Restricting pensions tax relief Government policy decisions on the reduced annual and lifetime allowances. slaughter and may.

Restricting pensions tax relief Government policy decisions on the reduced annual and lifetime allowances slaughter and may October 2010

Contents A. Summary of key Government decisions 01 B. How accurate were our predictions for the revised annual allowance? 03 C. Background 05 D. The revised annual allowance 06 E. Defined benefit arrangements valuing the input 08 F. Exemptions 12 G. Carry forward of annual allowance 14 H. Managing the annual allowance charge cap and carry 17 I. Details of tax relief and annual allowance charge 19 J. Lifetime allowance 21 K. EFRBS and non-registered schemes 24 L. Overseas schemes 25 M. Administration 26 N. Next steps 27 APPENDIX 28 Cautionary note: Please remember this document is based on our current understanding of draft legislation. This document is for general information only and is not intended to provide legal advice.

A. Summary of key Government decisions 1. Revised annual allowance 1.1 The annual allowance will reduce to 50,000 (from 255,000) for pension input periods ending in the tax year 2011/2012. 1.2 There will be no indexation of the annual allowance in the first 5 years of operation (up to 5th April, 2016). 2. Defined benefit arrangements valuing the input 2.1 A single flat valuation factor will continue to be used. The factor is raised to 16 (from 10). 2.2 The value of unreduced early retirement pensions will only count towards the annual allowance where added years are granted. Flat factors do not place a value on early retirement where either no early retirement reduction is made or it is made on terms favourable to the member. 2.3 Accrued benefits for active members will be re-valued by CPI. Only increases in excess of this will be tested against the annual allowance. 2.4 Deferred members benefits will not be tested against the annual allowance so long as the revaluation applied does not exceed the greater of: CPI increases, and a rate fixed by the scheme s rules at 14th October, 2010. 3. Exemptions 3.1 The final year exemption is removed except for death and serious ill-health lump sums. So redundancy enhancements will be tested against the revised annual allowance but the carry forward mechanism (see 4. below) may assist. 3.2 A further ill-health exemption is proposed. Details are to be announced later this year. But, the ill-health test is expected to be more stringent than the current ill-health test. SLAUGHTER AND MAY 01

3.3 The exemption for members with enhanced protection 1 is removed, so the annual allowance will, for the first time, apply to these members. 4. Carry forward of annual allowance If you are a member of a scheme, unused annual allowance for the past 3 tax years can be carried forward. This may assist in managing redundancies and spikes in defined benefit accrual due to pay rises. 5. The annual allowance charge 5.1 The annual allowance charge will be set at the member s marginal rate of tax. 5.2 There will be options (still to be determined) for paying this charge out of accrued pension benefits. 6. Lifetime allowance 6.1 The lifetime allowance will reduce to 1.5 million (from 1.8 million) probably from 6th April, 2012. 6.2 Consultation on associated protections ends on 29th October, 2010. 7. EFRBS 7.1 Funded employer financed retirement benefits schemes ( EFRBS ) are to have their tax advantages taken away so they are no more attractive than other forms of remuneration. 7.2 Unfunded EFRBS will survive but the Government will monitor use of these for fiscal risk. 1 Only relevant to those with defined benefit arrangements who have registered for enhanced protection. 02 SLAUGHTER AND MAY

B. How accurate were our predictions for the revised annual allowance? 1. Table 1 below sets out our predictions from the revised annual allowance and what the Government announced: Table 1 Slaughter and May prediction Result Prediction 1 A reduced annual allowance will be adopted. ü Prediction 2 The level of the annual allowance is likely to be set at close to 30,000. x Prediction 3 Flat factors will be used, but with an increase to perhaps a factor of 15. ü (set at 16) Prediction 4 Prediction 5 Prediction 6 The final year exemption will be curtailed, but will continue to apply on death, ill health which meets a tough test and (strictly defined) redundancy. Active members will be given an uplift to accrued benefits to protect from the effects of inflation. Scheme pays as a method of collecting the tax charge will not be imposed. ü (except redundancy) ü ü (looks unlikely to be compulsory) Prediction 7 The rate of the tax charge will be set by the member s marginal rate of tax. ü Prediction 8 The annual allowance will be set on the assumption it rises with at least price inflation - but the legislation may not spell this out. x Prediction 9 Pension input periods will be aligned with tax years. x Prediction 10 New information requirements will be imposed. ü SLAUGHTER AND MAY 03

2. As it turns out, 7 out of 10 of our predictions were correct. We under-estimated the level of the annual allowance ( 30,000 against 50,000). 3. Alignment of the pension input periods to tax years would have created considerable simplification of the legislation. However, the Government accepted the representations by those involved in scheme administration of the additional pressures that this would impose at an already busy time of year for scheme administrators. 4. We also thought that the revised annual allowance would rise in line with inflation. The Government has, however, frozen it until at least 5th April, 2016. 04 SLAUGHTER AND MAY

C. Background 1. In June 2010, the Coalition Government announced that it was considering a simpler approach to restricting pensions tax relief than the high income excess relief charge proposed by the previous administration. 2. The simpler approach proposed was the restriction of the existing annual and (possibly) lifetime allowances. This approach was confirmed on 14th October, 2010 and some of the key policy decisions have been made. 3. Draft legislation covering the core aspects of the reduced annual allowance, and draft HMRC guidance has also been published. 4. The reduced annual and lifetime allowances will apply to all scheme members. Comment: In the original Treasury announcement relating to the reduced annual allowance charge, the Government said it would look at options to ensure basic rate taxpayers were not subject to the restrictions. There are no measures specifically relating to basic rate taxpayers in these proposals. 5. However, the relatively high annual allowance, the CPI increase uplift and the flat factors that are to be adopted, combined with the new 3 year carry forward facility for scheme members for unused annual allowance, should mean that, in practice, basic rate taxpayers and members on moderate incomes will not be affected by the reduction in the allowance in most circumstances. 6. The model Slaughter and May interim or definitive amending deeds executed in relation to tax simplification included an auto-fix provision relating to the annual allowance. This caps contributions (in the case of money purchase arrangements) and pension accrual (in the case of defined benefit arrangements) so that the annual allowance is not inadvertently exceeded. 7. These auto-fix provisions are expected to continue to apply once the annual allowance is reduced. The position will need to be checked against the final legislation. 8. A summary of how the annual allowance works at present, before the proposed changes are made, is included in the Appendix to this document. SLAUGHTER AND MAY 05

D. The revised annual allowance 1. The level of the annual allowance The annual allowance will be 50,000 for pension input periods ending in the tax year 2011/2012, reduced from the current 255,000. Comment 1: This is a higher level than was expected. In their discussion document, the Government suggested a level of between 30,000 and 45,000. Comment 2: A pension input period ending in the tax year 2011/2012 will usually have started in the current tax year. See further 3. below. 2. Indexation The level of the annual allowance will not be indexed during the Government s forecast period (which runs from 6th April, 2011 to 5th April, 2016). The Government will consider options for indexing the allowance for periods after 5th April, 2016. Comment: The real value of the annual allowance will decline over the next 5 tax years, with more occupational scheme members potentially being caught by it. 3. Transitional provisions 3.1 There are transitional provisions to deal with: pension input periods that started before 14th October, 2010 and will end in the 2010/2011 tax year (a straddling pension input period ), and pension input periods that start after 14th October, 2010 and end in the 2010/2011 tax year. 06 SLAUGHTER AND MAY

3.2 Most occupational pension schemes have nominated pension input periods that begin on either 1st April or 6th April in each year. For these schemes, the transitional provisions are unlikely to have practical effect. 3.3 Another relatively common date for pension input periods to start is 1st January. For schemes that have nominated this date, members will be restricted to pension savings of 50,000 in the period beginning 1st January, 2011. The special annual allowance provisions 2 will also continue to run until 5th April, 2011. Depending on personal circumstances, a member may have to consider both the special annual allowance and the new reduced annual allowance for the period from 1st January, 2011 to 5th April, 2011. 3.4 For straddling pension input periods there is a two part test, which is complex and is not considered further in this document. 2 The special annual allowance provisions (also known as the anti-forestalling provisions) were introduced in the Finance Act 2009 to prevent forestalling of the restriction of tax reliefs, which was originally announced in the 2009 Budget. SLAUGHTER AND MAY 07

E. Defined benefit arrangements valuing the input 1. Valuation factor 1.1 A single flat valuation factor will continue to be used. For pension input periods ending in the tax year 2011/2012, the factor is raised to 16 (from 10). 1.2 This is at the lower end of the expected range. In their discussion document, the Government suggested a range of between 15 and 20. Example 1: Currently, Member A with an accrual rate of 1/60th, 15 years service and a salary of 100,000 will have a pension value for annual allowance purposes of (15/60 x 100,000 x 10 = 250,000). Following the change, the pension value for the same benefit will be (15/60 x 100,000 x 16 = 400,000). 1.3 Remember, however, that it is the difference between the value of the member s benefits at the start of their input period and the value at the end of the pension input period which is tested against the annual allowance. See further the Appendix for how the annual allowance calculation currently works. 2. Early retirements 2.1 There will not be any variation of these flat factors to take account of a person taking a pension earlier than the scheme s normal retirement age. 2.2 As a consequence, an early retirement will only have an additional value for annual allowance purposes where added years are granted. The value of the grant of an early retirement pension with no actuarial reduction or a favourable actuarial reduction is not measured for annual allowance purposes. But, added years would be caught. 2.3 The Government has considered whether to alter the approach to the lifetime allowance valuation factors, to pick up the value of unreduced early retirement benefits. It is not currently minded to make such a change. 2.4 It is not clear from the current draft amending legislation exactly how the mechanics of calculation work where a whole arrangement comes into payment, and the final year exemption does not apply. We will be clarifying this with HMRC. 08 SLAUGHTER AND MAY

3. Revaluation for active members 3.1 Accrued benefits for active members at the beginning of a pension input period will be revalued by the increase in the CPI (set by reference to the annual CPI increase in the September preceding the tax year). Only increases in excess of this will be tested against the revised annual allowance. Example 2: Currently, the figure used for Member A (see Example 1) for his pension value at the beginning of a pension period, when calculating the input for his defined benefit promise, is 250,000. The new figure that will apply following the change, (assuming for these purposes a CPI rate of 3%) will be ( 400,000 x 1.03 = 412,000). 3.2 If Member A has a salary rise of 5% during the pension input period, under the current annual allowance calculations the pension value at the end of the input period will be (16/60 x 105,000 x 10 = 280,000) and the pension input for the period will be ( 280,000 250,000 = 30,000). 3.3 Following the change, Member A s pension value at the end of the input period will be (16/60 x 105,000 x 16 = 448,000). The pension input for the period will be ( 448,000 412,000 = 36,000). 3.4 This relatively straightforward approach for revaluation may leave some rough edges for schemes that have to provide revaluation at a higher rate for parts of benefits for active members. An example is revaluation of the GMP element in a scheme that has contracted back into the State scheme, where the required level of revaluation is likely to be higher than the CPI rate. 4. Dealing with deferred members 4.1 A member with a defined benefit arrangement where his benefits have deferred status for the whole pension input period will have a nil input for that arrangement so long as the revaluation of the rights does not exceed the greater of: the rate set out in the scheme rules on 14th October, 2010 where the rate is specified as a fixed percentage figure, a percentage derived from an index, or a combination of the two, and otherwise, the increase in CPI, for a period chosen by the scheme administrator. 4.2 If the scheme s rules at 14th October, 2010 require revaluation to be by a rate produced by a person exercising a discretion, the scheme rules revaluation option is not available. 4.3 HMRC have said that a member will not be a deferred member for these purposes if pension accrual has stopped but the accrued benefits are still linked to increases in pensionable pay. SLAUGHTER AND MAY 09

4.4 It is unclear whether an individual who has ceased accrual under a scheme (for example having opted out) but who continues to be provided with life cover under the scheme is intended to be a deferred member for these purposes. The position will need to be confirmed with HMRC. 5. Negative accruals Negative accruals in a pension input period will be treated as zero. 6. Increases in pensions in payment 6.1 There is a Government concern that avoidance of the annual allowance charge could occur if a member starts with an artificially low pension amount, but there are subsequently significant increases in the pension once it comes into payment. 6.2 Such increases would currently be captured through benefit crystallisation event 3, and tested against the lifetime allowance. However, they would not currently be tested against the annual allowance, which operates as benefits accrue but not once they come into payment. 6.3 The intention is to bring forward legislation to counter this avoidance risk. 6.4 There are currently no details of how significant pension increases might be identified and dealt with under the revised annual allowance provisions. 6.5 One possible approach would be: to use the excessive increase test, currently used under benefit crystallisation event 3, as the trigger, and to treat the excessive increase as subject to a special tax charge at the member s marginal rate of tax. 7. Transfers 7.1 The opportunity has been taken to tidy up the drafting of various aspects of the current annual allowance provisions. One area where the drafting has changed relates to transfers in and out of defined benefit arrangements, where the current provisions were known to be unsatisfactory. 7.2 An issue that will need to be explored further with HMRC is the statement in the draft guidance that on making a transfer the pension input period relating to the transferring scheme ends and any input counts for the tax year in which the transfer is made. 10 SLAUGHTER AND MAY

7.3 This will not be of practical importance where the pension input period ends at the same time as the tax year. However where pension input periods end earlier in a tax year, this approach could be an issue. Example 3: Member B belongs to a money purchase scheme and his pension input period ends on 31st December. He and his employer together make total contributions of 50,000 for the period ending 31st December, 2013, which count towards the annual allowance for the tax year 2013/2014. He then continues to contribute for a further 3 months before transferring to another money purchase scheme. If HMRC continue to take this approach, the fact of the transfer would bring the 3 months of contributions made in 2014 into the tax year 2013/2014. Member B would exceed his annual allowance for that tax year even though the contributions, when made, were intended to relate to the tax year 2014/2015. 7.4 This could be of significance on scheme mergers, since it can effectively potentially shift accrual into an earlier tax year. 8. Waiting periods 8.1 Where a scheme operates a waiting period with back-dated benefits being provided once the member joins the scheme, the total benefits provided on joining the scheme (including the back dated benefits) will count for the tax year when the member actually joins. It does not make any difference if the waiting period related in whole or part to a previous tax year. 8.2 It may be possible for the member to carry forward any previous tax years unused annual allowances (see Part G below). 8.3 However, the position will depend in part on where HMRC come out on the question of whether the member needs to have been an active member of a pension scheme in the previous tax years. See G.3 below. SLAUGHTER AND MAY 11

F. Exemptions 1. Final year exemption restricted 1.1 Currently there is an exemption from the annual allowance in the year in which all benefits are drawn from an arrangement (the final year exemption ). 1.2 This general exemption will now be restricted to cases of: death, or payment of a serious ill health lump sum (which requires a medical opinion that the recipient is expected to live for less than one year). 1.3 Currently the final year exemption enables augmentations without having to test against the annual allowance, for example in cases of ill health and redundancy. 1.4 From 6th April, 2011 a new and tougher ill-health exemption is expected (see 3. below). 1.5 The new carry forward provisions may assist in other ill health cases or on redundancy where augmentations are made (see Part G below). 2. Enhanced protection exemption removed 2.1 The current exemption from the annual allowance provisions for individuals who have claimed enhanced protection will be removed. 2.2 This will only be relevant for individuals who have claimed enhanced protection but who retain a link to salary increases for accrued benefits. It will not be relevant to members who have claimed enhanced protection, but only have money purchase benefits, or who have become deferred members within their defined benefit scheme, so long as the revaluation of their defined benefit benefits is in line with the limits described at E.4 above. 12 SLAUGHTER AND MAY

3. Proposed new major ill health exemption 3.1 The Government intends to include a further exemption for cases of major ill health. Further details are expected to be published towards the end of 2010. 3.2 Whilst the Government is minded to grant this further exemption, the concern is to manage the risk of misuse of the exemption. 3.3 Schemes will need to test any ill health benefits that include an added years enhancement against the new exemption, once further details are made available. 4. Redundancy 4.1 In cases of redundancy, the final year exemption will no longer be available where added years are to be granted or additional contributions made. 4.2 However, in practice, the provision of the facility for scheme members to carry forward unused allowances for 3 tax years may provide some headroom. See further Part G below. SLAUGHTER AND MAY 13

G. Carry forward of annual allowance 1. Carry forward 1.1 The Government has decided that scheme members will be able to carry forward unused annual allowances from up to 3 previous tax years. These unused allowances are treated as increasing the individual s annual allowance in the tax year in question. 1.2 As a result, unused allowances from the three previous tax years can be offset against pension inputs in excess of 50,000 in the tax year in question. 1.3. The primary purpose of the carry forward provision is to assist individuals who would typically have pension inputs below the annual allowance but who have a spike in their pension accrual in a single year. In many cases, the carry forward will prevent a tax charge. 2. Carry forward from tax years before the annual allowance is reduced 2.1 The facility will be available in tax year 2011/2012. 2.2 Any individual who was a scheme member with a pension input of less than 50,000 for any of the tax years 2008/2009, 2009/2010 and 2010/2011, will be able to carry forward that notional unused allowance. 2.3 For defined benefit arrangements, the inputs for these prior tax years have to be re-calculated on the new basis to determine the notional input and excess for those years, using the valuation factor of 16 and applying CPI increases to the accrued benefits. 2.4 This facility may be of assistance where the operation of the special annual allowance charge in tax years 2009/2010 and 2010/2011 has limited pension inputs for particular members to 20,000. 2.5 For example, a new joiner who was not able to benefit from the new joiner exemption in the anti-forestalling legislation was limited to a pension input of 20,000. 2.6 In tax year 2011/2012 (and following years) unused allowance will be available to that member. 14 SLAUGHTER AND MAY

Example 4: Member C joined a new employer s money purchase scheme on 1st May 2009: contributions of 20,000 were made in respect of him in the tax year 2009/2010 (which was also his pension input period for annual allowance purposes). a further 20,000 was contributed in tax year 2010/2011. He had benefited from 40,000 of contributions in tax year 2008/2009, paid to a previous employer s scheme. in 2011/2012 he has unused allowances from the previous 3 tax years of ( 10,000 + 30,000 + 30,000 = 70,000). this increases his annual allowance for 2011/2012 to 120,000. 3. Who can benefit from the carry forward provisions? 3.1 It is unclear from the draft legislation and draft guidance whether, in order to qualify for the carry forward of unused allowances: it is sufficient for an individual to have been a member of an arrangement in a registered pension scheme at some time in the tax year in question (which can include an active, deferred or pensioner member) this is what the draft legislation says, or whether the individual needs to have made pension savings (had an actual pension input) in the tax year in question this is what the draft guidance says. Note: The position of life cover only members is also unclear. 3.2 We will be seeking clarification of the policy intention from HMRC as part of the consultation process. 3.3 The point will be of significance in cases where: individual s benefits have been wholly deferred in a tax year, or the individual was not a member of a registered pension scheme in that tax year. 3.4 This may be the case, for example, where a secondee to an EEA country has ceased active membership of a pension scheme to avoid triggering the cross-border provisions. 3.5 Typically on return to the UK, the secondee is provided with infill pension benefits for the period of absence. Unused allowances for previous tax years would be available if HMRC s intention is that deferred membership of a scheme is sufficient to qualify for the carry forward provision. SLAUGHTER AND MAY 15

3.6 If HMRC do require some form of active accrual in a tax year in order for the carry forward facility to be available, then a fairly basic tax planning point for individuals will be to ensure that, regardless of their employment status, they make some form of pension contribution to a registered pension scheme (e.g. to a personal pension scheme) in each tax year. 4. Redundancy cases 4.1 The carry forward facility may be of assistance in redundancy cases where the scheme member has not fully utilised the available annual allowance in the 3 previous tax years. 4.2 The scheme member s available annual allowance for the tax year of redundancy will be increased by the balance of the unused allowances for the 3 previous tax years (see 2. above). 16 SLAUGHTER AND MAY

H. Managing the annual allowance charge cap and carry 1. Managing accrual to avoid spikes 1.1 The Government has reconfirmed that it is happy for schemes to take steps to manage accrual where there are spikes in pension inputs, for example as a result of a pay rise in a particular tax year. This can be achieved by, for example, smoothing accrual so that the effect of the pay rise is spread forward over a number of tax years. Comment: The cap element of a cap and carry mechanism is included in the model Slaughter and May interim and definitive amending deeds (see C.6 above). However, this will need to be checked in the light of the final legislation in this area to establish whether the provisions of the deed in question will, in fact, apply. 1.2 The design of any carry forward mechanism will be up to individual schemes and the terms of the scheme s particular amendment power will need to be observed. 2. Anti-avoidance 2.1 The Government has stated that it will take appropriate action against manipulation of the smoothing mechanism, in order to avoid payment of tax that is properly due, although it has not stated what form this action will take. 2.2 The policy expectation is that: accrual should only be smoothed in the period before benefits are put into payment, and only for so long as employment continues. 2.3 It is to be hoped that the Government will recognise a concept of group employment so that forward spreading of accrual, if adopted, can continue if a member moves employment between group companies. 2.4 A similar concept was used in the grandfathering protections that were enacted at the time that the 1987 and 1989 Revenue limits restrictions were introduced. 2.5 In addition, it is to be hoped that the Government will include appropriate provisions to cover changes in connection with TUPE transfers and other business activities which are outside the control of the member in question. SLAUGHTER AND MAY 17

3. Statutory power of amendment? 3.1 The Government has recognised that in some cases scheme trustees may not have the power to amend their rules to smooth accruals forward. It will continue to discuss this issue with interested parties including the DWP and will, if necessary, take action. 3.2 It seems likely that the action that would be taken would be the introduction of an overriding statutory power to amend for these purposes for schemes that would not otherwise have such powers. 18 SLAUGHTER AND MAY

I. Details of tax relief and annual allowance charge 1. Tax relief 1.1 Tax relief will continue to be given at an individual s marginal rate of tax. 1.2 In the discussion document the Government had considered capping tax relief at 40%. This was rejected in favour of simplicity. 2. Rate of annual allowance charge 2.1 The annual allowance charge is tailored to recoup the full marginal rate of tax relief which the individual has benefited from. This is achieved by increasing the individual s taxable income by the excess over the annual allowance. 2.2 This is a change from the current position where the annual allowance charge is set at a flat rate of 40%. 3. Collection and reporting of the annual allowance charge 3.1 The charge will continue to be collected through self-assessment. This means that, from HMRC s point of view, the individual is responsible for monitoring the amount of the annual allowance that has been used up, and reporting any excess to HMRC. 3.2 The draft guidance issued to date by HMRC is aimed at individuals, reflecting the fact that it is individuals who need to report the tax due. 3.3 The obligation of the scheme administrator and the employer is simply to provide information to the member (see further Part M below). 3.4 Where an individual, by using the carry forward facility, has an increased annual allowance due to unused annual allowance for previous tax years (see G.1 above), there is no need to report that fact to HMRC. 3.5 The carry forward facility operates automatically. HMRC will only require a report from the individual where the individual s annual allowance, as enhanced by carry forward, is exceeded in a particular tax year. SLAUGHTER AND MAY 19

4. Paying annual allowance charge out of pension entitlement 4.1 The Government is considering options for individuals to be able to pay any annual allowance charge out of their pension entitlement rather than current income. 4.2. The options being considered are: for the scheme to pay the charge on behalf of the individual at the time at which the charge arises (the scheme pays option), and roll forward of the liability to the tax charge until the benefits are actually crystallised (so that the tax charge could, in effect, be paid out of the member s tax-free commutation lump sum (if sufficient for that purpose)). 4.3 It does not appear that scheme pays will be made compulsory, which is welcome. The compulsory scheme pay proposals were an element of the previous administration s approach to the restriction of tax relief which would have imposed considerable administrative burdens on pension schemes. 4.4 Final decisions on the approach to be taken are now expected in advance of 6th April 2011. Previously the Government had said that the decisions on this would be deferred to the Finance Act 2012. 20 SLAUGHTER AND MAY

J. Lifetime allowance 1. Reduction in the lifetime allowance 1.1 The lifetime allowance will reduce to 1.5 million (from the current 1.8 million). The Government is currently minded that the reduction will take place on 6th April, 2012. 1.2 The reduction is expected to occur one year later than the reduction for the annual allowance. This later effective date is to enable the Government to put in place, and individuals to respond to, appropriate transitional provisions. See further 7. below. 1.3 There is a short consultation period, ending on 29th October, 2010, within which the Government seeks views of interested parties on the proposed protection regime for the reduced lifetime allowance. 2. Valuation factor 2.1 The Government is minded to continue using a single flat factor of 20 to value defined benefit pensions for the purposes of testing against the lifetime allowance. 2.2 The Government has considered whether to alter the factor to a different rate or to make the lifetime allowance valuation factor age related, to capture the value of early retirements. 2.3 These will not be captured through the annual allowance (other than in circumstances where added years are given) (see D.2 above). 2.4 However, for the moment the Government s provisional view is that it does not intend to move away from flat factors, and will stick with the 20 factor. 3. Rate of charge It is currently intended that the lifetime allowance tax charges will remain as at present, that is: 25% of the capitalised amount over the lifetime allowance where a pension is paid, and 55% of the amount over the lifetime allowance where a lump sum is paid. SLAUGHTER AND MAY 21

4. Tax free cash 4.1 It is currently intended that the maximum tax free lump sum payable on retirement will continue to link to 25% of the pension arrangement s value with a maximum of 25% of the standard lifetime allowance. 4.2 Once the reduced lifetime allowance comes into effect, therefore, the maximum tax free lump sum will reduce to 375,000 from the currently permitted 450,000. 5. Trivial commutation 5.1 The trivial commutation limit is currently set at 1% of the standard lifetime allowance. This will be de-linked from the standard lifetime allowance to ensure that the limit is maintained at the current 18,000. 5.2 This is a welcome move as reduction of the trivial commutation limit would have made it more difficult to commute small pensions an area where tax simplification actually made matters more difficult for registered pension schemes. 6. Transitional protections primary and enhanced protection 6.1 Members who have claimed enhanced or primary protection will continue to receive those protections. 6.2 Changes will be needed to the way primary protection is expressed in Finance Act 2004, as it currently provides protection as an uplift factor to the standard lifetime allowance. This will need to be adapted once the standard lifetime allowance reduces to 1.5 million. 6.3 However, the annual allowance charge will be applied, for the first time, to individuals who have claimed enhanced protection. Comment 1: This will only be relevant for individuals with enhanced protection who have ceased pensionable accrual but who have retained a link to salary increases (see E.2 above). Comment 2: Subject to the terms of the final legislation, the auto-fix provision in the model Slaughter and May interim and definitive amending deeds should assist in these circumstances (see C.6 above). 22 SLAUGHTER AND MAY

7. New transitional protections 7.1 A new protection is expected to be provided for individuals who currently hold a pension pot in excess of 1.5 million but have not registered for primary or enhanced protection. This protection will be capped at the level of the existing lifetime allowance of 1.8 million. 7.2 A further protection, pension growth protection, is expected to be provided for individuals who have planned their retirement savings on the basis that they will grow to a level of 1.8 million by retirement. 7.3 The option floated in the policy paper is to provide a personalised LTA set at a fixed level of 1.8 million on the condition that the individual ceases to make further contributions to money purchase arrangements or to acquire any further active benefits in defined benefit arrangements. 7.4 The personalised LTA would be lost if the individual subsequently became an active member of any pension arrangement. 7.5 It will be necessary to watch out for whether life cover only (or life cover and incapacity protection) will cause a loss of this new protection. SLAUGHTER AND MAY 23

K. EFRBS and non-registered schemes 1. There are changes affecting funded EFRBS. 2. Unfunded EFRBS will not, at present, be affected. 3. It also appears that non-registered life cover only schemes will survive. 4. Further details are set out in a longer form memorandum available to clients. 24 SLAUGHTER AND MAY

L. Overseas schemes 1. There are some changes in relation to overseas schemes. 2. Further details are set out in a longer form memorandum available to clients. SLAUGHTER AND MAY 25

M. Administration 1. There are a number of administration issues that will need to be managed, including: pension input periods, information requirements imposed on scheme administrator, and additional information requirements imposed on employers. 2. Further details are set out in a longer form memorandum available to clients. 26 SLAUGHTER AND MAY

N. Next steps In terms of next steps, employers may wish: 1. to analyse member data to identify which individuals are likely to have annual pension benefits which are in excess of the reduced annual allowance, or may be affected by the reduced lifetime allowance. 2. to consider remuneration policy for members whose ongoing benefits are in excess of the reduced annual allowance, or are approaching the reduced lifetime allowance. 3. to check whether scheme contains auto-fix provision for capping at the annual allowance (see C.6 above). If not, consider whether to include a cap. 4. to consider adding a cap and carry mechanism into the scheme rules to deal with one off spikes in accrual, for example on a salary increase. 5. where individuals are currently being provided with funded EFRBS, to consider remuneration policy for the tax years from 2011/2012 and the continued use of such EFRBS. 6. where members have registered for enhanced protection but continue to have accrued benefits revalued by reference to salary increases, to consider the potential effect of the annual allowance applying. 7. where individuals have had pension benefits limited by the special annual allowance (for example, new joiners), to consider remuneration policy once the annual allowance moves to 50,000 and the carry back facility is available. 8. to commence systems changes for calculating defined benefit pension inputs on new basis. Be prepared to re-calculate defined benefit pension inputs for members on the new basis for tax years 2008/2009, 2009/2010 and 2010/2011. These figures will not have to be provided until 6th October, 2013. Slaughter and May 2010 This material is for general information only and is not intended to provide legal advice. For further information, please speak to your usual Slaughter and May contact. SLAUGHTER AND MAY 27

APPENDIX REMINDER OF THE ALLOWANCES INTRODUCED FROM 6TH APRIL, 2006 Note: This Appendix outlines the pre-6th April, 2011 position. 1. Overview 1.1 The so called Pension Tax Simplification Regime came into force on 6th April, 2006, under the Finance Act 2004. 1.2 The Pension Tax Simplification Regime has 2 key concepts: First, in any tax year, there is an annual rationing of increases in tax privileged pensions savings. This annual rationing amount is called the annual allowance. For the tax year starting 6th April, 2010 the annual allowance is 255,000. Second, there is a lifetime pension tax relief ration called the lifetime allowance. For the tax year starting 6th April, 2010 the lifetime allowance is 1.8 million. 1.3 In addition, tax relief on an individual s relievable pension contributions to registered pension schemes has to date been given, up to 100% of taxable UK earnings, at the individual s appropriate marginal rate of tax. 1.4 What were previously called tax approved or exempt approved schemes, following the Finance Act 2004 changes, became registered pension schemes with effect from 6th April, 2006. 2. Categorising benefit structures for allowance purposes 2.1 For the purpose of calculating the annual allowance and the lifetime allowance, benefit structures under a registered pension scheme are divided into the following categories: Cash balance arrangements in summary where the benefit provided is in a capital sum form but is not determined solely by reference to contributions paid in and investment return on those contributions. For example, if the benefit available at retirement is expressed as a lump sum calculated as a percentage of the 28 SLAUGHTER AND MAY

member s final pensionable pay for each relevant year of service and this can then be taken, in part, as tax free cash and, in part, converted into a pension or annuity. Note: These arrangements are referred to as cash balance in this document. Other money purchase arrangements where the benefit provided is a lump sum available at retirement which is derived from contributions made as adjusted for investment return. That lump sum can be taken, in part, as tax free cash and, in part, converted into a pension or annuity. Note: For ease of reference, this type of arrangement is referred to as a money purchase arrangement in this document. Defined benefit arrangements this has the meaning it is expected to have. In other words, for example, a pension of 1/60th of final pensionable pay or of career average earnings for each year of membership of the scheme. Hybrid arrangements where the arrangement is expressed to be the better of one or more of the preceding arrangements. In practice, the arrangement s categorisation will be known when the benefit is taken. Note: This type of arrangement is not considered further in the rest of this document. 3. When do you test against the allowances? 3.1 A test of the annual increase in and individual s tax privileged pension savings (called the pension input ) is made against the annual allowance for each tax year. 3.2 Testing against the annual allowance for a tax year is by reference to the pension input periods for each of the arrangements an individual has in a registered pension scheme which end in that tax year. 3.3 The scheme administrator can choose the pension input period for defined benefit and cash balance arrangements and may, for example, pick the period that coincides with the scheme s year end, rather than the tax year end. 3.4 Either the scheme administrator or the member can nominate the pension input period for money purchase arrangements. Where more than one nomination is made, the first one made is given effect. 3.5 For new arrangements, until a different pension input period is selected, the default position is that an individual s input period will end on the anniversary of: the date on which benefits began to accrue (for defined benefit and cash balance) or the date of the first contribution is made (for other money purchase arrangements). SLAUGHTER AND MAY 29

3.6 Generally, a nomination will be made by the scheme administrator to bring the input period in line with other arrangements under the scheme. 3.7 Where the individual has more than one pension arrangement, all the pension inputs for all those arrangements for the input periods ending in the tax year are aggregated and tested against the annual allowance for that tax year. A member may have more than one pension arrangement in a single scheme (for example, a defined benefit promise and a money purchase AVC pot under an occupational pension scheme) or active arrangements under more than one scheme (for example, he or she may benefit from a money purchase benefit under an occupational scheme and also contribute to a personal pension). 3.8 A test is made against the lifetime allowance on the occurrence of a benefit crystallisation event. A benefit crystallisation event occurs primarily where the member s benefits come into payment on retirement or on earlier death. 4. Calculation for testing against allowances money purchase arrangements 4.1 To calculate the pension input for a money purchase arrangement for the purposes of the annual allowance, you add up the total of the member contributions and the employer contributions made to the arrangement during the pension input period ending in the tax year in question. 4.2 An important point to note is that pension inputs under an arrangement which comes fully into payment in a tax year are excluded in testing against the annual allowance of the member for that tax year. Comment: This disregard does not apply when calculating whether the special annual allowance, applied under the anti-forestalling measures, is exceeded, except in limited circumstances of ill health. 4.3 The amount tested against the lifetime allowance, when a benefit crystallisation event occurs for a money purchase arrangement (such as securing a lifetime annuity) is the value of the pension pot used to buy the benefit. 5. Calculation for testing against allowances defined benefit arrangements 5.1 A more complex procedure is required to calculate the pension input for a defined benefit arrangement for the purposes of the annual allowance. This can be summarised as follows: Step 1: Establish the member s accrued pension at the start of the pension input period, assuming that the member has reached such an age that there is no reduction for early payment. Multiply this by 10. Note: Where the arrangement is deferred throughout the tax year (i.e. rights do not accrue to the individual under the arrangement during the tax year), the amount at Step 1 is up-rated, in summary, by 5% or the 30 SLAUGHTER AND MAY

annual increase in the Retail Prices Index (whichever is the greater) before being multiplied by 10. There is no equivalent provision for active members. Step 2: Establish the member s accrued pension at the end of the pension input period, assuming that the member has reached such an age that there is no reduction for early payment. Multiply this amount by 10. Note: There are rules that cover adjustments for transfers in, transfers out, benefit crystallisation events and the effect of pension sharing on divorce. These are considered at 6, 7 and 8 below. Step 3: Take-away from the amount at Step 2 the amount at Step 1. The net amount (if positive) is then tested against the annual allowance for the tax year in question. 5.2 An important point to note is that pension inputs under a defined benefit arrangement which comes fully into payment in the tax year in question are excluded in testing against the annual allowance of the member for that tax year, just as they are for money purchase benefits. Comment: This disregard was retained for the purposes of the special annual allowance, applied under the anti-forestalling measures, but additional conditions were applied. This contrasts with the approach taken for money purchase benefits where the disregard is not applied at all for special annual allowance purposes. 5.3 For the purposes of testing against the lifetime allowance: Where a pension comes into payment from a defined benefit arrangement, it is valued by multiplying the starting annual pension by 20. If a tax free lump sum is paid, it is valued as the amount paid. 6. Adjustment of defined benefit calculations for transfers in and out 6.1 Transfers in and out are dealt with through adjustments to the closing value (found under Step 2 in 5.1 above), with the intention that they should be neutral for annual allowance purposes. 6.2 If a transfer in relating to the individual is made during the pension input period, involving the transfer in of sums or assets from another pension scheme, the aggregate of the amount of any sums transferred and the market value of any assets transferred is to be subtracted. This adjusts the calculation of the value of the pension at the end of the pension input period, as shown at Step 2 in 5.1 above. Comment: A transfer in from any pension scheme, whether registered or not, is covered by this provision. 6.3 The intended effect of the subtraction process is to exclude the value of the transferred in benefits from the input calculations for the tax year. In other words, transfers in are intended to be neutral for annual allowance purposes. SLAUGHTER AND MAY 31

6.4 Although the natural meaning of the words used in Finance Act 2004, Section 236(7) is that the transfer payment amount is subtracted from the closing value calculation, HMRC read this provision as enabling the reduction to be expressed in pension terms (so the subtraction is 10x the pension transferred). Comment: It is to be expected that this infelicitous drafting will be corrected as part of the annual allowance charges announced on 14th October, 2010. 6.5 Likewise, where a transfer out is made during the pension input period, to either another registered pension scheme or a qualifying recognised overseas pension scheme ( QROPS ), the aggregate of the amount of any sums transferred and the market value of any assets transferred is to be added. This adjusts the calculation of the value of the pension at the end of the pension input period as shown at Step 2 in 5.1 above. 6.6 Again, the intended effect of the addition is to include the transferred benefits when measuring the input for the tax year. Transfers out are meant to be neutral for annual allowance purposes. 6.7 The intention is to identify any genuine increase in the accrued rights which may have arisen between the opening value and the transfer. Comment 1: There could be a manipulation of these rules. The transfer out measure will use salary and accrual up to the transfer out date. On the transfer in, the amounts of pension transferred in are subtracted, but there is no control on how this is expressed. A higher pension could be granted in the receiving scheme, and this increase on transfer would not be captured in the current annual allowance calculation. Comment 2: We can expect that either this loophole will be closed in the proposed revisions to the annual allowance, or that anti-avoidance provisions will be included to prevent abuse of these provisions. 6.8 Again, although the natural meaning of the words used in Section 236(5) is that the transfer payment amount is added back to the closing value calculation, HMRC read the provision as enabling the addition to be expressed in pension terms. Comment: HMRC go on to say that this approach means it is not necessary to attribute a value to each member s benefits on a bulk transfer. This was the context in which HMRC s interpretation of these provisions was first queried. 7. Adjustments of defined benefit calculations for pension sharing on divorce 7.1 Where a pension credit or debit is made, these are again dealt with through adjustments to the closing value, with the intention that they should be neutral for annual allowance purposes. 7.2 When a pension debt occurs during the pension input period, the amount of the debit is to be added back to the closing value. 32 SLAUGHTER AND MAY

7.3 Where a pension credit entitlement occurs, and the credit is sourced from a registered pension scheme, the amount of the credit is subtracted. 7.4 There is no express statement by HMRC that the pension credit subtractions and additions are to be calculated in pension terms (rather than cash terms). However, adjusting in pension terms is consistent with the HMRC statements in relation to transfers in and out (see 6 above) and benefit crystallisation events (see 8 below) and is how we assume HMRC interpret these provisions. We have asked HMRC to confirm that this is the correct approach. 8. Adjustment of defined benefit calculations for benefit crystallisation events 8.1 It will usually be the case, in practice, under a defined benefit scheme that any benefit crystallisation events will occur when an arrangement is being fully crystallised, for example on retirement. 8.2 In this circumstance, the final year exception referred to at 5.2 above will apply, and the pension inputs for that defined benefit arrangement will not have to be tested against the annual allowance for that tax year. 8.3 However, there can be a benefit crystallisation event in circumstances where the arrangement is not fully crystallised, for example: on a flexible retirement, or on a transfer to a QROPS. 8.4 Where there is a benefit crystallisation event in these circumstances, the amount crystallised is to be added (adjusting the calculation at Step 2 in 5.1 above). 8.5 Again, on the face of it, this requires an adjustment in monetary terms. 8.6 This would cause a spike in the pension input. For example, a pension that comes into payment is valued for crystallisation purposes with a factor of 20, whilst the pension at the start of the input period is valued using a factor of 10. 8.7 However, HMRC confirmed, in the context of the special annual allowance, (where the annual allowance legislation is used in adapted form) that the actual package of benefits is converted back into the prospective entitlement [of pension for the member] under the DB scheme before [the benefit crystallisation event]. Comment 1: In this guidance, at RPSM15106040 HMRC state that for these purposes, they are following the principles for the annual allowance. Comment 2: There is currently no equivalent explanation in the guidance on the annual allowance itself. We have written to HMRC to request confirmation that these principles apply equally to the annual allowance. We SLAUGHTER AND MAY 33