Employer pension contributions – an extremely efficient way of withdrawing cash from your business

Scott Hansell
Financial Planning
Scott Hansell, director of financial planning

For owner-managers of incorporated businesses, making employer pension contributions can be an extremely tax-efficient way of withdrawing cash from a business, says Scott Hansell of Lovewell Blake Financial Planning.

Scott Hansell, director of financial planning

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.

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