23 june 2022
Employers must take care that tax relief on employee pension contributions via the payroll is not given when it’s not due. Mistakes can be expensive and complicated to correct.
It is important to note that here we’re considering only registered pension schemes, that is pension schemes that have been registered by HMRC under sections 153 to 159 of the Finance Act 2004. Unregistered pension schemes do not enjoy the same tax treatment that registered schemes do.
Most workplace pension schemes are now defined contribution schemes. Contributions are made by the employee and/or the employer, and the pension fund hopefully grows through these contributions and through the return on investments.
There are two different ways that employees can obtain tax relief on their pension contributions to defined contribution pension schemes and the pension scheme will be set up to take one or the other:
1. Relief at source
Where ‘relief at source’ applies, employee contributions are deducted from the employee’s net salary (ie after tax has been deducted under PAYE). The employer deducts only 80 per cent of the total employee contribution from the employee’s net salary, as basic rate tax relief is then added to the fund by the pension scheme, which the scheme reclaims from HMRC. If the employee is a higher rate taxpayer, they can also separately claim higher rate tax relief personally, either through their tax return or by making a claim to HMRC.
2. Net pay
In a ‘net pay’ scheme, 100 per cent of the employee contributions are deducted from the employee’s gross salary. This means that the employee pays tax on their salary after their pension contribution is deducted. In other words, the employee pays tax on a salary which is ‘net’ of their pension contribution, meaning that they automatically receive tax relief at their highest rate of income tax.
What is the issue?
The above terminology is confusing. It is therefore relatively easy for employers (or their outsourced payroll teams) to incorrectly set up their workplace pension schemes on their payroll. For example to operate a 'net pay’ arrangement when it should be ‘relief at source’ tax relief, so that 100 per cent of the employee’s contributions are deducted from their salary before income tax is calculated under PAYE. The pension scheme may then also add the tax relief when the employee pension contributions are paid into the pension fund, and reclaim this from HMRC. So, tax relief has mistakenly been given twice!
We have seen examples of this happen where there is a change in payroll provider, and the wrong box on the payroll set-up form is ticked because the person completing the form misunderstood the terminology.
Where this happens, especially over an extended period covering multiple tax years, it can be difficult to correct what has gone wrong because:
- The employer won’t have subjected the correct amount of earnings to tax under PAYE, and HMRC will hold them responsible for the underpaid income tax. If the employer has not exercised reasonable care, HMRC can go back six tax years to recover the underpaid income tax due and levy a financial penalty. HMRC will also charge interest on the underpaid and overdue income tax.
- The employer may have recovered too much in the way of employee contributions from the employee. As noted above, they may have collected 100 per cent of the employee contribution by incorrectly applying a net pay arrangement, rather than collecting 80 per cent in accordance with a relief at source arrangement.
- The pension fund may have recovered too much basic rate tax relief from HMRC.
An employer has a workplace pension scheme set up to operate ‘relief at source’ tax relief. Employee contributions are 5 per cent of net pay. Shortly before the 2021/22 tax year, the employer changes payroll provider and the workplace pension scheme is inadvertently set up to operate as a net pay arrangement.
The impact on a higher rate employee earning £6,000 a month is (this does not cover any tax relief that the employee may or may have not claimed personally through their tax return from HMRC):
|Employee contribution deducted||£300.00||£3,600.00|
|Employee contribution that should have been deducted||£240.00||£2,880.00|
|Employee contributions over-deducted by employer||£60.00||£720.00|
|Tax relief claimed (See N1)||£195.00||£2,340.00|
|Tax relief which should have been claimed (see N2)||£60.00||£720.00|
|Tax relief overclaimed||£135.00||£1,620.00|
|N1 Monthly tax relief incorrectly given via payroll||£120.00
£300 x 40%
|N1 Monthly tax relief claimed by pension scheme||£75.00
(£300 x 100/80)*20%
|N2 Monthly tax relief via payroll||£0.00|
|N2 Monthly tax relief which should have been claimed by pension scheme||£60.00
(£240 x 100/80)*20%
What should employers do?
Where employee contributions are still being made (see below regarding salary sacrifice for pensions), employers should check what type of tax relief their workplace pension scheme is set up to operate and make sure that that it is being operated correctly for payroll purposes.
In particular, employers with workplace pension schemes set up to apply ‘relief at source’ tax relief should check that employee contributions are not being collected from employees’ gross pay and reducing their taxable pay for PAYE purposes.
What about salary sacrifice for pensions?
Salary sacrifice for pensions is an arrangement whereby an employee agrees to a reduction in their contractual gross earnings (by an amount equal to their employee pension contributions). In exchange, the employer agrees to pay increased employer pension contributions instead.
Where implemented correctly salary sacrifice for pensions results in the employer and the employee paying less Class 1 National Insurance Contributions (NIC). This is because the employee gives up their right to receive salary (which would otherwise be liable to Class 1 NIC) and instead receives an employer contribution to a registered pension scheme (which is not liable to Class 1 NIC).
Salary sacrifice for pensions can potentially be used as an alternative, more NIC-effective way of operating a workplace pension scheme, regardless of whether the pension scheme is set up to operate ‘net pay’ or ‘relief at source’ tax relief on employee contributions.
We recommend that all employers who are not operating salary sacrifice in respect of their workplace pension scheme consider this option, especially given rising employment costs and the NIC savings that can be achieved.
If you have any questions, or would like to discuss this further, please contact Lee Knight or Susan Ball.