In this week's consideration of unapproved schemes under the new pension tax regime, I would like to look at the post-A-Day position for existing Furbs. Two key questions for those with these schemes are:
Whether to make further contributions and
Whether to leave benefits in the scheme or, if possible, to remove them.
Broadly speaking, under proposed transitional provisions, the current tax regime will be maintained. Provided contributions into the Furbs have been taxed on the employee, gains and income on the underlying investments have been brought into charge to tax at scheme level and no further contributions are made after A-Day, all lump-sum benefits received will be capable of being paid to the member tax-free. There will be continuing inheritance tax freedom on any payments on the death of the member. This freedom is currently available provided the scheme is a sponsored superannuation scheme under section 624 ICTA 1988, which most Furbs would be.
The position is not so clear when contributions are made to the Furbs on or after A-Day on April 6, 2006. I will look at this a little later in the article.
Provided no further contributions are made to the Furbs and it is effectively frozen, the largely favourable tax consequences will be preserved. But there is one significant change that will have to be considered for such a frozen Furbs that is not to do with tax simplification. Instead, it concerns the increase from April 6, 2004 of the rate of tax for trust capital gains from 34 to 40 per cent. This applies to the gains of all trusts other than those where the gains are assessed on the beneficiary under absolute/bare trusts or assessed on the settlor under settlor-interested trusts.
In considering Furbs, as non-registered schemes, it might seem that the settlorinterested rules apply. But it is necessary to consider if the Furbs is a settlement made by the person who will primarily benefit – the member. To be a settlement, there has to be donative intent and an element of bounty.
It has generally been accepted that in the context of most Furbs (funded by the employer), these conditions will not be satisfied within the context of what is a commercial arrangement. The Inland Revenue's booklet on taxing top-up pensions, published some time ago, made the point that provided the structure and operation of the Furbs was broadly similar to an approved scheme, these provisions would not be applied.
In the proposals for simplifying pension taxation issued in December 2003, it was stated that, from A-Day, all income and gains of non-registered schemes established under trust will be subject to the rate applicable to trusts. So we can assume that the 40 per cent rate will be relevant for Furbs' income and gains from A-Day, with gains being subject to 40 per cent tax from April 6, 2004.
To the extent that dividends from UK companies and collectives are concerned, the Schedule F trust rate will almost certainly rise to 32.5 per cent from 25 per cent from A-Day. This rate will be applied to the dividend received – grossed up by 10 per cent – and the 10 per cent tax credit can then be taken off to ascertain the tax payable. Income will continue to be subject to basic-rate tax until A-Day and not the 40 and 32.5 per cent rates.
Most people would probably conclude that if the Furbs was considered tax-attractive prior to these changes, the preservation of its tax status beyond A-Day would make sense. But I ought to point out that if further contributions are made on or after A-Day, there will be a proportionate downwards adjustment of the tax-free lump sum that can be paid. This is to reflect the fact that, for post-A-Day contributions, no tax liability on the member or deductibility for the paying company will have taken place. The Finance Act 2004 states that if contributions to a protected Furbs are made on or after April 6, 2006, only the value at April 5, 2006, increased by the RPI, will be tax-free. Not only will the value of funds driven by post-A-Day contributions be taxable but also any increase in the value of the fund at April 5, 2006 over and above the RPI.
Even if no further contributions are made, trustees of existing Furbs must consider the impact that the new 40 per cent tax rate (32.5 per cent for dividends) will have on the attraction of the Furbs from A-Day. It will be necessary to consider:
The value attached to the continued benefit of IHT freedom and the payment of a tax-free lump sum.
The tax appropriateness of existing investments and whether there are more tax-effective alternatives to hold inside the Furbs trust.
Whether it is possible to remove funds from the Furbs ahead of retirement and what the consequences would be.
The increase in the tax rate applicable to trusts is unavoidable so what strategies can be considered to reduce its impact, assuming the IHT benefit available to protected Furbs is valued by the member and employer?
The pre-A-Day protected Furbs offers an extremely attractive means of assets being held outside of IHT but fully accessible to the member. How many other trust structures deliver this? It is not a benefit to give up lightly.
The 40 per cent trust rate applies to realised gains so a growth strategy will defer tax. It can also enable full use to be made of taper relief. Taper relief starts to operate after three years of ownership and after 10 years gains are reduced by 40 per cent. This means the effective trust rate payable on realised capital gains (and remember that the new 40 per cent rate applies to existing as well as new Furbs) will be 24 per cent. Obviously, the investment wrapper to be used for the portfolio will determine the timing and tax treatment of the gains.
An insurance wrapper will not enable taper or the annual CGT exemption to be used as policy gains are subject to income tax. I will consider the use of life policies in later articles.