PTM063220 - Member benefits: lump sums: Pension commencement lump sum (PCLS): conditions and entitlement

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Paragraph 1(3)(b) Schedule 29 Finance Act 2004

Normally, a lump sum may be treated for tax purposes as a pension commencement lump sum only if the member has become ‘actually entitled’ to a relevant pension benefit under the registered pension scheme making the lump sum payment. The maximum amount payable will be capped by reference to the value of that arising pension entitlement. PTM088200 explains when entitlement to different forms of pension benefit arise in different circumstances.

What is meant by ‘a relevant pension’
Why the entitlement to a pension commencement lump sum where funds are designated for drawdown pension is linked to an arising entitlement to income withdrawal
When an entitlement to a pension commencement lump sum arises in connection with a scheme pension
The lump sum and pension can be paid from different arrangements under the same scheme

What is meant by ‘a relevant pension’

The definition of relevant pension includes income withdrawal, a lifetime annuity or a scheme pension.

Article 28 The Taxation of Pension Schemes (Transitional Provisions) Order 2006 - SI 2006/572

Where a member of a scheme within paragraph 1(1) (a), (c) or (e) of Schedule 36 of the Finance Act 2004 (as listed below) had taken a lump sum before 6 April 2006 but on or after 27 July 2004 had elected to defer entitlement to the related pension until after 5 April 2006 no further lump sum can be paid in respect of the pension. The deferred pension is not a relevant pension.

The scheme types concerned are:

  • Retirement benefit schemes approved under Chapter 1 of Part 14 of Income and Corporation Taxes Act 1988 (commonly known as an approved occupational pension scheme). This includes Additional Voluntary Contribution (AVC) schemes.
  • Relevant statutory schemes (more commonly known as public sector pension schemes), which are not approved schemes. Examples include schemes such as those for employees of the NHS, civil service, police, fire, armed forces, teachers, Parliament and National Assemblies, and also schemes not established by statute but which have been treated as statutory schemes.
  • Certain deferred annuity contracts which, although not approved pension schemes prior to 6 April 2006, were automatically treated as registered pension schemes from 6 April 2006.
  • Schemes or funds mentioned in section 613(4) (b) to (d) of ICTA (Parliamentary pension schemes or funds).

Where sums or assets in respect of a deferred pension from one of the types of scheme listed above have been transferred to another registered pension scheme, these restrictions will continue to apply to the new scheme, so that the pension is not a relevant pension and no further pension commencement lump sum can be taken.

Why the entitlement to a pension commencement lump sum where funds are designated for drawdown pension is linked to an arising entitlement to income withdrawal

Section 165(3)(a) Finance Act 2004

When uncrystallised funds are designated to provide a drawdown pension, that means the member can be paid income withdrawal or a short term annuity. The legislation links the pension commencement lump sum to the arising entitlement to income withdrawal, rather than an entitlement to a drawdown pension.

A lump sum can be treated for tax purposes as a pension commencement lump sum only when pension benefit entitlement first arises from uncrystallised rights or funds. This occurs at the point uncrystallised funds are designated to provide a drawdown pension. The lump sum is not paid from the arising drawdown pension fund or flexi-access drawdown fund, but from a proportion of the uncrystallised funds alongside those being designated to generate the drawdown pension fund or flexi-access drawdown fund.

Where funds are designated to provide a drawdown pension, the initial pension entitlement arising at that time will always be an entitlement to income withdrawal, and not to a short-term annuity income. This is because the legislation states that entitlement to income withdrawal arises at the point uncrystallised funds are designated to provide a drawdown pension (section 165(3)(a) Finance Act 2004). So this is the point at which a lump sum can be treated for tax purposes as a pension commencement lump sum. The lump sum may of course have been paid earlier (within the 6 month period before the entitlement to the income withdrawal arose), or it may be paid up to 12 months later. Entitlement to income withdrawal arises at that point, whether or not income withdrawals are actually paid.

Entitlement to a short-term annuity arises only when that contract is purchased. This will always occur after the initial designation to provide drawdown pension, and will be purchased from the drawdown pension fund or flexi-access drawdown fund rather than from uncrystallised funds. So as far as the legislation is concerned, entitlement to a short-term annuity will always arise after an entitlement to income withdrawal.

Because the legislation links the pension commencement lump sum to the pension entitlement that arises at the actual point uncrystallised funds are designated to provide drawdown pension, which is the entitlement to income withdrawal, a lump sum payment cannot be treated as a pension commencement lump sum where an existing drawdown pension fund or flexi-access drawdown fund is used to purchase a lifetime annuity contract, applied to provide a scheme pension, or used to purchase a short-term annuity. A further tax-free pension commencement lump sum will only be possible where further uncrystallised funds are designated for drawdown.

When an entitlement to a pension commencement lump sum arises in connection with a scheme pension

Section 165(3) Finance Act 2004

A lump sum can only be treated for tax purposes as a pension commencement lump sum in connection with an arising entitlement to a relevant pension under the same registered pension scheme. A pension commencement lump sum cannot be paid in connection with a pension while it is deferred (which is what the legislation refers to as a ‘prospective’ right to a pension).

The definition of scheme pension refers to an amount that is payable rather than paid, which can cover situations where a person cannot be traced. In such a case, if the scheme rules so provide, a pension benefit can have become payable, as opposed to a deferred pension which does not become payable during the period of deferral. PTM088200 gives an example.

The lump sum and pension can be paid from different arrangements under the same scheme

The pension entitlement giving rise to the pension commencement lump sum payment does not have to arise under the same arrangement paying the lump sum. The pension commencement lump sum can be linked to an arising pension entitlement under one or more different arrangements the member may hold in the same registered pension scheme.

This allows the maximum pension commencement lump sum payable to be calculated on a scheme-wide basis, based on all that member’s entitlements arising under that scheme. And the member can be given the choice of drawing their lump sum entitlement from one source under a scheme, rather than potentially drawing two or more smaller lump sum payments from different types of arrangements held under the scheme.

For example, many registered pension schemes providing defined benefits to its members hold additional voluntary contributions (AVCs) paid by the member under a money purchase arrangement(s) thus separating them from the main scheme benefits which are held under a defined benefit arrangement(s). Instead of drawing two separate lump sum payments, each based on the pension entitlement from one of the arrangements, the scheme can give the member the option of drawing more (or all) of their total lump sum entitlement under the scheme from the money purchase arrangement(s) holding their AVC benefits. This means that the member can use any funds generated from their AVC fund to provide their entire lump sum benefit entitlement. The main scheme benefits retained in the defined benefits arrangement are then used to generate a higher scheme pension and no lump sum.

To take another example, the member may hold two policies under a scheme in different money purchase arrangements, each one with a different insurance company, and may wish to use the contract with the lower annuity rate to provide their lump sum benefit.

Where a pension commencement lump sum is paid that has been generated, either in full or in part, by cross-reference to a pension entitlement under a different arrangement under the same scheme, any lump sum entitlement arising under that other arrangement must take into account the payment from the arrangement paying the lump sum.

PTM063230 gives more information.