Oct 31, 2010


The major philosophical difference between a defined benefit (final salary) scheme and a defined contribution (money purchase) was mentioned earlier. Moving from final salary to defined contribution provision shifts all of the risk from the employer to the employees.
Add a note hereFor this reason, many commentators now advocate 'hybrid schemes' that seek to split the risk between both parties. Some employers have started to adopt such designs, and examples include the following:
§  Add a note hereCareer revalued average salary scheme. This is a type of defined benefit scheme. Instead of pension being based on final salary, the employee receives a pension proportional to service and career average salary, with salary from earlier years revalued by RPI (say).
§  Add a note hereCombined final salary/defined contribution scheme. Under this approach, both types of scheme are in operation. A final salary scheme might be provided for staff who meet an age and/or service qualification, with defined contribution provision applying to other staff. For example, membership of the final salary scheme might be limited to staff aged 40 or more, with no backdating of service; pension in respect of previous service would be provided on a defined contribution basis.
§  Add a note hereCash balance scheme. Employees are provided with a guaranteed individual retirement fund proportional to service and final or average salary. As in a defined contribution scheme, a proportion may be taken as cash with the balance being used to buy an annuity.
§  Add a note hereSchemes with an element of discretion. Low-level guaranteed benefits are provided, perhaps on a final salary or career average basis. However, there is discretion to provide enhanced pensions as and when the scheme's funding position allows it. A variant of this approach is to operate a defined contribution scheme with a modest final salary (or career average salary) guarantee.
§  Add a note hereCapped final salary. A self-imposed cap is applied to pensionable salary with defined contribution provision on the excess salary. The logic here is that it is reasonable to transfer some risk to the employee once a basic level of guaranteed retirement income has been built up.
§  Add a note hereReduced cost final salary. This is not strictly a hybrid scheme, but has been adopted in a number of companies. This approach involves retaining final salary provision but with some benefits scaled back to restrain costs. For example, some have reduced the accrual rate from 1/60th per year of service to 1/80th or, more commonly, have increased employee contributions. Often employees and unions prefer this to a move towards defined contribution provision.

Oct 27, 2010

Defined Contribution Scheme Design

Add a note hereThere is a very wide variety of defined contribution design models available, as follows:
§  Add a note hereEmployer contribution is a fixed percentage of salary. For example, the employer pays 8 per cent of salary for all members. This is easy to understand and explain.
§  Add a note hereEmployer contribution is a percentage of salary that increases with age (or service). For example, the employer pays 6 per cent of salary for all members, increasing to 9 per cent at age 40 and 12 per cent at age 50. This design partly mirrors the way final salary schemes work and may be targeted to deliver a benefit equal to a certain percentage of final or average salary.
§  Add a note hereEmployer contribution is a multiple of that paid by the employee. For example, the employer will pay double what the employee contributes up to a maximum employer contribution of 10 per cent of salary. This design ensures that employer spend is targeted on those who most value it.
Add a note hereAll three approaches are fairly common, and are often used in combination. For example, the employer may pay a fixed contribution of 3 per cent of salary and then match what the employee pays up to 5 per cent of salary. Hence, the maximum employer contribution is 8 per cent of salary.
Add a note hereThere is also considerable variation in the maximum available employer contribution rates. Typically, for staff and middle managers these range from 3 per cent to 15 per cent with a median of around 8 per cent (source: Hay Group Survey of Employee Benefits 2003).
Add a note hereIt is evident that the lower levels of contribution are highly unlikely to deliver an adequate retirement income unless the employee makes substantial contributions and/or has other forms of saving. For example, a pension contribution of 3 per cent of salary made from age 20 to age 60 might be expected, using conservative assumptions, to provide a pension of only around 10 per cent of final salary.
Add a note hereAt retirement, the employee may take up to a quarter of the fund as a tax-free lump sum. The remainder of the accumulated fund is used to purchase a regular pension ('annuity') from an insurance company. The member typically determines the form of annuity chosen, subject to some government-imposed restrictions. The decisions required include:
§  Add a note herethe rate at which the annuity should increase in payment;
§  Add a note herethe benefits payable to a surviving partner on death;
§  Add a note herewhether the annuity should be guaranteed or on an investment-linked basis (for example, a 'with profits' annuity).
Add a note hereThere is also the option not to take an annuity initially and instead 'draw down' an income from the pension account. (This approach is used mainly by more financially sophisticated members and/or those with larger individual funds.)

Oct 26, 2010


In general, employees used to be taxed under Schedule E set out in the Income and Corporation Taxes Act 1988. In 2003, a new Act was introduced, the Income Tax (Earnings and Pensions) Act (ITEPA) 2003. This Act primarily restates the elements of income tax legislation relating to employment income, pension income and social security income. Income from sources other than employment will continue to be taxed under the various schedules set out in the Income and Corporation Taxes Act 1988.

Add a note hereIncome tax was introduced in the UK as a temporary measure to finance the war against Napoleon, and to this day it remains a temporary tax that must be re-enacted each year or lapse. The schedular system of tax in the UK has its roots in the earliest days of income tax when it was necessary to allocate each specific source of income received to a particular schedule; rental income from land is assessed under Schedule A, income from woodlands was assessed under Schedule B and income from government securities under Schedule C. As mentioned above, employment income was taxed under Schedule E; however, it is now taxable under ITEPA 2003.

Add a note hereUnder ITEPA 2003, tax is charged on 'employment income'. Employment income is split into 'general earnings' and 'specific employment income'. The term 'specific employment income' includes amounts that count as employment income and in particular refer to payments made to and benefits received from a pension scheme, payments and benefits on termination of employment and share-related income.

Add a note hereThe term 'emoluments' has generally been replaced by the term 'earnings', which is defined by section 62 ITEPA 2003. This defines earnings in connection with an employment as:
§  Add a note hereany salary, wages or fees;
§  Add a note hereany gratuity or other profit or incidental benefit of any kind obtained by the employee for money or money's worth;
§  Add a note hereanything else that constitutes an emolument of the employment.

Add a note hereTo a great extent, the new definition of earnings is based on the old definition of emoluments. There are, however, some changes. Now, the use of the words 'any gratuity or other profit or incidental benefit of any kind' refers to the more familiar 'perquisites and profits whatsoever'.

Add a note hereHowever, the addition of the term 'money or money's worth' is new and reflects that the Revenue recognizes the fact that only money or money's worth falls within the provisions of the new legislation. The concept of money or money's worth is something that is of direct monetary value to the employee or capable of being converted into money or direct monetary value to the employee. There have been a number of tax cases that discuss this very point. In Tennant v Smith HL 1892 3 TC 158 an individual was an agent for the bank and, as part of his duty, he was required to reside in a house provided by the bank. If the individual was ever absent, another bank official was deputed in his place. There was an argument put forward by the Crown to include the annual value of the house occupied rent free in the taxable income of the individual. It was held that the value of the house was not an emolument of office, as the benefit could not be converted into money. Therefore it was established that, if a benefit is conferred upon an employee that cannot be converted into money (or money's worth), that benefit should not be taxable in the hands of the employee. These are the general principles; however, a number of statutory exceptions to these principles have since been established most notably in a separate benefits code. This code taxes certain benefits without specifically linking it to its realisable value.

Add a note hereGeneral earnings relate to the net taxable earnings from employment for a particular tax year. The charge to tax for general earnings does depend upon the residence status of the employee.

Add a note hereResidency

Add a note hereIf an employee is resident, ordinarily resident and domiciled in the UK, the entire amount of his or her earnings that are received are taxable in the tax year of receipt. Prior to ITEPA 2003, these earnings were taxable under Schedule E, Case I. If, however, an employee is either resident, ordinarily resident or domiciled outside the UK, the basis on which his or her earnings are chargeable to tax differs.

Add a note hereIf an employee is resident, ordinarily resident but not domiciled in the UK, any earnings arising for 'duties performed in the UK' are taxable in the UK. If, however, the earnings are 'chargeable overseas earnings', they are only chargeable to UK tax to the extent to which they are remitted to the UK. Chargeable overseas earnings are earnings from an employment with an employer based overseas where the duties relating to this employment are performed wholly outside the UK. Prior to ITEPA 2003, chargeable overseas earnings were taxable under Schedule E, Case III.

Add a note hereGenerally, if the earnings relate to a UK employment or UK duties, they are liable to UK income tax. Therefore an individual who is not resident in the UK can still be liable to UK income tax.

Add a note hereAllowable Deductions

Add a note hereThe legislation governing allowable deductions has substantially been rewritten in ITEPA 2003, with the aim of achieving consistency. In general, a deduction is usually allowable for expenses incurred 'wholly, exclusively and necessarily' for the purposes of employment. In addition, it is necessary that expenses reimbursed cannot exceed earnings from employment.

Add a note hereExpenses are deductible from either general earnings or specific employment income. Expenses are deductible for the year in which the income is assessed.

Add a note hereIf an individual has two different income sources, one taxable as employment income and the other under Schedule D, for example business profits from a trade or profession, expenses incurred in connection with income from one source cannot be deducted from income of another source. The reason for this is that there are different rules governing the taxation of income from different sources.

Add a note herePAYE Obligations

Add a note hereThe Inland Revenue does depend on the employer to provide it with details of employment income earned by the employee. The operation of PAYE requires that the employer deducts tax at source from employment income paid to the employee in a tax month. A tax month runs from the 6th of the month to the 5th of the following month. The employer is then required to account for this tax directly to the Inland Revenue, by the 19th of each month.

Add a note hereThe scope of PAYE has gradually increased over recent years with more and more elements of remuneration coming within its ambit. In addition to withholding tax on pay and other cash remuneration, employers have a number of other withholding obligations. In particular there is an ever-growing list of non-cash benefits provided to employees that are treated as 'notional payments' and in respect of which PAYE must be operated. The list includes such things as cash and non-cash vouchers, credit cards and 'readily convertible assets'.

Add a note hereThe concept of 'readily convertible asset' (and its forerunner 'tradeable asset') was first introduced in 1994 and substantially enhanced in 1998 and 2003. If an employee is given an asset that is 'readily convertible', the employer has an obligation to account for PAYE on this as if the employee had received cash. The PAYE due is normally based on the best estimate that can be reasonably made of the amount of the assessable income. It is therefore possible that even after PAYE has been operated there will be a residual liability to income tax, if the 'best estimate' turns out to be less than the total liability to income tax, when this is determined. A readily convertible asset for these purposes includes a trade debt, gold bullion and any other asset that is capable of being sold on a recognized investment exchange. It will therefore catch listed shares and securities among other things. The list of readily convertible assets also extends to assets where trading arrangements exist or where there is an understanding that such arrangements may exist. For example, this could catch certain shares in private companies, perhaps where a share dealing service is set up to allow employees to realise the value of their holding.

Add a note hereOther arrangements now brought within the scope of PAYE include enhancements to assets held by employees and gains made from the exercise of certain share options and other share-related benefits.
Add a note hereA number of other benefits, although taxable, are not subject to PAYE. Strictly the tax on these benefits should be collected by self-assessment. However, in many cases the tax on these benefits is also collected through PAYE by an adjustment to an individual's PAYE Coding Notice. The Inland Revenue gives this Notice to the employer and through this, the correct withholding tax should be applied through PAYE. In short, the PAYE Coding Notice specifies the amount of income that can be paid tax-free and reflects reliefs available to the individual as well as taxable benefits.

Add a note hereIn general, prior to Finance Act 1989, the taxable amount was based on amounts earned by an employee in a tax year irrespective of whether these amounts had actually been paid. After Finance Act 1989, this was changed so that an employee was taxed on the total amount received in a tax year rather than an amount earned. In the case of directors, the amount taxable in any one tax year is based on when the director becomes entitled to the sum. Directors in large public companies are likely to be treated in the same way as senior employees in that they will receive a regular monthly salary and an annual bonus.

Add a note hereThere are five points at which director's earnings may be treated as having been paid for the purposes of PAYE. The five occasions are listed as follows and the earliest of these occasions is considered to be the tax point:
1.     Add a note herethe time when the payment is made;
2.     Add a note herethe time when the person becomes entitled to the payment;
3.     Add a note herethe time when sums on account are credited in the company's accounts;
4.     Add a note herewhere the amount of income is determined before the period ends, when the period ends;
5.     Add a note herewhere the amount of income for a period is not known until after the period has ended, the time at which the amount is determined.
Add a note hereOccasions stipulated in (1) and (2) apply to all employees whereas (3), (4) and (5) only apply to directors.

Add a note hereReporting

Add a note hereIn addition to the obligation to account for tax under PAYE, employers are also required to submit a number of different returns to the Inland Revenue listing payments made and benefits provided to employees. The most well-known return is that for employees with earnings in excess of £8,500 in any year (formerly known as 'higher paid' employees but since the limit has not been raised since 1979 the 'higher paid' tag has long since been dropped). This return, referred to as a P11D, is required for every employee to whom an employer provides expenses and benefits, unless the Revenue has given a specific dispensation.

Add a note hereIf an employer grants share options to individuals or makes any share awards, whether under an Inland Revenue approved scheme or not, during the course of the tax year, the employer is required to notify the Inland Revenue by 7 July of details of the option grants/share awards made.

Add a note hereAt the end of each tax year, the employer needs to send the Inland Revenue an end of year return (P14) and a declaration on form P35. The P14 records details of earnings paid to the employee together with details of deductions of tax and National Insurance contributions, among other details.

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