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Sue Jones reviews HMRC's efforts to bring all retirement annuities into the pay as you earn system.

All retirement annuities will be taxed under PAYE from 6 April 2007. This change has been the aim of one of the Low Incomes Tax Reform Group’s (LITRG) most persistent campaigns, and we are pleased to see that it is about to come to fruition after seven years of trying to get the Government to implement a more equitable system for annuitants on low incomes.

Retirement annuity contracts (RACs) – providing annuities on retirement at age 60 at the earliest and a lump sum payment (linked in some cases to life assurance policies) – started in the 1950s. They could be taken out until July 1988, when personal pensions came into being. RACs were very popular with the self-employed and company directors in particular, and pay out generally between the age of 60 and 75. Contributions can continue to be made to existing policies until retirement age. RACs were often known as section 226 or section 226A policies.

The current system

Under the present system, tax is automatically deducted at source from retirement annuities at the basic rate of 22 per cent, unless the annuitant is a non-taxpayer and has completed a form R89 (or R86 for joint annuitants) confirming that they are not liable to pay any income tax. In those circumstances the annuity can be paid gross. Forms R89 will continue to be applicable for new annuitants until 5 April 2007, when they will be withdrawn as the new system is implemented.

For basic rate taxpayers, there are clearly no problems in the current treatment of their retirement annuities. Issues do arise with the existing tax treatment for those liable to pay tax on their annuities entirely at the starting rate of ten per cent, or partly at ten per cent and partly at 22 per cent. These annuitants inevitably will need to claim a repayment of tax each year. According to HMRC, this group and nontaxpayers together comprise around 200,000 individual cases.

This present regime is obviously expensive in administrative terms because of the level of repayment claims that are necessary. In addition the system is detrimental to unrepresented pensioners, because many fail to make claims since they do not realise that they are eligible to do so. In the past, no advice or encouragement was generally offered which might have pointed these individuals in the right
direction.

The new system

The amendments are intended to bring RACs in line with occupational pensions and personal pension plans with effect from 6 April 2007, as regards how they are taxed on the recipient.

They will apply to existing RACs and those coming into payment subsequently [FA 2004, Sch 36 para 43; FA 2005, Sch 10 paras 60, 61(a), 64(2)].

HMRC encountered problems in trying to set up the new scheme because providers had very little national insurance number information. The main issue has been to identify the RAC annuitants affected by the changes:

• those paying 22 per cent who should not be doing so;
  
• those receiving gross annuities who should be paying tax;
  
• ten per cent taxpayers and those liable to tax on their annuities at ten per cent and 22 per cent, who should be claiming a repayment; and
  
• people who are 22 per cent taxpayers and already receive annuities, but who
  will not be represented and will not understand what is happening.

Between 80 and 90 per cent of annuitants and annuities will go into PAYE with verified national insurance numbers attached, but the matching process has been difficult for various reasons. For example, many widows will have inherited their late husband’s annuity but may have had no previous tax record and may not have a national insurance number. Some providers add together separate annuities for an annuitant, whereas others keep each one separate.

HMRC’s press release of 10 January rather boldly stated: ‘There are 1.2 million RACs in payment at present, of which around 80% are less than £3,000 per annum. Up to 2 million more are due to enter into payment over the next 15 years.’ About half of all RACs are paid gross. For more background information, see:

1. HMRC’s Tax Bulletin 85 (October 2006).

2. HMRC’s RACs pages.

We have been told that the various RAC letters and forms mentioned in this article will shortly be available for download from the HMRC website.

Timeframe

In August 2006, letters RAC1 and RAC2 with the RAC3 REPLACE were sent to those 371,000 annuitants for whom HMRC could not trace a tax record.

There was a relatively high response rate. Those who have not responded will get a code number based on whatever limited information is available (e.g. age, amount of annuity or annuities, and assuming a basic state pension).

In September 2006 HMRC sent out bespoke letters to annuitants with a tax record where there was a need to verify or update some information.

During January 2007 HMRC will have sent a letter (RAC6 and REPLACE RAC7) to 307,000 annuitants who were getting their annuity gross but who may find, in some cases, that from April 2007 they have some tax to pay because of changes in circumstances since they completed form R89. HMRC were re-emphasising the assurance given in the earlier letter RAC2 that they will not be trying to recover any tax arrears up to 5 April 2007, unless there is evidence of deliberate tax avoidance, and that the new scheme will apply to all individuals after 5 April 2007. Any annuitants who have not supplied information requested by HMRC will be allocated an emergency week 1/month 1 code number when their 2007/08 notice of coding (form P2) is issued.

The plan is to send to every annuitant, in the period from January to March 2007, a form P2 which will explain how their code number has been worked out. This will also include another general message about the change in the way that annuities will be taxed from 6 April 2007. It should be borne in mind that most of these people will be unrepresented – the number being represented is unknown - and for many people this is the first contact they will have had with HMRC. This in itself is posing potential future problems in that the degree of confusion as to how the annuitant will be affected is likely to be very high.

To add to the melee, HMRC have confirmed that previous de minimis limits or local arrangements applied by pension providers in the past, such as operating NT codes on very small pensions, will no longer apply from 6 April 2007. This applies to occupational pensions and personal pensions as well as RACs.

Other issues

In RACs newsletter 8 for RAC providers, HMRC explained that they have changed their minds about devising a dedicated form P46 for RACs which could be used in all cases where the annuitant did not have a form P45. Instead, they intend that providers operate the same process as they use for other personal and occupational pensions coming into payment. Clearly, most represented people will be paying tax at basic or higher rates, so the change is unlikely to alter their amount of tax paid but it may affect the timing of tax payments. How this affects annuitants under self assessment is set out below.

There is a further potential problem in that a state pension may be omitted from, or recorded in an incorrect amount on, some forms P2. This is likely where the annuitant fails to respond to requests from HMRC for information. The errors are expected to be remedied by the 2008/09 uprating figures which HMRC receive automatically from the Department for Work and Pensions. However, annuitants and their advisers should check benefits figures and also check that the national insurance number and annuity amounts are correct. There may be teething problems bringing the new system into play.

There may be other issues affecting annuitants after April. Providers are likely to start asking for RACs and pension PAYE schemes to be merged. HMRC will then have to decide where the merged scheme should live. Some of the provider schemes are very large and neither of the two existing sites may be suitable, so a third one may have to come into play. This is very likely to prove a source of confusion for annuitants as records are transferred.

Multiple annuities

The treatment of multiple annuities depends entirely on the set-up of the payer’s payroll system. HMRC may issue one coding to be used against all annuities or they may be required to issue a separate form P2 for each annuity. So, in some cases, the annuitant could receive multiple forms P2. HMRC have quoted a figure of 15 such forms for one individual.For obvious reasons it has been suggested that providers write to their annuitants to whom this type of issue applies.

In these types of circumstances there is a potential problem establishing which coding notice applies to which annuity, especially where codes are subsequently changed, and a further issue may be increased numbers of cases where allowances are duplicated. It is crucial for advisers and taxpayers alike to ensure that, where there are multiple coding notices, these reflect the most beneficial allocation of allowances/deductions as HMRC are unlikely to be able to co-ordinate this themselves, given the sheer volume of cases involved.

HMRC have in fact confirmed that RACs recipients with multiple RACs sources will be treated no differently from any other person taxed under PAYE who has multiple employments and/or multiple pensions. On that basis, in terms of how to code, there is nothing new being introduced specifically to facilitate RACs.

The annuitant’s self assessment

Where the RAC will be the only PAYE source of income of an existing SA customer, HMRC’s dedicated RACs unit at Leicester and Northants LPO (see contact details below) will take responsibility for any SA record immediately. In these cases each individual taxpayer’s affairs will be reviewed independently and an appropriate
coding notice issued.

Where the RAC is a ‘sub-source’, and advisers know that the main tax office is elsewhere, they may prefer to phone the main HMRC office. In principle both offices should both be aware of the situation, but this remains to be seen. If the existing SA record already has an associated PAYE source, this record will not move and the RAC itself will be a sub-source. In these cases the code number to be issued will be BR.

Repayment claims

If an annuitant makes annual claims to an HMRC Claims Office, the year to 5 April 2007 will be the last year for claims to be submitted to those offices. The RACs unit will process claims for 2007/08 onwards. Once the code number is right there should be no requirement for future claims because the ten per cent problem outlined above should be resolved. This is one of the beneficial outcomes of moving
RACs into PAYE.

If the RACs unit find a potentially overpaid position when they review a record, they intend to encourage annuitants to make additional claims and they will go back six years to make any appropriate repayments for earlier years. There is a simple form RAC5 which is intended to cover all years involved to avoid the necessity of multiple forms R40, but at the time of writing it is not clear whether this form
is actually being issued.

However it must be said that in 2004, a Treasury Minister promised that HMRC would take action to explain to these pensioners that they had been overtaxed, and how to recover the excess. Despite this, HMRC have only now – more than two years later – sent out the letters. As a consequence, LITRG asked that the normal six-year time limit for repayment of overpaid tax be extended to eight years in recognition of the two-year delay. But HMRC are insisting that the maximum number of years they are prepared to repay in these cases is six years. This is despite the fact that it took them two years, from when the Minister promised maximum help, to write and warn people. It is hardly equitable that when a taxpayer is negligent and fails to pay the correct tax, HMRC can collect any underpayments going back twenty years. However, when some of the poorest pensioners in the land want repayment of the taxes they have overpaid, HMRC permit claims for only six prior years.

Pension providers will not need to produce duplicate statements for earlier years, as HMRC have indicated that a letter confirming the amount of the annuity and tax deducted will suffice.

Retention of existing rules

Death of an annuitant

Where RACs are paid to a third party, for example to an executor, personal representative or trustee, PAYE tax will not be deducted after 5 April 2007 and the current scheme will continue for such payments. The status quo is also retained for payments other than to individuals, e.g. to charities.

Non-residents

If exemption has been claimed from UK tax under a double taxation agreement, the new system will not affect the annuitant. If exemption has not been claimed under an agreement then the new rules apply, but HMRC have not yet definitively advised whether they will be using an emergency week 1/month 1 code or a BR code.

One potential issue for non-residents arises as letters were sent out to 8,000 non-resident annuitants advising them that whilst they are now paid gross, under the new rules they may actually be liable to tax under PAYE. Whilst only a few individuals are involved, it is likely that if they are being paid gross now it is probably for the very good reason that the recipients are not liable under the terms of double taxation agreements. Such individuals may have already gone through a long process with HMRC to get gross payment. Consequently it would seem quite inequitable that having done so, HMRC might now start to withhold tax.

RACs unit: contact details

The telephone helpline for annuitants is 0845 366 7868 and the lines are open Monday to Friday, from 8.30am to 5.00pm. As might be envisaged, the helpline is currently inundated with calls so you may have a long wait. The address of RACs unit is: HMRC RACs, Leicester and Northants LPO, Saxon House, 1 Causeway Lane, Leicester LE1 4AE.

The above article was first published in Tolley's Practical Tax Newsletter, and is reproduced with the kind permission of LexisNexis UK.