The 2006 changes to UK pensions tax law brought greater flexibility in respect of the amount and timing of contributions. 

But members who pay too much may not get the tax breaks that they hoped for. And those who breach the limits on when and how they take benefits will suffer severe tax penalties.

Are unauthorised payments easy to spot?

No, not necessarily. HM Revenue & Customs have not published a full list of unauthorised payments, presumably because that might give the unscrupulous ideas on how to get money out of a scheme.

Helpfully, some payments are described in legislation as “unauthorised”, including assignments and surrenders of annuity payments, excessive loans from the pension scheme to employers operating the scheme and “value shifting” (passing the value of assets from a registered pension scheme to members or employers without actually creating a payment). However, other payments are caught by the unauthorised payments rules purely because they do not meet the criteria set for authorised payments.

The most common unauthorised payments are:

  • pension payments continuing incorrectly after death which are not recovered – ignoring overpayments under £250. More often than not, at least one pension payment is made after the pensioner’s death before the scheme or pension provider is told that the pensioner has died. But often the payments continue for many months after the pensioner’s death. A pension should cease on death, so payments after death are unauthorised unless the pension attracted a minimum guarantee period or was set up to continue to a surviving spouse, civil partner or named dependant;
  • lump sum death benefits paid more than two years after the scheme administrator was told about the member’s death or ought to have known about it;
  • pensions paid incorrectly under the triviality rules;
  • small restitution payments to correct benefit errors, for example, because of valuation or calculation errors, where the scheme administrator does not consider it is commercially acceptable to justify the administration cost of setting up an additional benefit payment from the scheme;
  • refunds of member contributions that do not include all non-contracted-out benefits.

    There are other types of unauthorised payments which are less common simply because the contracts involved cover a smaller number of members. For example:

  • a child’s pension continuing after age 23, for pensions set up after 6 April 2006;
  • a dependant’s scheme pension greater than the member’s pension at date of death plus 5% of the tax free cash taken at retirement, but only where the member retired after 6 April 2006 and died on or after age 75. This will be difficult to monitor in practice;
  • transfers overseas, unless the transfer is to a Qualifying Recognised Overseas Pension Scheme;
  • ·variations in pension payments where the increase or reduction is outside the limits or conditions set by HMRC;
  • taking more than the 120% maximum from an unsecured pension drawdown arrangement, an income drawdown arrangement that can apply for members under age 75;
  • taking less than the minimum 55%, or more than the maximum 90%, from an alternatively secured pension, an income drawdown arrangement which is an alternative to an annuity for members from age 75;
  • trustees agreeing rent from an employer for property owned by the trustees at less than market rates, or failing to collect the rent when it is due.

Trivial commutation payments

The excessively complicated rules governing trivial commutation of benefits (triviality) result in a very common type of unauthorised payment. These rules apply when a member has only a very small pension entitlement, and trustees are allowed to pay a one-off lump sum instead of having to make trivial regular pension payments. Members often confirm that they are entitled to triviality but then they confirm, after they have received the lump sum, that they have benefits in other schemes meaning that they do not qualify for triviality after all. Unless the member can repay the scheme, the lump sum payment is an unauthorised payment.

From a scheme’s perspective, where a member does not qualify for triviality but there is only a small residual pension, after tax-free cash, paying that small pension is likely to involve disproportionate administration expenses. Small pensions may also be below the minimum value that pension providers are prepared to allow for purchasing an annuity, meaning that trustees may not be able to buy out small pension liabilities. So there are times when schemes may actually prefer to make an unauthorised payment to reduce ongoing administration charges.

Correcting errors

Inadvertent payments – genuine errors – identified and corrected as soon as possible do, however, escape the unauthorised payment rules. Recipients of payments would first need to repay anything that would otherwise constitute an unauthorised payment.

The penalties

The unauthorised payment tax charges are a percentage of the unauthorised payment:

for the recipient of the unauthorised payment, a 40% tax charge + 15% where the unauthorised payment exceeds a certain threshold.

for the scheme, a tax charge of up to 40%, known as a scheme sanction charge, although this may be reduced to 15% where the recipient’s tax liability is paid.

If a scheme makes too many unauthorised payments, HMRC could also de-register the scheme, giving rise to a further tax charge of 40% of the scheme assets.

All in all, a substantial chunk of benefit disappears in tax charges associated with unauthorised payments – tax charges that cannot be offset by any other allowance. However, the 'good faith' principle may mean that schemes can avoid scheme sanction charges in some circumstances.

If a scheme has acted in good faith and followed proper procedures – for example, by giving a member full details of the triviality rules and paying a triviality payment only where the member confirms in writing that he is entitled to one – the scheme should not suffer a scheme sanction charge.

How will HMRC know about an unauthorised payment?

Scheme administrators have to report each unauthorised payment to HMRC in an 'Event Report'. HMRC will then bill the recipient of the unauthorised payment and, if necessary, the scheme for the tax charges. This process is likely to take many months to complete. Pension providers have reported large numbers of unauthorised payments – far more than HMRC anticipated – and would prefer to pay any unauthorised payment tax charges direct to HMRC. Direct payment of the tax would allow transaction records to be completed far quicker, easing for accounting and monitoring requirements; and would bring certainty that the tax liability has been paid, fixing the scheme’s tax liability and allowing the scheme, subject to scheme rules, to deduct the tax and arrange payment to HMRC when an unauthorised payment is knowingly made.

HMRC has been receptive to the feedback it has received on the unauthorised payment requirements. It is looking at ways of simplifying the payment processes and possibly relaxing aspects of the unauthorised payments rules. There has been no announcement from HMRC, but there may yet be some kind of simplification.