Pension tax relief administration call for evidence – a step towards a flat rate relief?

The issue arises due to there being two methods of obtaining tax relief on member pension contributions:

1 Relief at Source (RAS) schemes – where contributions are paid to the scheme out of taxed income.   The contribution is then grossed up by basic rate tax relief which the provider reclaims from HMRC. Higher and additional rate tax-payers have to reclaim the additional tax relief due via HMRC.

2. Net pay schemes – where contributions are deducted before income tax is applied. This means that all taxpayers immediately receive tax relief at their highest marginal rates.

Apart from the timing differences, both methods result in the individual receiving the same level of tax relief in the vast majority of cases.  However, for low earners, this can lead to discrepancies. This is because with a RAS scheme, basic rate relief is added by the provider even where the individual is not subject to income tax. With a net pay scheme if the individual doesn’t earn enough to pay income tax, no relief is available on the contribution. 

This has increasingly become an issue with significant increases in the personal allowance in recent years, along with an automatic enrolment earnings threshold which is below the personal allowance. This can mean an individual is automatically enrolled into their workplace scheme and does not receive any tax relief on their personal contributions where the employer has chosen a net pay scheme.

In the March 2020 Budget, the Government stated it was committed to addressing the discrepancy and have now issued the call for evidence looking at possible solutions to resolve this.

The consultation outlines four potential solutions

• Paying a bonus based on Real Time Information data to low earners in net pay schemes
• Applying a standalone charge on a RAS to recover the relief applied to low earners
• Employers offering multiple schemes and ensuring lower-paid workers are placed in a RAS scheme
• Mandate the use of RAS for all defined contribution schemes.

In the document, the Government provide an initial view of each of the four options.  In the Government’s view, option one is considered to add too much complexity and administrative changes for all.  Option two would involve removing the tax benefits of pension saving for low earners and the Government is not minded to proceed with this approach.  They also state that option three is only likely to be feasible for large employers. 

The fourth option is described as a more radical approach and it appears that this is the one that the Government may favour based on its “initial view”. Whilst they acknowledge this will require significant change for pension providers who currently use net pay, they state that it would have the strong attraction of introducing a single method of tax relief for all defined contribution schemes.

With pension taxation relief regularly under review, the change could pave the way for wider changes to the taxation of defined contributions. If all defined contribution schemes were to become relief at source schemes this would make it far simpler to introduce a flat rate relief on personal contributions at some point in the future. Of course, there are other complexities to overcome in relation to changing pensions tax relief, however, this could signal a move to a two-tiered approach with differing taxation for defined contribution and defined benefit schemes which some favour.

The closing date for responses is 13 October 2020.