The tax consequences of increasing pension commencement lump sums out of time

A pension scheme that is registered with HMRC may pay a member a pension commencement lump sum (PCLS) when certain conditions apply. To benefit from favourable tax treatment, a PCLS must be paid within a window which ends one year after the member retires[1].

In a recent determination[2] the Pensions Ombudsman ordered pension scheme trustees to pay a PCLS more than a year after the member retired and considered the tax consequences of his order.

How did the situation arise?

Mr E was a member of his employer’s pension scheme (the Scheme). In 2005 the Scheme was closed for the build-up of future benefits.  In 2011 the Scheme’s new administrator began to review the Scheme’s benefit basis. In 2012, while the review was ongoing, Mr E took early retirement.  He took a PCLS and a reduced annual pension.

The trustees had believed that following the closure of the Scheme in 2005, members’ benefits would be calculated based on their salaries  at the closure date.  As part of the review, the trustees’ legal advisers concluded that in fact, the link to salary had not been broken, and benefits should not be calculated using a member’s salary in 2005, but his salary at the date of leaving service with the employer.  Mr E’s benefits had therefore been understated when he retired in 2012.  The Scheme’s administrators increased his annual pension and backdated the increase; they did not offer to increase his PCLS because more than a year had passed since he had retired.  Payment of a further lump sum in such circumstances would in their view have attracted tax charges.

Mr E complained to the Ombudsman that the trustees and administrator should have recalculated his PCLS and allowed him to take the extra cash as a lump sum.  The trustees and administrator argued that any payment along those lines would not be permitted by tax legislation and tax charges would apply.

The PCLS should have been increased

The Ombudsman upheld Mr E’s complaint.  The trustees had failed to interpret the Scheme rules correctly, which had led to Mr E’s benefits being understated and he had suffered financial loss. He held that citing factors of costs and tax charges was not sufficient reason for refusing to pay the additional sum as part of the PCLS.  The Ombudsman said that Mr E should be given the opportunity to fully reconsider his retirement options as if they had been correctly calculated in 2012.

What about the potential tax charges?  The Ombudsman highlighted legislation which states that tax would not be payable on such a sum if the payment is made to comply with an order of a court or of a person or body with power to order making the payment, or on the ground that such an order is likely to be made.[3]

The Ombudsman stated that if the circumstances were explained to HMRC, particularly in light of the legislative provision, HMRC might make a concession, recognising that the trustees and administrator had made a genuine mistake when calculating Mr E’s benefits in 2012.

Given that the miscalculation of Mr E’s benefits arose from the trustees’ incorrect understanding of the Scheme rules, the Ombudsman held that it would be unreasonable for Mr E to pay any tax charged as a result of the payment of the increase in the PCLS.  The Scheme would have to foot the bill, should tax be charged.

Can trustees relax about the tax implications of making late PCLS payments?

Trustees are usually reluctant to rely on the legislative provision quoted by the Ombudsman in making a late payment of a PCLS, as there is no guarantee that HMRC will agree with their view and significant tax charges could result.  Following this Ombudsman decision, trustees may feel more confident about relying on the provision and make payments in similar circumstances.  It will be interesting to see whether HMRC does make a charge to tax on such payments; HMRC’s approach will also inform the decisions of trustees who find themselves in a similar position to those in this case.

[1] Paragraphs 1-3, Schedule 29, Finance Act 2004

[2] Mr E (PO-12248)

[3] Section 241(2) Finance Act 2004