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Wholly spirit

Standard Life marketing technical manager John Lawson warns that advisers are in for a rollercoaster ride trying to explain the implications of the new pension tax rules to business clients as the Revenue moves in to take more control of employer contributions

Employers claiming tax relief on contributions to pension schemes could face problems when the new tax rules come into force on April 6, 2006. From that date, tax inspectors will have the final say on whe-ther a business can deduct pension contributions in calculating taxable profits.

The new rules are set out in section 196 of the Finance Act 2004. This section makes all employer contributions to pension schemes subject to the “wholly and exclusively” test defined in section 74 of the Income and Corporation Taxes Act 1988.

Section 74 says: “In computing the amount of the profitsno sum shall be deducted in respect of any expenses, not being money wholly and exclusively expended for the purpose of the trade, vocation or profession.”

The test stops businesses from getting tax relief on what is essentially personal expenditure of the owners and their families. In particular, the test stops businesses from paying principals and close relatives excessive amounts of money for any work they perform. For example, paying the husband or wife of a company director 50,000 a year for doing a job that normally pays 5,000 a year is not allowed.

Tax inspectors apply this test to employee pay and other benefits but they have no experience of applying the test to pension contributions because they are currently subject to strict limits.

By limiting tax-deductible earnings using the wholly and exclusively test, the Revenue is effectively limiting pension contributions, too, because these contributions are currently a product of the amount earned. For example, personal pension contributions are limited to 17.5-40 per cent of earnings, depending on age.

The new pension tax rules change all this. From April 6, 2006, employer contributions are, in theory at least, unlim-ited. From the same date, the link between earnings and pension contributions is also broken. In fact, it will be possible for employers to pay contributions on behalf of employees who have no earnings at all.

This change presented tax inspectors with a problem. How could they stop businesses from paying the business principal and his or her family excessive pension contributions? The simple answer was to apply the wholly and exclusively test directly to pension contributions in the same way as earnings.

The current application of the wholly and exclusively test on earnings determines whe-ther they are reasonable in relation to the duties performed. For common tasks, this is easy to determine.

The jobs market advertises similar roles open to candidates with no family connection. If the market is prepared to pay Xs for a particular job, it is reasonable that a business employing a family member should also pay them Xs for performing a similar function.

However, it has always been more difficult for tax inspectors to determine what a reasonable level of pay is for company directors. The value of the role that they perform is by its very nature less tangible. How does one measure the energy that a director applies in driving a business forward or the decision-making skills that might take a business in a particular direction?

Even in these more difficult areas, tax inspectors have built up years of experience in determining what is and is not reasonable. Court cases, triggered by the Revenue challenging earnings deducted from businesses profits, have also helped to determine boundaries.

It will be necessary to establish similar boundaries for pension contributions when the new pension tax rules come into force. What is and is not a reasonable level of pension contribution will be determined through practice.

In the meantime, the pension industry and advisers are in for a rollercoaster ride. Financial advisers will find it difficult, if not impossible, to recommend a given level of employer pension contribution to be paid in favour of the business principal or close relatives working in the business.

How does the adviser exp-lain to their client why part or all of the employer pension contribution subsequently fails to qualify for tax relief and how might the FSA view such a recommendation using the benefit of hindsight?

The Revenue’s desire to control tax relief on employer contributions for this group of people is understandable. After all, people who own small businesses have almost complete control over how much they are paid. They also control the way in which they get their remuneration, whether it is through a salary, dividends or pension contributions. The pension industry must accept that the Revenue will want to have the final word. However, what the industry needs, and has been asking for since the Revenue first mooted these changes, is guidance. We need to have some idea where the boundaries of acceptability lie – what is reasonable and what is not.

It is comforting that the Revenue recognises the problem. The March 10 edition of Money Marketing reported that the Revenue is drawing up guidance for tax inspectors. It would be immensely helpful if the Revenue shared this guidance with the industry before the new tax rules go live.

After all, it has have shown considerable willing to listen to the industry’s concerns throughout the journey tow-ards our new pension world.

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