Charlene Young: Compensation rule flaws add insult to injury

Charlene Young lists three examples where tax rules on compensation payments are being applied inconsistently - which results in investors who have already suffered a loss being further penalised...

A lack of consistency in the tax rules for compensation payments, and the way HM Revenue & Customs (HMRC) guidance is applied, is creating more problems for investors who have already suffered a financial loss.

It needs clarification and simplification – and here’s why…

1) Inconsistency across tax wrappers

Compensation relating to investments held within a stocks and shares ISA can be paid into the ISA as a defaulted investment subscription. This means that the payment will not use any of the investor’s annual ISA allowance.

Compensation paid in relation to a service or advice that has been provided to a member of a pension scheme, however, is treated by HMRC as being payable to that member. So compensation relating to a self-invested personal pension (SIPP) or advice given on it can be made to the member (outside the SIPP) without being treated as an unauthorised payment by HMRC.

If the payment is made to the SIPP, it is treated as a tax relievable contribution. This can cause problems for investors who may not have sufficient UK earnings to make a contribution, those subject to a reduced annual allowance, and those who would lose enhanced or fixed lifetime allowance protections.

In contrast, compensation relating to poor investment advice given to trustees of a pension scheme would not be treated as a tax relievable contribution. For a small self-administered scheme (SSAS), where the members are nearly always trustees of the scheme, this means compensation can be paid into the scheme without being considered a contribution.

2) Inconsistency in application

Consider two recent compensation cases administered by KPMG; the first relates to Tesco’s accounting scandal and the second to Aviva’s recent U-turn on cancelling its preference shares.

KPMG guidance has told investors that the SIPP trustee is the only party eligible to make a claim and that any compensation paid directly to the member would be treated as an unauthorised payment. This contradicts HMRC’s guidance that it is the member who is eligible to claim and receive the compensation directly without such a penalty.

HMRC has previously come under pressure from firms administering compensation claims in the past and, for those specific schemes only, has stated that the claims can be treated as being made by SIPP trustees.

However, when SIPP firms and industry bodies have approached HMRC with similar cases they are directed straight back to the published guidance.

3) FOS claims are proving taxing

Even the Financial Ombudsman Service (FOS) has trouble with the tax consequences of SIPP compensation.

Claims for poor advice have seen a deduction of 20% or more applied to them by the party paying the compensation if they are to be made into a SIPP. The argument here is that the compensation will receive tax relief. But is it really appropriate that the tax payer foots some of the bill?

On the other hand, we have seen other compensation payments adjusted upwards when paid to schemes to reflect the fact that when funds are withdrawn from a SIPP, 75% of the payment is subject to income tax.

These are just three examples of the issues caused by the compensation rules.

Investors who have already suffered a loss ultimately suffer again when compensation guidance is not applied consistently or there are delays when the position is unclear.

The solution? Bring the treatment of compensation payments for SIPPs in line with ISAs. This would not only simplify the position for all parties but ensure that clients are put back into the position they should have been in without delay and further loss each time.

Charlene Young is technical resources consultant at AJ Bell