Lump sum recycling in pensions

• Set out the rules on lump sum recycling in pensions.
• Explain the implications of breaking the rules.
• Explain how recycling cases are assessed in practice.

Introduction

Pensions legislation generally works by authorising specific types of payment.

These ‘authorised payments’ include, among other things, pension commencement lump sums (i.e. tax-free cash), pension income, transfers and death benefits, and they’re mostly contained in a small number of sections (164 to 171) of the Finance Act 2004.

If a pension scheme were to make a type of payment not listed in legislation, it would not be an authorised payment. The payment would, by definition, therefore be an ‘unauthorised payment’.

Unauthorised payments (UPs) incur significant tax charges for the member and the scheme, and they’re generally to be avoided at all costs. In fact, it’s likely that many scheme rules won’t permit them.

However, the legislation also lists types of payments that are specifically unauthorised.

There are around a dozen of these, and while some are quite rare, one that crops up frequently in questions from scheme members and advisers is lump sum recycling.

What is lump sum recycling?

In broad terms, lump sum recycling occurs when a client takes their tax-free pension commencement lump sum (PCLS) and then pays it back into a pension as a new contribution.

The logic is that the new contribution would attract tax relief. Therefore, the client would be gaining tax relief on funds that they had received tax-free, and which had already benefitted from tax relief in the past. (Some refer to this as ‘double-dipping’.)

The recycling rule therefore aims to prevent the exploitation of the tax rules.

To be clear, the recycling rule does not extend to pension income. Income must be taxed under PAYE, so there is much less benefit in paying taxed pension income back in as a contribution. The money purchase annual allowance also serves to reduce the viability of recycling income.

What are the conditions for recycling?

Under legislation, several conditions must be satisfied for a PCLS to be considered recycled.

• The pension scheme member receives a PCLS.
• The PCLS (and any other PCLSs in a twelve-month period) comes to more than £7,500.
• The amount of the contribution(s) is over 30 per cent of the amount of the PCLS.
• Contributions for the member are significantly above what they would normally be.
• The contributions can be paid to any scheme belonging to the member, and they can be paid by the member, a third party or an employer.
• The recycling was planned (i.e. a conscious decision).

If all these conditions apply, the value of the UP is the value of the PCLS received by the client.

There would then a UP tax charge of 40 per cent, which the client would be liable for personally. If the client crystallised their entire pension when taking the PCLS, a UP surcharge of 15 per cent would also apply (given that the PCLS would account for 25 per cent of the whole pension scheme).

There would also be a scheme sanction charge on the pension itself of between 15 and 40 per cent, depending on how much of the UP charge the client paid. However, if the scheme administrator was unaware of the client’s plans it may be able to ask HMRC to discharge its liability.

How does HMRC approach recycling?

While most of the above conditions are straightforward to apply, two questions come to mind. What constitutes a significant increase in contributions? What constitutes planning? HMRC covers both of these in its published guidance.

Taking the contribution point first, HMRC uses a 30 per cent rule of thumb. (Be careful not to confuse this with the ‘30 per cent of PCLS’ condition.) This means that HMRC is unlikely to scrutinise additional contributions unless they’re 30 per cent more than what the client might otherwise have paid in.

They will also ignore increases that are outside of the client’s control, such as contractual increases, and increases that are due to ‘natural’ fluctuations, and they will consider the broader context.

Example 1

Sandra runs her own business, and her income fluctuates. Historically she has contributed 10 per cent of her income each year to a personal pension.

During the Covid-19 pandemic, her income virtually ceased, so she took a PCLS from her personal pension to make up the shortfall.

Sandra changed how her business operated and it bounced back strongly, so this year she has a much higher income than normal. She therefore makes a much higher contribution than normal but it’s still at 10 per cent of her income.

From a recycling perspective, this latest contribution is likely to be disregarded given it was made on the same basis as contributions in previous years and had no relation to any PCLS payment.

When assessing increases, HMRC works on a cumulative basis and will look at contributions over a five-year period. This period includes the tax year in which the client took PCLS, the two tax years before that and the two tax years after. The purpose is to identify cases where individuals are attempting to spread the increased contribution over several years in order to avoid scrutiny.

In terms of the planning aspect, the guidance does not indicate what evidence can or can’t be taken into account. It does say that the onus is not on the individual to prove an absence of planning: it’s on HMRC to demonstrate the individual had planned to increase their contributions following receipt of a PCLS.

In terms of other points to note, HMRC is clear in the guidance that recycling can involve more than just the two key transactions of lump sum and contribution. It will look beyond these, and it will take into account other transactions entered into for the purpose of recycling.

Furthermore, there is no prescribed order of transactions and no requirement that the actual PCLS funds are used to make the contribution.

For example, if a member borrowed money in order to make an increased contribution, received a PCLS, and used some or all of the PCLS to pay off the loan, this would put it in the category of recycling.

In terms of how HMRC might identify recycling cases, there are a few points to note.

Firstly, there is no requirement on scheme administrators to monitor for recycling or report suspected cases. Recycling is a UP, so a scheme administrator would have to report it if it took place. However, the administrator is unlikely to have the full facts, so would be reliant on member notification.

In terms of broader detection measures, HMRC will of course have details of tax relief granted on all personal contributions.

However, they have less data on PCLS payments. Some PCLSs must be included on a scheme administrator’s annual report to HMRC – for example if the client is relying on a form of lifetime allowance protection – but the majority of PCLSs won’t be reported.

Example 2

Steve has a Defined Benefit pension scheme. He has retired from the company and started taking benefits, including a PCLS, from the DB scheme. However, Steve then carries on working as a consultant.

Given he has a comfortable income coming from the DB scheme, he can afford to contribute most of his consultancy income into a SIPP, with a view of eventually passing it onto his beneficiaries. On paper, HMRC could potentially view this as recycling. From the context, however, it’s clear that the PCLS and subsequent contributions are unconnected.

Published cases?

While it’s useful to have official guidance from HMRC, it’s always instructive to see how cases are pursued in practice.

In recent years we’ve seen courts and tax tribunals wrestle with a range of pension issues including taxable property, lifetime allowance protection, contributions in specie, Inheritance Tax and investment due diligence.

To date, however, we are yet to see any cases involving lump sum recycling. Therefore, we have very little to go on in terms of judicial treatment.

From a policy standpoint, it seems likely that the recycling rule was included more as a deterrent than anything, and it’s difficult to ascertain how closely HMRC monitors for potential breaches.

Certainly, the guidance says that very few payments are likely to be affected, and that PCLSs won’t be caught if paid as part of a client’s normal retirement planning.

It’s also worth noting that the annual allowance has decreased significantly since the late 2000s, meaning the ability to re-contribute significant lumps sums has also decreased. This might push it further off HMRC’s radar.

Putting this into practice

With this in mind, it’s possible you might have clients who are tempted to view such a payment as low risk. They might have unused annual allowance from previous tax years, for example, and could be inclined to use a PCLS to fund a large one-off contribution.

However, the recycling rules are clear, and if the conditions were satisfied in a given case it could be fairly straightforward for HMRC to prove it. Therefore, most advisers will flag the recycling rules with clients and head off these conversations at the earliest opportunity.

A more likely scenario is where there are already general plans for a client to take a lump sum and continue working, and therefore contributing, perhaps to a different pension scheme. In other words, the client isn’t actively looking to recycle their PCLS – it just happens that as part of their retirement planning they will receive a PCLS and they will also make contributions that are potentially higher than those they’ve made in the past.

In these situations, the key point is to make sure that any decisions around PCLS and contributions are fully documented as being part of normal retirement planning. Certainly if the PCLS is being earmarked for a particular purpose, such as paying off a mortgage, it makes sense to record this in the client’s file.

This article was previously published by FT Adviser