EPPs, Furbs and basis years for salary all help in tax planning for pensions but the forthcoming Green Paper could make any such planning suitable only in the short term
The National Insurance increase due in the 2003-4 tax year further focuses the debate on whether remuneration for directors and high earners should be in the form of salary or dividend.
Taking remuneration as dividend offers a number of advantages. It is usually more tax efficient, even for higher rate tax payers, where the company profits are taxed at 19% (profits between £50,000 and £300,000 a year). Tax benefits also arise from the fact neither the employer nor the individual pays National Insurance contributions on the dividend declared. A further advantage is that dividends may be redirected to, say, a spouse on a lower tax band.
However, one of the main disadvantages in following the dividend route is that the amount remunerated is not counted as pensionable earnings. This would severely limit sensible pension planning if it were not for regulations that allow considerable scope to secure the best of both worlds: low salary/high dividends for tax planning opportunities but with the ability to pay high pension contributions.
Since April 2001, individuals under the personal pension regime, including those few directors with a stakeholder plan, have been able to pay pension contributions based on earnings from a previous tax year. This is known as earnings certification or, more commonly, the basis year rule.
The director can take a high salary in one year and pay a correspondingly high pension contribution. They can then maintain this level of contribution for a further five years even if their salary is drastically reduced in favour of a dividend strategy (see table 1).
A pension contribution equivalent to 100% of salary could be appropriate and has the bonus of considerably reducing the income tax payable. If the director has a remuneration package of £50,000, a number of options are available (see table 1).
This concept can be further stretched if the director is nearing retirement, or indeed simply stops earning, with the use of cessation years. When earnings stop, the individual can base their pension contributions on the earnings in any of the preceding five years for a further five-year period. This is known as the cessation year rule (see table 2).
For particularly high earners, it is interesting to note the change concerning the basis year and earnings cap. Pensions Update 130 has recently changed this rule by confirming that, if the earnings cap is increased, a pension contribution can correspondingly increase without change to basis year and without the need for further evidence of earnings.
For example, a 37-year-old director earning £130,000 in his elected basis year of 2001-2 can pay 20% of the earnings cap for that year of £95,400. For the 2002-3 tax year, he is able to pay 20% of the new cap of £97,200 without further salary reference. As the earnings cap is effectively increased each year by RPI, high earners are hitting this level earlier.
If we assume an executive's pay increases at a rate of 4% above RPI, a 40-year-old currently earning £65,000 would be restricted by the earnings cap within 10 years. Planning using alternative regimes such as Executive Pension Plans (EPP) may then be necessary.
For directors and other high earners unable to elect to take a dividend strategy or who wish to fund a pension to a level exceeding the personal pension contribution limits, an EPP may be a good alternative, providing scope for considerable company tax savings.
Take the following example. A man retiring at 60 working for a company with profits of £300,000 per year has no retained benefits. The difference between the maximum allowable contributions, comparing personal pension with an EPP, is surprising. Assuming the company pays the contribution, the difference in tax saved is as shown in the tables below.
Funded Unapproved Retirement Benefit Schemes (Furbs) are becoming an increasingly popular option for allowing senior executives/directors to fund their pensions in excess of the earnings cap.
A survey published by William M Mercer in May 2001 found 34% of employers offer to contribute to Furbs on behalf of their executives. This is not surprising when you consider the tax breaks and that 83% of board directors raise the issue of excess pension facilities in the recruitment interview.
Furbs are designed to provide a lump sum for an employee on reaching retirement (age 50 at the earliest) with no liability to further tax or National Insurance. Assets held within Furbs are not part of the employee's estate for inheritance tax, so Furbs can be a very effective IHT shelter. The scheme is held within the ultimate trust vehicle, a flexible, discretionary revert-to-settlor trust.
This means the investor can benefit whoever he pleases, including himself, with trust assets during his lifetime, without creating a charge to inheritance tax. The ultimate tax benefit is that Furbs can be held until death if required, when all capital gains tax liabilities are extinguished and assets can be passed immediately, with no IHT liability, to the chosen beneficiary.
There is no limit on the contribution an employer may make to a Furbs and corporation tax relief is allowed on the whole contribution, as long as the contribution is used 'wholly and exclusively for the purposes of the company's trade'. This means the employee's total pay package must not be excessive for the duties undertaken.
The contribution is liable to income tax on the employee as a benefit in kind and deferred under P11D procedures. The tax is payable on 31 January following the end of the tax year in which the contribution is paid, so a deferral period of up to 22 months is possible. However, National Insurance contributions are due and are payable in the month following the payment to the Furbs.
Furbs pay tax on income and capital gains at the basic rate only. Dividends and bank and building society interest is taxed at only 20%. Accumulating savings via Furbs is therefore very tax effective.
It is important to note that all the above discussion regarding utilising maximum allowances could soon be irrelevant following the publication in December 2002 of the DWP's pensions Green Paper, together with the accompanying Inland Revenue review of pension taxation.
Radical reforms and simplification of the rules surrounding pensions and their taxation are proposed and have been covered substantially elsewhere. The changes are likely to be introduced in the 2004 Finance Bill, meaning their effective start date could be as early as 6 April 2004. This means the tax planning ideas I have outlined above are likely to have a limited lifespan.
Regulations allow clients to secure the best of both worlds for tax planning benefits ' low salary and high dividends.
EPPs and Furbs are a good alternative for company directors and allow considerable tax savings for the company.
Reforms in the Green Paper may make these tax planning tools obsolete.
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