Seaton Says

Employers are not restricted on the level of pension contributions they can make for their employees, although any contribution in excess of the annual allowance, will generally be subject to an annual allowance charge.

However, Her Majesty’s Revenue and Customs (HMRC) may test pension contributions to ensure that they are “wholly and exclusively for the purposes of the employer’s trade”. Pension contributions are normally an accepted cost of employing staff but problems may occur when an employer’s contributions represent more than 100% of an individual’s remuneration.

Controlling Directors and business owners are in the difficult position of being responsible for agreeing their own salaries and pension contributions and as such, their decisions may be open to challenge by the Inspector of Taxes. We believe these rules will not normally affect controlling directors working in the business, however, directors and spouses, who have no clearly defined role in the business may well be caught by these rules.

Given that it is invariably good business practice to enter into employment contracts for all staff, including directors, it seems wholly appropriate that bonuses and salaries voted by the Board may be sacrificed in favour of an employer pension contribution.

An employer may also agree to fund a pension scheme for the employee by targeting an income at a specific retirement date, 100% of salary for example. In profitable years, the employer can invest some, or even all, of its profits in the pension scheme to fund for that intended level of pension. Actuarial advice should be sought on what would constitute a reasonable contribution.

In advice to Inspectors of Taxes (BIM46001), HMRC has stated that the following principles need to be taken into account when deciding whether pension contributions pass the wholly and exclusively test:

• To find out whether the payment was made for the purposes of the taxpayer’s trade it is necessary to discover the taxpayer’s object in making the payment.
• The general rule is that establishing the object behind making the payment involves an inquiry into the taxpayer’s subjective intentions at the time of the payment.
• The “purposes of the trade” means “to serve the purposes of the trade”.
• The “purposes of the trade” are not the same as “the purposes of the taxpayer”.
• The “purposes of the trade” does not mean “for the benefit of the taxpayer”.
• The purpose for making the payment is not the same as the effect of the payment.
• A payment may be made exclusively for the purposes of the trade even though it also secures a private benefit. This will be the case if the securing of the private benefit was not the object of the payment but merely a consequential and incidental effect of the payment.

Inspectors of Taxes are then further advised to seek additional evidence to satisfy themselves that the contribution to the scheme is paid wholly and exclusively for the purposes of the trade. i.e.:

• Are there any comparable third party employees? If the spouse works alongside an unrelated third party and they have comparable salaries, pension contributions, terms and conditions, this would indicate that there is not a non-trade purpose for paying the pension contribution.
• If the pension contribution paid on behalf of the spouse is greater than that for an unrelated third party, then is there any business reason for this? Or is this an indication that there was a non-trade purpose for the payment?

Additional information could indicate that there are special reasons for the size of the pension contribution. For example, the pension fund may have a funding deficit as a result of losses on its investments.

• It is possible that the right question is not so much the level of pension contributions, as the level of salary. Does the level of the salary reflect the value of the work undertaken by that individual for the employer. If not, then it is likely that that there is also a non-business purpose for the payment of the pension contributions.
• Where the salary is less than the commercial rate and the size of the pension contribution appears to have been inflated, you will need to establish why this has been done and whether any tax or National Insurance planning for the employees was one of the purposes for the size of the pension contribution rather than an incidental benefit arising from it.

The most appropriate person to advise businesses on these matters is their usual tax accountant.

27 April 2006