Contributions: refunds of contributions
The payment of a refund of contributions validly held by a registered pension scheme, is an ‘authorised payment’ for tax purposes only if it meets the conditions for either a:
- short service refund lump sum, or a
- refund of excess contributions lump sum.
If, on the other hand, membership is cancelled within the ‘cooling off period’ specified by the appropriate Regulatory Body, contributions paid within that period may be refunded (see PTM146000).
Short service refund lump sum
In broad outline, Department for Work and Pensions (DWP) legislation provides a level of benefit protection to a member of an occupational pension scheme who leaves that scheme early, before their normal pension age under the scheme. This is referred to as preservation.
The principal requirement of preservation is that where a member leaves pensionable service under an occupational pension scheme with a minimum period of two years ‘qualifying service’ they will be entitled to a minimum level of preserved benefit. The minimum period was 2 years, however from 1 October 2015, section 36 Pensions Act 2014 shortened the two-year limit to 30 days where the member’s entitlement is entirely to money purchase benefits. This minimum level of preserved benefit is referred to as a ’short service benefit’. It represents a fair proportion of what the member’s prospective benefits would be under the scheme at their normal pension age.
Where a member leaves pensionable service before acquiring rights to a short service benefit under the scheme (for example, before completing adequate qualifying service), DWP legislation still requires that the member be given certain benefit options, providing they are still below their normal pension age and have by then completed at least three months of relevant pensionable service (broadly speaking under the scheme). Those early-leaver options are:
- a refund of their own contributions to the scheme (see below for an explanation of when such refunds can be considered to be authorised payments under the tax rules), or
- a transfer of their accrued rights, which will include the elements provided by the employer as well as the member’s own contributions (see PTM100010 to find out when transfers are authorised under the tax rules).
Whilst schemes are free to preserve members’ benefits earlier than the two-year limit laid down in legislation, there is one situation in which the DWP legislation ensures that a member will automatically acquire short service benefit rights much sooner. This is where the scheme has accepted a transfer value from a personal pension scheme or a retirement annuity contract. In these circumstances, the member has an entitlement to a short service benefit immediately and is not therefore able to receive a refund of their contributions, even if they have less than three months pensionable service in either or both schemes.
The relevant DWP legislation is at Chapter 1 of Part 4 and Chapter 2 of Part 4ZA Pension Schemes Act 1993 (particularly section 71, which defines the above terms used, and sections 101AA to 101AI, as introduced by section 264 of the Pensions Act 2004) and the Occupational Pension Schemes (Preservation of Benefit) Regulations 1991 (SI 1991/167).
Conditions that must be met for a short service refund lump sum to be paid
Paragraph 5 Schedule 29 Finance Act 2004
Paragraph 27 Schedule 23 Finance Act 2006
A short service refund lump sum may be paid if:
- the registered pension scheme making the payment is an occupational pension scheme,
- the member’s ‘pensionable service’ under the scheme was terminated before ‘normal pension age’ and the member is not entitled to a ‘short service benefit’ by virtue of section 71 of the Pension Schemes Act 1993. The definitions of ‘pensionable service’, ‘normal pension age’ and ‘short service benefit’ can be found through section 181(1) of the Pension Schemes Act 1993,
- the member has not previously been subject to a lifetime allowance test in relation to that scheme (not just a particular arrangement), and so there have been no previous benefit crystallisation events triggered under that scheme in relation to that individual.
- the payment of the lump sum extinguishes the member’s entitlement to benefits under the scheme, except where the scheme is required to retain liability to provide protected rights benefits in accordance with DWP requirements (but see next section), and
- the payment is made before the member reaches their 75th birthday.
Where specifically identifiable contingent dependant benefits/rights exist, these must be extinguished along with the member’s own entitlement to benefits.
Part refund payments relating to short service where it is the scheme’s rules that prevent the extinguishing of the entirety of the member’s entitlement to benefits
Regulation 20 the Registered Pension Schemes (Authorised Payments) Regulations 2009 – SI 2009/1171, inserted by regulation 5 the Registered Pension Schemes (Authorised Payments) (Amendment)(No 2) Regulations 2012 – SI 2012/1881
As mentioned in the previous section on this page, one condition for a short service refund lump sum is that the lump sum must extinguish the member’s entitlement to benefits, except where the scheme is required to retain liability to provide protected rights benefits. In other words, a scheme can still pay a short service refund lump sum even though some (non-tax) legislation requires them to hold back certain of the member’s pension rights.
Contracting-out through a money purchase/defined contributions pension scheme was abolished from 6 April 2012, so there is no longer legislation preventing a contracted-out money purchase scheme from paying a full refund of member contributions as a short service refund lump sum.
However, some schemes have rules which have been worded in such a way that they are still required to hold back former protected rights even though the legislation requiring this has now been repealed. It may take schemes affected some time to amend these rules and there may even be a rule in the scheme’s own rules which prevents such amendments. Such schemes can no longer make a part refund of member contribution as a short service refund lump sum as the retention of former protected rights is required by the scheme’s rules, not legislation. If these schemes continued to make part refunds which, before 6 April 2012, would have been payable as a short service refund lump sum, the refund would be an unauthorised payment.
Regulation 20 provides a possible solution. The regulation allows certain payments (part refund payments relating to short service) made by registered pension schemes to be treated as though they were short service refund lump sums. Providing certain conditions are met, the payment of a part refund payment will be an authorised member payment even though the member’s entitlement to benefits is not fully extinguished. The payment is treated as a short service refund lump sum for tax purposes (see Taxation of refunds of contributions below for more details). The conditions to be met are that:
- the payment is made by an occupational pension scheme
- the member’s pensionable service was terminated before normal pension age but the member is not entitled to a short service benefit under section 71 of the Pension Schemes Act 1993
- there has been no previous benefit crystallisation event in relation to the member and the pension scheme
- the payment is paid when the member hasn’t reached the age of 75
- the payment does not exceed an amount equal to the member’s contributions under the pension scheme (for more information on what payments to a scheme count as member contributions see PTM044000).
- the payment extinguishes the member’s entitlement to benefits under the scheme except to the extent that the entitlement is prohibited from being extinguished at the time of payment by rules of the pension scheme which:
- have the effect of prohibiting a member’s entitlement to benefits under the scheme from being extinguished by the payment of a lump sum, and
- at the time those rules took effect there was a provision made by or under an enactment which was in force and had the effect of prohibiting a member’s entitlement to benefits under the scheme from being extinguished by the payment of a lump sum.
Should the amount of the proposed lump sum exceed the total of the member’s aggregate contributions then the payment has not met all the conditions required for regulation 20 to apply. The entire payment will therefore be an unauthorised payment and taxed accordingly. See PTM131000 for more detail about the unauthorised payment tax.
The reference to extinguishing the member’s entitlement to benefits under the scheme is to all the rights that could reasonably have been known about at the time of the payment. The lump sum will not cease to be an authorised payment purely because further entitlement is later created that could not have been known about at the time of the initial payment, for example, through a pay revision.
Where the member has transferred benefits into the scheme, under DWP legislation, they may be entitled to a short service benefit even if they have less than two years’ service in relation to the current employment being pensioned through the scheme.
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Amount of the short service refund lump sum
Section 205 and Paragraphs 5(2) and 5(2A) Schedule 29 Finance Act 2004
The Taxation of Pension Schemes (Rates, etc) Order 2010 – SI 2010/536
To be treated as a short service refund lump sum the amount actually paid as a lump sum must not be more than the total amount of the actual contributions paid by the member to the scheme.
Contributions paid by the member
For the sake of clarity, the legislation provides that the following types of contributions are member contributions:
- any amount that has been paid to the scheme in relation to the member under section 7 of the Social Security Act 1986. These payments were made to schemes between 1986 and 1993 as incentives to them becoming contracted–out. Although the legislation permitting incentive payments was repealed by the Pension Schemes Act 1993, claims for incentive payments were permitted up to 5 April 2001 and such sums may still form part of a member’s short service refund lump sum.
- any rebates paid by HMRC under either section 42A(3) of the Pension Schemes Act 1993 or section 38A(3) of the Pension Schemes (Northern Ireland) Act 1993
- any amount recovered from the member by their employer in respect of minimum payments (whenever made) made to the scheme for any period before 6 April 2012 under regulations made under either section 8(3) of the Pension Schemes Act 1993 or section 4(3) of the Pension Schemes (Northern Ireland) Act 1993. In some cases, the employer may not have recovered the minimum payment from the member. Where this has happened, the contribution is an employer contribution, not a member’s contribution so cannot be included in a short service refund lump sum. DWP’s view is that this employer contribution can be used for other purposes of the scheme – it does not have to be used to provide the member with benefits – and where this happens the requirement for the member’s entitlement to benefits under the scheme to be extinguished will be satisfied.
Scheme rules may provide for investment growth to be included in the refund of contributions. An amount bringing the total payment up to the short service refund lump sum limit can be treated as part of the short service refund lump sum for tax purposes. Any excess may qualify to be treated as a scheme administration member payment.
In a contracted-out scheme, the scheme administrator deducts the employee’s share of the Contributions Equivalent Premium (CEP) from the amount to be refunded, where the scheme is required to pay a CEP to HMRC to ‘buy back’ the member into the State Second Pension (formerly SERPS).
The payment of a CEP by a scheme administrator is an authorised payment under the Registered Pension Schemes (Authorised Payments) Regulations 2006 (SI 2006/614).
Because some of the contributions have been used to pay the CEP, the amount of actual contributions available to be refunded is less than the HMRC limit of the amount of contributions paid by the member to the scheme.
Under the scheme rules, investment growth can be included in the amount refunded to the member on leaving service within two years of joining the scheme.
The member had paid contributions of £23,000. The CEP is £1,000. The amount of the contributions to be refunded is therefore £22,000. The amount of investment growth on those contributions over the period was £800. The total amount refunded to the member is £22,800, and because under the scheme rules the investment growth is part of the lump sum payment, not an additional payment of interest, and also because it is within the limit of £23,000 for that member, this qualifies for tax treatment in its entirety as a short service refund lump sum.
If the refund was made in any of the tax years 2006-07 to 2009-10, the first £10,800 is taxed at the rate of 20 per cent and the balance of £12,000 is taxed at the rate of 40 per cent.
If the refund is made in the 2010-11 tax year or later, the first £20,000 is taxed at the rate of 20 per cent and the balance of £2,800 is taxed at the rate of 50 per cent.
The scheme administrator is liable for the tax charge.
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Short service refund lump sum and the lifetime allowance
Section 216(1), Paragraph 5 Schedule 29 and Schedule 32 Finance Act 2004
The payment of a short service refund lump sum does not trigger a lifetime allowance test. So the payment is not caught through BCE 6, and no amount crystallises for lifetime allowance purposes. Also, unlike the other authorised member lump sum payments, the member does not have to have available lifetime allowance in order for such payments to be made.
As such, a short service refund lump sum can be paid where the member has used up all their lifetime allowance (although no earlier BCE can have occurred under that scheme in relation to the member). Given that no benefits crystallise for lifetime allowance purposes when the lump sum payment is made, there will never be a chargeable amount and so no lifetime allowance charge.
Refund of excess contributions lump sum
Sections 188(2) and 190, and Paragraph 6 Schedule 29 Finance Act 2004
Where a member has paid pension contributions in a tax year of more than the maximum amount that can receive tax relief (see PTM044100), the amount of contributions that cannot receive tax relief (the excess) may be repaid to the member.
The legislation refers to this as the ‘excess contributions condition’. If this condition is met, the excess contributions can be paid to the member as a refund of excess contributions lump sum.
The payment must be made before the end of the period of six years beginning with the last day of the tax year in which the ‘excess contributions condition’ was met, that is the tax year in which the ‘excess’ contribution was paid.
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Amount of refund of excess contributions lump sum that may be paid
Paragraphs 6(4) to (6) Schedule 29 Finance Act 2004
The amount that may be paid as a refund of excess contributions lump sum is referred to in the legislation as the ‘available excess contributions allowance’. This allowance is the amount of ‘excess’ contributions paid in that tax year, less any earlier refund payments made (either in the same or an earlier tax year) to the member in respect of the contributions paid in that tax year from any registered pension scheme.
This is represented in the legislation by the following formula:
RPC – MAR – ALS
RPC is the amount of relievable pension contributions paid by (or on behalf of) the member in the relevant tax year (other than contributions paid by an employer, or paid by HMRC to a contracted out scheme, or any contributions paid after the member has reached the age of 75).
If any tax relief given in accordance with the operation of relief at source (see PTM044220) in relation to any contribution included in RPC is in excess of the maximum amount of relief to which the member is entitled (see PTM044100), RPC is taken to be reduced by the amount of that excess.
MAR is the maximum amount of relief to which the member is entitled in that tax year.
ALS is the total value of any refund of excess contribution lump sum(s) previously paid in respect of that tax year to the member.
It may be that the rules of a registered pension scheme provide for the payment of interest on refunded contributions. If the amount of the lump sum under the scheme rules is to be determined with reference to an interest rate or investment growth, and the interest or investment growth forms part of the lump sum, it can be treated as part of a refund of excess contributions lump sum for tax purposes, to the extent that it falls within the member’s available excess contributions allowance.
In other cases, the interest may be being paid in addition to the lump sum. This may arise simply because of a delay in making the payment, or may be a payment over and above the computed lump sum for some other reason. If it qualifies to be treated as a scheme administration member payment for tax purposes (see Interest paid on the refund of contributions below) a payment of interest in addition to the refund is an authorised payment.
In each case, it is a question of fact, based on the circumstances of the case, whether a payment is a lump sum, or comprises a lump sum plus a separate payment for interest, and it is possible that different pension schemes’ rules could lead to different results.
In the tax year 2006-2007, Ian paid gross contributions of £30,000 to a registered pension scheme. However his relevant UK earnings for that tax year turned out to be £25,000. So £5,000 of those contributions did not attract tax relief.
Under the scheme rules, Ian can have a refund from the scheme.
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Refund of excess contributions lump sum and the lifetime allowance
Section 216(1), Paragraph 6 Schedule 29 and Paragraph 15 Schedule 32 Finance Act 2004
Because the member does not have to have available lifetime allowance in order for a refund of excess contributions lump sum to be paid, a member who has used up all their lifetime allowance may take such a refund.
The payment of a refund of excess contributions lump sum is not a BCE 6, and does not trigger a lifetime allowance test. As no amount crystallises for lifetime allowance purposes, there will be no chargeable amount or lifetime allowance charge.
Interest paid on the refund of contributions
Paragraphs 5 and 6 Schedule 29 Finance Act 2004
Section 171 Finance Act 2004
The definitions of both a short service refund lump sum and a refund of excess contributions lump sum limit the amount that can be treated as such a payment to the amount of actual contributions (or excess contributions) made by the member. But a registered pension scheme’s rules may provide for interest to be paid to the member in respect of these refunds. In some cases that interest etc. may be paid as a separately calculated amount or may form part of the lump sum payment.
Interest as a separately calculated amount
A registered pension scheme’s rules may provide for interest to be paid in addition to the contributions being refunded. The interest may arise simply because of a delay in making a payment or may be a payment over and above the computed lump sum for some other reason. If it qualifies to be treated as a scheme administration member payment for tax purposes, a payment of interest on top of the refunded contributions is an authorised payment.
A scheme administration member payment is a payment made for the administration or management of the scheme – see PTM026000. Such payments should be made on an arm’s length, commercial basis. So any interest paid by a scheme on a refund of contributions should be no more than a reasonable commercial rate if it is to be a scheme administration member payment. Any excess, presuming that excess amount does not meet any of the other definitions of authorised member payments, will be an unauthorised member payment and taxed accordingly – see PTM134100.
Interest payments made in addition to a short service refund lump sum or a refund of excess contributions lump sum that meet the definition of a scheme administration member payment are taxable under section 369 Income Tax (Trading and Other Income) Act 2005. The scheme administrator should make the payment without deducting income tax, and the recipient should include the interest in a self-assessment tax return or notify their HMRC income tax office of liability if they do not receive a notice to make a return.
Interest as part of the short service refund lump sum
If the contributions to be refunded are less than the statutory maximum then schemes may be able to provide for interest to be paid as part of the lump sum. For example, the lump sum may be computed with reference to an interest rate. If the interest is part of the lump sum, and the lump sum paid is within the statutory maximum, the tax treatment set out in section 205 Finance Act 2004 applies.
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Taxation of refunds of contributions
Short service refund lump sum
Section 205 Finance Act 2004
Section 636A(3) Chapter 15A Income Tax (Earnings and Pensions) Act 2003
The Taxation of Pension Schemes (Rates, etc) Order 2010 – SI 2010/536
The scheme administrator is liable to a charge to income tax on payment of a short service refund lump sum. The tax charge applies whether or not the scheme administrator or the person receiving the short service refund lump sum are resident, ordinarily resident or domiciled in the UK.
This tax is to reflect the fact that tax relief will have been given in respect of the contributions being refunded when first made by the member.
Tax years 2010-11 onwards
The rate of the tax charge for a short service refund lump sum is:
- 20 per cent in respect of the first £20,000 refunded, and
- 50 per cent in respect of the remainder of the refund over £20,000 (if there is any such remainder).
The Treasury can amend these rates and the threshold by order.
The scheme administrator may deduct the tax they are liable to from the actual payment made to the individual, where the rules of the scheme making the payment allow this. This will not change the level of charge due; the tax charge applies to the gross amount of the lump sum before the deduction of the tax.
It is the scheme administrator who is liable to the tax charge and not the person who receives the lump sum payment. So if the recipient is a non-taxpayer they cannot make any repayment claim in respect of the tax paid. There is no further tax due for the person who receives the lump sum payment, even if they are a higher rate tax payer. Also, the person receiving the payment cannot off-set the tax paid against any other taxable income.
Refund of excess contributions lump sum
Section 636A Chapter 15A Income Tax (Earnings and Pensions) Act 2003
A refund of excess contributions lump sum is not subject to any income tax charge. It is paid tax-free. This reflects the fact that no tax relief has been granted on the contributions being refunded in the first place.