10 January 2022

Following the government’s call for evidence regarding the discrepancies between the two predominant ways of receiving tax relief on pensions contributions (net pay arrangements (NPA) and relief at source (RAS), Amy Davies and Jordan Russell, senior associate and trainee at Burges Salmon respectively consider the government’s proposed changes and how they will affect employers of the lowest paid.

Who should read this legal update?

This update will be of interest to employers of pension scheme members whose earnings fall below the tax free personal allowance and who operate a net pay arrangement for their pension arrangements, under which employee contributions are taken from a member’s pre-tax income.

What was the background to the call for evidence?

Pensions were originally provided exclusively through employment. Tax relief was achieved through employers deducting employee pension contributions from members’ pre-tax pay. The introduction of personal pensions in 1988 allowed individuals to make contributions from their net income, meaning that a new system of providing tax relief on pension contributions was needed.

There are now, therefore, two main ways to receive income tax relief on pension contributions:

  • Net pay arrangements ('NPA') where pension contributions are taken from pre-tax income by the employer; and
  • Relief at source ('RAS') where pension schemes claim tax relief at basic rate for all contributions made during a tax year. Individuals who are subject to higher rates of income tax can claim extra relief directly from HMRC.

The differences in these two income tax methods mean that those who do not pay income tax, or whose earnings are under the tax free personal allowance, receive different treatment. RAS schemes assume that all contributions made have been taxed and claim tax relief accordingly. This means that members who have not paid income tax effectively receive a government top up of 20 per cent to their pension contributions. In contrast, NPA schemes do not receive a government top up. However, deducting pension contributions from income before applying tax means that members of NPA schemes use less of their personal tax allowance.

The Conservative Party made a manifesto pledge in 2019 to review options to address the differing tax treatments of low earnings saving into a pension. In its Call for Evidence, the government sought the views of relevant stakeholders on how best to achieve balance between consistency of outcomes for savers with simplicity for individuals, employers and pension schemes.

What was the outcome? What issues were raised?

The Call for Evidence suggested four approaches. These are outlined below with a summary of the responses received in respect of each:

1. Pay a bonus to NPA scheme members based on real time information data through the HMRC P800 reconciliation process at the same rate as the tax-relief paid to RAS schemes (20 per cent in England and Wales). This would put low-earning NPA scheme members in the same position as those in RAS schemes who receive the government 'top-up'. The government was concerned that this would require significant and costly administrative changes for savers, employers, pension schemes and HMRC. However, 61 per cent of respondents supported this approach.

2. HMRC to apply a standalone charge against RAS scheme members to recover the top up payments. There was no support from respondents for this approach: it was widely considered to be a 'levelling down' approach which would affect the low-paid by reducing their pension and removing an incentive to contribute to a pension.

3. Make it compulsory for employers to operate both an NPA and RAS scheme. Employers would switch employee contributions between schemes depending on whether that employee’s earnings was above or below their pro-rated personal allowance for each pay period. Most respondents felt this would add unreasonable administrative complexity and extra operating costs for employers, which was disproportionate to the benefits for members.

4 Mandate the use of RAS schemes for all DC schemes. 56 per cent of respondents were actively opposed to this option due to the unreasonable and disproportionate administrative costs and disruption to those who are currently operating a NPA scheme. There were also concerns that tax relief for higher and additional rate taxpayers would be delayed.

The government noted that the majority of respondents favoured the first, top-up bonus option and have decided to adopt this approach, with one modification to the original proposal. Since the consultation, they have identified an alternative solution which uses the PAYE reconciliation process rather than the P800 reconciliation process.

What happens next?

  • HMRC must make significant IT system changes to introduce the proposed PAYE reconciliation top-up bonus option.
  • The new system is scheduled to start in 2024-25 with first payments to be made after the end of the 2024-2025 tax year in 2025-26.
  • HMRC plans to write to eligible individuals after the end of the 2024-25 tax year, to invite them to make a claim and provide necessary details for payment to be made.
  • This process will then continue each year from April 2026 onwards.
  • The government proposes to introduce primary legislation in 2022 to be legislated for in a subsequent Finance Bill.

Takeaways for employers, pension schemes and their members

  • Fortunately, the option taken by the government is the least burdensome for pension schemes and employers as it is for HMRC (and not employers) to make the necessary changes. Any of the other suggestions would have led to increased complexity and unreasonable and disproportionate administrative costs for pension schemes and employers. As such, employers can rest easy that they do not need to make any immediate changes.
  • Nevertheless, employers should familiarise themselves with the proposed changes and consider communicating in general terms what members must do to claim the top-up to any employees who may benefit. Up to 1.2m low-income earners, 75 per cent of whom are women, will benefit from a government top-up regardless of which tax relief arrangement is followed by their pension scheme – it will no longer be limited to those under RAS schemes. The government anticipates that this will produce an average pension top-up of £53 per affected individual. However, like higher and additional rate tax relief, the money has to be claimed and there are concerns that only a fraction of those eligible will do so. Indeed, the government’s documents suggest that they only expect 25 per cent of the money due to be claimed. However, unlike higher and additional rate tax relief, HMRC does plan to write to eligible individuals and invite them to make a claim so hopefully, the government’s figures will prove to be a significant underestimate, given that the change does benefit the lowest paid.

We are well placed to advise on issues relating to pension schemes of all sizes. If you would like to explore this, or any other, topic further please contact a member of our pensions team.

This article was first published in substantially the same format on Lexis® PSL on 8 December 2021 and can be found here.

Key contact

Richard Knight

Richard Knight Partner

  • Head of Pensions Practice
  • Pensions Services
  • Pensions Legal Advice

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