The framing of the debate around the fairness of higher rate tax relief always tends to focus on the favourable position of high earners in defined contribution (DC) schemes receiving higher rate relief on the personal contributions they pay into their pension.
At face value, this relief is very straightforward to deal with.
Simply stop these individuals from receiving the extra tax relief through their tax return. Instead, they’re left with the 20% tax relief credited directly into their pension.
A major flaw in this thinking from a financial sense is that the biggest cost in relation to higher rate tax relief on pension contribution doesn’t come from member contributions to DC schemes but from employer contributions to DC schemes and the value of the tax relief on the accrual in defined benefit (DB) schemes.
Relief on neither of these is reclaimed through the tax return, they are just automatically obtained because the individual receives a different type of gross, free of tax, remuneration paid directly into their pension scheme. Removing higher rate tax relief on member contributions alone would only put a small dent in the value of tax relief granted each year – meaning restricting the policy to that type of tax relief wouldn’t achieve much for the Treasury.
Only removing higher rate tax relief from member contributions would also simply lead to increased use of salary sacrifice, with higher earners diverting some of their pay directly into the pension through employer contributions to obtain the higher rate tax relief through that route.
So in order to effectively remove higher rate tax relief in DC schemes and lessen avoidance, employer contributions need to be dealt with as well as member contributions.
As soon as employer contributions are brought into the picture we hit the interesting anomaly that the removal of higher rate tax relief becomes an issue even for those who only pay basic rate tax.
Using an example of an individual earning £48,000 with a 10% employer contribution paid to their pension scheme – generous, but by no means unusual. The individual’s earnings sit below the higher rate tax threshold of £50,000, but the £4,800 employer contribution means that £2,800 of the combined remuneration is deemed to have earned tax relief of 40%. If higher rate tax relief is removed and has to be clawed back the individual faces a tax bill of £560 even though, through salary alone, they are not a higher rate tax payer.
Of course, if you’re going to tackle this in the DC pension space, the problem also has to be addressed in the DB space, including within the civil service.
It would be difficult to avoid arguments of unfairness if an advanced nurse/nurse practitioner employed by an agency, so contributing to the DC scheme offered by the private firm, was treated differently from their NHS-employed colleague on the same ward who was a member of the NHS DB scheme.
With DB, we need to value the indirect remuneration gained from the pension accrual. So how do we do it?
In an unfunded DB scheme, like those operated for much of the civil service there are two potential options. Firstly, we could use the Accruing Superannuation Liability Charges (ASLC) to establish the value of the employer ‘contribution’ to the DB scheme. This is probably the closest equivalent to the employer contribution in a DC scheme – one is an amount the employer is deemed to pay, the other an actual amount the employer pays – so some logic there.
The second option is the amount of annual allowance used up by the individual in a tax year. As this is based on a calculation decided by HM Revenue & Customs rather than an amount paid, it isn’t as close an equivalent to a DC employer contribution as the ASLC, so at first glance might not seem the best candidate.
The problem with using ASLCs is that they don’t work in funded DB schemes – the concept doesn’t exist in funded DB schemes. Employers using funded DB schemes make payments to the scheme by referring to a range of factors – demographics; scheme funding; performance of underlying investments; the make-up of the scheme between active, deferred and pensioner members etc. So the amount an employer contributes to a funded DB scheme cannot be used.
This leaves us with the use of the annual allowance for the purposes of calculating the value of accrual for all DB schemes.
Readers will recall the furore over the impact of the tapered annual allowance on members of the NHS pension scheme. If the annual allowance is used to calculate the value of accrual for the purposes of removing higher rate tax relief on deemed DB contributions, we’re going to see similar problems.
Using an example taken directly from the NHS Pensions website an individual moving from a salary of £25,000 to £40,000, so not a higher rate taxpayer, has annual allowance accrual of £90,843.75. This is an old example, though taken from the live NHS website, but the principles remain the same. If the individual’s salary for the tax year was £40,000 and their pension accrual was valued at £90,843.75, removal of higher rate rax relief would mean they’d face a tax bill of £16,168.75 (20% of the value of their remuneration exceeding £50,000).
So does the Treasury:
- Just deal with tax relief on member contributions – which raises questions around fairness; is ineffective in terms of tax impact; and encourages use of salary sacrifice to avoid the tax bill; or
- Deal with tax relief on both member and employer contributions in DC schemes – this removes the salary sacrifice issue, but creates an issue around basic rate taxpayers facing tax bills on the higher rate relief they’re deemed to have received on their employer contributions; or
- Tackle the problem across DC and DB schemes – which, as seen above, has the potential to leave basic rate taxpaying nurses facing five figure tax bills.
Perhaps unsurprising that the idea has been pushed into the weeds more than once in the past.
Gareth James is head of policy at AJ Bell