The tax rules for compensation payments are inconsistent and, in the context of pensions, fundamentally flawed. Without change, there is a risk they will be exploited by claims management companies, and ordinary taxpayers will be left to pick up the tab.
For Isas, a compensation payment for an investment can be made to the account as a “defaulted investment subscription”.
Money can be paid back into the Isa and not use any of the investor’s annual subscription limit.
However, compensation in relation to a service or advice provided to a member of a pension is – in the eyes of HM Revenue & Customs – personally due to that member.
This means if compensation in relation to advice upon or investments held within a Sipp is made back to a Sipp – for example, to put the fund back in the position it should be – HMRC says we must treat it as a tax-relievable contribution.
This can cause problems for successful complainants, as the payment counts towards their annual allowance (or the tapered or money purchase allowances, where applicable). It will also cause the loss of any enhanced or fixed lifetime allowance protection that might be held.
As Sipp providers generally apply tax relief at source automatically, their scheme rules state any personal contributions they receive must be eligible for tax relief.
This relies on the member having earned income in excess of the gross contribution amount – not always possible for those who structure their earnings as investment income (dividends), or those on low salaries.
FOS awards and PI claims
We have seen the Financial Ombudsman Service and professional indemnity insurers get themselves tangled up when it comes to paying compensation relating to a pension. Often an award or redress amount is subject to a reduction to reflect the fact taxpayer-funded basic rate relief will automatically be reclaimed by a Sipp provider to uplift the amount that ends up in the Sipp.
Why is HMRC allowing taxpayers to foot the bill? It seems at odds with the Treasury’s constant threat to reform tax reliefs and HMRC’s own efforts to pursue tax liabilities.
Pay to the member
So how do Sipp providers usually deal with compensation payments? The rules on which payments can be made to and from a pension scheme are typically very strict.
Yet a compensation payment in respect of a Sipp can be paid to the member directly, and it is not an unauthorised payment.
So a client makes a complaint in relation to their Sipp, the advice they received on it or an investment held in it, and receives a payment into their bank account if successful. This is where rogue CMCs may get involved and exploit the flaws – no doubt a tempting prospect when their success fee often amounts to 30 per cent of the award amount.
DB transfer complaints
Are these rules storing up trouble when it comes to defined benefit transfers and claims against rogue advisers?
If you believe a slew of complaints might be on the horizon, then it could be the perfect storm when you also consider the recent increase in the FOS award limit from £150,000 to £350,000, with CMCs ready to prey on those who received poor advice, or who received advice but still went ahead as insistent clients.
I am not the first to outline the issues with compensation and many before me have tried to show HMRC the flaws.
Interestingly, the Revenue has recently been persuaded by large accountancy firms running a small number of major compensation schemes that payments can be made into a pension without them being treated as a pension contribution, rather than to the member personally.
Other than the fact they have involved thousands of potential claimants, these cases have not been any different from the individual claims where HMRC has always argued payments should go to the member.
If HMRC can be persuaded to completely change its stance on one-off cases by Big Four accountancy firms, perhaps there is some hope it can be persuaded to change its stance more widely? It doesn’t really make sense if it doesn’t.
The present position encourages increased claims from CMC activity by allowing payments directly to the individual, and leaves taxpayers to foot the bill if payments are directed to pensions (with the additional issue of potentially bad outcomes for those with lifetime allowance protections). So we call on HMRC to revisit the wider position urgently.
Charlene Young is senior technical consultant at AJ Bell
You can follow her on Twitter @Charlene__Young