject to an important qualification. If the liability to make recurring revenue payments is reduced or brought to an end by the modification or disposal of an identifiable capital asset, then any payment made for the modification or disposal is itself a capital payment. 9. Although an employment contract could conceivably constitute a capital asset, this would be highly unusual An addition to the qualification noted by Millet LJ above, in Tucker v Granada Motorway Services Ltd, 6 Lord Wilberforce observed that money spent on improving an asset or making it more advantageous is similarly regarded as capital. Could it be argued that the compensation payment had the effect of improving the value of the shares in the company, and is therefore a capital payment? Assuming that the employment contract can be terminated within a reasonable time frame, so that contributions are effectively made from one year to the next to reflect the efforts of the employee during the year, it is difficult to see how the compensation payment could affect the value of the shares. Wholly and exclusively for the purposes of the company s trade 11. If the compensation payment is made to rid the company of a drain on its resources, but in such a way that the employee remains content, and for no other purpose, then that is a trading purpose. 12. It follows from the above that in all but the most unusual of cases the company can expect to obtain a tax deduction for the compensation payment. 5 Millet LJ said that It is only where such a contract is one the cancellation of which would effectively destroy or cripple the whole structure of the taxpayer's profit-making apparatus that it falls to be treated exceptionally as a capital asset. 6 [1979] 1 WLR 683 3

4 Income tax Part 2 ITEPA 2003 (earnings) 13. Payments made solely to compensate the employees for the loss of pension rights are not earnings from the employment, and are therefore not taxable as employment income. 7 This was confirmed recently by the Court of Appeal in Kuehne + Nagel Drinks Logistics Ltd, Stott and Joyce v HMRC. 8 Part 9 ITEPA 2003 (pension income) 14. Part 9 ITEPA 2003 taxes pension income. The compensation payment itself is neither a pension or a lump sum under a registered pension scheme, so chapters 5A and 15A of Part 9 would not appear to have any application. Chapter 3 of Part 9 only applies to pension, which is not defined so it must be given its usual meaning which would not include the compensation payment. 15. In Mairs v Haughey, 9 Lord Woolf said [a] payment made to satisfy a contingent right to a payment derives its character from the nature of the payment which it replaces. Could it be argued that this substitution principle means that the compensation payment could be taxed under Part 9 ITEPA? Lord Woolf did not appear to be limiting his principle to earnings. 16. In Tilley v Wales the House of Lords rejected the argument that just because the pension would have been taxable (under schedule E) then a sum payable in 7 Tilley v Wales (1943) 25 TC [2012] EWCA Civ 34 9 [1993] 3 WLR 393 4

5 commutation of it would be assessable under the same schedule. Viscount Simon LC said: I agree with the unanimous view of the members of the Court of Appeal that a pension is in itself a taxable subject-matter distinct from the profit of an office, and, if an individual agrees to exchange his right to a pension for a lump sum, that sum is not taxable under sch. E. This conclusion is in accordance with the views of the majority of the Law Lords when this House decided Dewhurst v. Hunter. 17. He also took the view that a lump sum paid to commute a pension is in the nature of a capital payment which is substituted for a series of recurrent and periodic sums which partake of the nature of income. He went on to note that the same cannot be said of earnings, where a lump sum paid to reduce salary would still constitute income (as per Cameron v Prendergast [1940] AC 549). 18. Lord Porter said: In my view, a sum received on the sale or surrender of pension rights is not taxable under sch. E because it is neither pension nor annuity and comes under no other heading of that section. It is in the headnotes to Dewhurst's case said to be exempt as being capital and not income. It is not, as I think, a pension or annuity, and, therefore, not income taxable under sch. E, but I doubt if much assistance is to be obtained by making use of the antinomy between capital and income. 19. In Kuehne + Nagel, HMRC did not even attempt to argue that the compensation payments were pension income under Part 9 ITEPA Part 7A ITEPA 2003 (employment income provided through third parties) 20. Part 7A ITEPA 2003 would not of course have any application. Chapter 2 of Part 6 ITEPA 2003 (employer-financed retirement benefit schemes) 21. As the employee is still employed at the time of the compensation payment, it will not constitute a relevant benefit for the purposes of s. 393B ITEPA 2003 unless it is in anticipation of retirement or a change in the nature of service. 5

6 National Insurance Contributions 22. In Kuehne + Nagel it was common ground that the test to be applied for NICs is, in substance, the same as that under Part 2 ITEPA 2003 (earnings). Before the FTT, HMRC had argued that the test in s. 6(1) SSCBA 1992 is broader than that in s. 9 ITEPA 2003 but that was rejected and there was no appeal on that point. It follows that payments made solely to compensate the employees for the loss of pension rights are not remuneration or profit derived from an employment, and are therefore not subject to NICs. 23. This reflects HMRC s position in the NICs manual that compensation payments are not generally subject to NICs. 10 Capital gains tax 24. An employment contract is an asset for CGT purposes. 11 Pursuant to s. 22 TCGA 1992, there is a disposal where any capital sum is derived from assets, notwithstanding that no asset is acquired by the person paying the capital sum. Section 22(1)(c) confirms that this applies in particular to capital sums received in return for forfeiture or surrender of rights, or for refraining from exercising rights. However, s. 22 is expressly subject to any exception in TCGA Section 237 TCGA 1992 provides that: Superannuation funds, annuities and annual payments. No chargeable gain shall accrue to any person on the disposal of a right to, or to any part of (a) any allowance, annuity or capital sum payable out of any superannuation fund, or under any superannuation scheme, established solely or mainly for persons employed in a profession, trade, undertaking or employment, and their dependants, (b) [ ] or 10 See NIM2010 and NIM02540, albeit in slightly different contexts. 11 O Brien v Benson s Hosiery (Holdings) Ltd [1979] 3 WLR 572 6

7 (c) annual payments which are due under a covenant made by any person and which are not secured on any property. 25. As a result of the exception in s. 237 TCGA 1992, the compensation payment should not but subject to CGT. Pensions Act As always, it is important to consider if any non-tax legislation could interfere with the proposal. Section 91(1)(a) PA 1995 provides that where a person is entitled to any benefit under an occupational pension scheme or has a right to a future benefit under such a scheme, the entitlement or right cannot be assigned, commuted or surrendered, and any agreement to do so is unenforceable. As the employee is not giving up anything that he already has (he has no more than a hope/expectation of continuing to be employed), it is difficult to see how s. 91 could have any application. Matthew Harrison STP Advisors Limited 01 February