Asset-backed pension contributions: HMRC consults on tax changes

Practical Law UK Legal Update 8-506-2545 (Approx. 6 pages)

Asset-backed pension contributions: HMRC consults on tax changes

by PLC Pensions

Background

Asset-backed pension contributions (ABC) have been an increasingly popular method of scheme funding used by employers of larger pension schemes.

An ABC structure commonly involves the employer using non-cash business assets to generate regular cash payments or income streams which are then paid to the pension scheme. The majority of the payments are back-end loaded, often with a final special payment designed to clear off any deficit that remains at the end of the payment plan (known as a "bullet" payment). The payments are backed with security over the assets from which the payments derive rather than the employer making a one-off lump sum contribution. For employers this gives the flexibility to spread deficit payments over several years, and avoid large payments they cannot afford. For schemes it can give security with a right to an underlying asset if the income stream ceases or the employer becomes insolvent. This can result in the trustees agreeing to a longer recovery period compared to situations where the employer's commitment is just to make cash contributions.

The issues for trustees are complicated and involve advice on legal, tax and accounting issues. In particular there has been uncertainty as to whether the transfer of property involved in an ABC breaches employer related investment (ERI) restrictions. The Pensions Regulator published guidance on ERI in November 2010 which was, in part, a reaction to the use of ABC by pension schemes, stating:

"We are issuing this statement now because funding arrangements between schemes and their employers are becoming increasingly complex and this has highlighted a risk that some structures could involve potential ERI breaches".

See Legal update, Pensions Regulator's statement on employer-related investments published and Practice note, Pension scheme investment: trustees' duties.

The Budget announced by the Chancellor of the Exchequer on 23 March 2011 confirmed that the government was planning to launch a consultation exercise with the aim of ensuring that the tax relief claimed by employers engaging in an ABC was not disproportionate to the value of the transaction, see Legal update, Budget 2011: key pensions issues: Employer asset-backed pension contributions.

The consultation document Employer Asset-backed Pension Contributions outlines the government's two proposals for changing the current tax structure so it is more adaptable to the different arrangements that are used in ABC vehicles. The consultation closes on 16 August 2011, and the finalised provisions will be included in the Finance Bill 2012.

Tax issues

The consultation sets out the main types of structures that have been used to demonstrate the tax implications of ABC.

Example 1: "Plain vanilla"

Here Company A sponsors a defined benefit pension scheme which has a £400 million deficit. The company commits to pay a cash contribution equal to the deficit. The trustees of the pension scheme agree to receive a transfer of a company property of equal value to offset the company's funding commitment. The trustees now own the property which is held as an asset of the scheme.

For tax purposes the transfer is equivalent to a cash contribution of £400 million on which the company receives pensions tax relief, and is treated as a disposal for the purposes of the charge to corporation tax on capital gains. The trustees will be liable for stamp duty land tax on the transaction.

Example 2: Lease-back

In identical circumstances, Company A again transfers the property to the trustees but leases the property back from the trustees. The commercial rent is estimated at £22.5 million a year for 20 years making the company's total financial commitment to the scheme £450 million. At the end of that period, the property will revert back to the company.

The tax treatment of this ABC is different from Example 1. In this example:

The company will get pensions tax relief on the value of the property at the point of transfer: £400 million.
Under the governing accounting standards, the transaction is treated as a loan in the company's accounts. Because of this it falls within the scope of the structured finance arrangement (SFA) provisions of the Corporation Tax Act 2010 which prevents any deduction of the rental payments for tax purposes. (See Practice note, Income tax: anti-avoidance and secondary liability: Factoring.)
The difference between the total rent and the value of the property (£50 million) is recognised as interest in the company's accounts and relief is allowed on this under the SFA provisions.
The total tax deduction for the company will be £450 million.

Example 3: Special purpose vehicle

Based on the same circumstances as Example 2, instead of transferring the property to the trustees, the company transfers the asset to a special purpose vehicle (SPV) for a period of 20 years, after which it will revert back to the company.

The company pays rent of £450 million to the SPV over a 20 year period. At the same time the SPV is required to make payments of an equal value to the pension scheme. However, the payments are contingent on the level of dividends paid by the company. Again the tax treatment is different to the previous examples as:

The company still gets pensions tax relief for the net present value upfront: 400 million.
The payments from the SPV are contingent, and so are treated as equity under the governing accounting standards and so do not fall within the scope of the SFA rules. This means that the company can claim a tax deduction for the rental payments: £450 million.
The total deduction over 20 years could be up to £850 million even though only £450 million would be received by the scheme.

In addition, where a "bullet" payment is involved, if this is lower than first expected due to a decrease in the scheme's deficit by the time the payment is due, there is currently no mechanism in place to allow HMRC to claim back part of the upfront tax deduction the employer has received.

Changes to the tax regime

The government is not prepared to allow the current mismatch between the tax relief claimed by employers and the contributions received by pension schemes to continue. It has proposed two options for reforming the current tax position and is seeking responses to these proposals via consultation.

Option 1

Under this option no upfront tax relief would be granted. Instead relief would only be granted when cash is paid to the trustees or where the scheme acquires full title to an asset that can be converted into cash. The employer would need to agree this with the pension scheme (and where necessary with HMRC) before setting up the ABC structure. This would affect those ABC structures where the asset used to offset the employer's funding obligation cannot be easily turned into cash, for example a right to an income stream that cannot be sold by the trustees.

If this option were applied to Example 3 there would be no upfront deduction as under the terms of the ABC structure the scheme would not be able to sell its rights to the income stream without the company and the SPV agreeing. The SFA rules would be disapplied to allow for the rental payments to be deducted, so the total tax relief deduction would fall to £450 million.

Option 2

The current tax regime would be changed so the tax relief more accurately reflects the "economic substance" of the transaction. The tax treatment would follow the accounting rules during the life of the ABC structure. However, the upfront tax relief would still be available where the arrangement is recognised as debt in the company's accounts, but not where it is recognised as equity. In practice this means that:

If the employer treats the structure as debt in its accounts the SFA regime will apply, an upfront deduction will be available for the value of the debt instrument, and relief would be available for subsequent payments that the accounts record as interest. Conversely if it treats the arrangement as equity, no upfront deduction will be possible.
If the accounting treatment changes during the life of the structure, or there is a change to the amount of contributions, then the excess of upfront tax relief could be clawed back.

Following Example 2, the application of Option 2 would mean that the company would get immediate tax relief for the £400 million transfer and a further £50 million over the remaining 20 years under the SFA rules. The rules would stop the double tax relief which occurs in Example 3.

Option 2 is the government's stated preferred option.

Changes to the rules would not affect the tax and accounting treatment of any ABC structures that have already "taken place" but will apply to any amounts which arise or fall due after the change which would otherwise have been treated as tax deductible.

Comment

A survey from KPMG Asset-backed Funding for Pensions stated that in 2010 around £4 billion of ABC structures had been put in place to benefit pension schemes. The nature of these transactions is such that they are used mainly by large schemes and involve transfers of substantial value. Given the potential "double-counting" in the tax relief available it was inevitable that the government would take steps to close this loophole.

Although the consultation is open in asking for responses it has only provided two options for consideration, and clearly indicates the government's preference is for an alignment of the tax and accounting rules to eliminate the current tax benefit for employers choosing an ABC structure.

ABC structures are a novel development of contingent asset arrangements, which companies have been using for some time, with the added advantage of a potential extra tax saving. An end to the availability of what is effectively double tax relief will not be welcomed by employers. However, it is unlikely to mean an end to the use of ABC structures. The flexibility they offer employers has promoted some unique arrangements, and this will still prove attractive. It remains to be seen if the proposed change to the tax rules will see their popularity decline, or whether yet more unique vehicles will be developed to deal with deficits.

Source

HMRC: Employer asset-backed pension contributions (24 May 2011).

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