With corporation tax rates rising up
to 25% in April this year, the dividend tax allowance having shrunk by 50% for
2023/24 and due to do so again next tax year, an extra 1.25% added to rates of
income tax on dividends, and frozen personal tax allowances, it is no wonder
that incorporated business owner-managers are seeking tax-efficient ways of
withdrawing funds from their businesses.
Fortunately, one method of doing
this in an effectively tax-efficient way does still exist – and that is to make
employer contributions to a UK registered pension scheme. Such contributions can be set against profits,
reducing corporation tax liability; they are also not taxed as a benefit for
the individual in the way that salary and dividend payments are.
The amount of contributions an
employer can make to a registered pension scheme is in effect unlimited. That said, there are some important caveats
to take into account if you want to avoid falling foul of HMRC.
The first and most obvious one is
that an annual allowance on pension contributions does still exist, albeit that
it was increased from £40,000 to £60,000 is this year’s Budget (although some
higher earners may have a reduced allowance due to tapering). It is important to remember that this
allowance is per tax year, so it is possible that two employer
contributions made in two different accounting years for the business could
fall into the same tax year and exceed this annual allowance.
Secondly, to qualify for
corporation tax relief, an employer contribution must be ‘wholly and
exclusively for the purposes of the business’.
What this actually means is that such contributions should be at a
‘reasonable level’ for the individual concerned.
What constitutes ‘reasonable’ is a
grey area, but would generally fall into one of the following categories:
- Any such employer pension contributions,
considered alongside the whole remuneration package (including salary, bonus
and benefits, but not dividends) should not be excessive for the value of the
work the individual actually does.
- The pension contribution is funded under a valid
salary or bonus exchange arrangement, where the individual sacrifices salary in
exchange for a higher level of pension contribution.
- The contribution is contractual and in line with
the level of contributions for all employees across the business.
- A defined benefit pension scheme is winding up
and an employer contribution is made to meet its statutory funding obligations.
Even if, taken as a whole, the
director’s remuneration package seems excessive, HMRC may still allow the
pension contributions as deductible for corporation tax if, for example, the
director is nearing retirement with inadequate pension funds having previously
preferred to retain cash within the business, or if the company has had a
particularly good trading year or built up significant cash reserves, enabling
it to make larger contributions than normal.
Although such employer pension
contributions can theoretically be challenged by HMRC, it is in fact very rare,
and for the vast majority of owner-managers, making employer pension
contributions is an extremely tax-efficient way of extracting cash from your
business – especially as it is such owner-managers who have borne the brunt of
tax changes in the last few years.
