Introduction to Unauthorised Payments in Pension schemes – What They Are and How They’re Taxed

What Is an Unauthorised Payment? 

Regulated pension schemes carry a great many tax advantages.  Therefore, it is not surprising that there are a number of rules governing what kind of investments they’re permitted to hold, and how much/what nature of funds can be paid into or out of a scheme.

At a very high level, there is a list of transaction types that are ‘authorised’.  These include the kind of routine payments necessary to operate any pension scheme: receipt of contributions into the scheme, receipt of financial returns on investments owned by the scheme, acquisition of permitted investments by the scheme, payments for administration/advice necessary to run the scheme, and payment of member benefits out of the scheme… and so forth.  The pension fund can enter into these transactions without any ‘adverse’ consequence.

However, if anything occurs outside of this list, then by definition it is an ‘unauthorised payment’, and additional tax charges will likely be due to HMRC.

Unauthorised Payments Don’t Always Involve Cash

There is a common misconception that for an unauthorised payment to occur it is necessary for cash to move in or out of the pension.  This is not necessary.  

An unauthorised payment can occur if a pension fund provides a member with ‘rent free’ use of a pension fund asset.  Situations involving ‘value shifting’ – where the financial rights or obligations in relation to a pension fund asset are altered in such a way that either the fund’s or the member’s financial position is improved – are also sufficient to create an unauthorised payment.

And if the pension fund enters a transaction with one of its beneficiaries, or someone connected to them, where the price paid is different from “that which might be expected if the parties to the transaction were at arm’s length” that also is an unauthorised payment.

Are Unauthorised Payments Against the Law?

There is another misconception that unauthorised payments are ‘against the law’.  This is not correct.  Unauthorised payments are not prohibited as such; the position is that if they do occur then additional tax charges are due to HMRC.  

The distinction that the unauthorised payment surcharge is a tax charge, rather than a penalty for ‘breaking the rules’ is key.  It means that if the charge applies it cannot be set aside or waived in the way that a penalty for failing to take reasonable care can sometimes be.  If an unauthorised payment has occurred, the tax is due to HMRC and neither HMRC or the courts have a legal route to setting it aside.

Tax Charges on an Unauthorised Payment

Generally speaking, there are two charges that arise from an unauthorised payment: one on the member and one on the pension scheme.

The Unauthorised Payment Charge (Member)

Typically, HMRC will assess the person who’s received the value for tax at 40% of the value of the unauthorised payment.  In a simple example where the pension makes a £100 payment to a member before they’ve reached normal pension age, the member would have to pay £40.  This does not sound too bad, until you consider that the member may become liable to the charge when they’ve received £100 of value rather than £100 of cash.  In these cases, they will have to pay this charge out of other income that has probably been taxed elsewhere.  The ‘pre-tax’ cost of earning the required £40 could easily be £67.  This means the effective rate on the pension withdrawal is therefore likely to be 67%.

The Scheme Sanction Charge (Scheme Administrator)

On top of this, there is another charge of at least 15%.  Technically this is a sanction assessed on the Scheme Administrator.  Based on our £100 example, another £15 would be due.  

Why the Effective Tax Rate Can Exceed 55%

The combined effective tax rate is often quoted as being 55% [40%+15%] but in reality, taxpayers can suffer an effective tax rate of over 80%.  This is not accidental – the legislation was written with deterrent in mind.

Who Pays the Tax Charge on an Unauthorised Payment?

The charge (Unauthorised Payment Charge) is paid by the member(s) that have received the value from the fund.  

Rent-Free Use of Pension Property

This means that if a syndicate of SIPPs allow rent free use of scheme property to a company controlled by one member of the syndicate, it is that member only who is assessed for the charge; other members haven’t received value so there’s no tax charge on them.  

To give a real-world example: business partners have fallen out and the person remaining in the building refuses to pay rent to a pension arrangement that includes former business partner(s).  The person in the building has received the value so the tax is assessed on them.

Tax on Unauthorised Loans

If the charge relates to a loanback gone wrong, tax is payable by the sponsoring employer of the fund.

Who Ultimately Pays the Scheme Sanction Charge? 

Technically this falls on the Pension Administrator, but most providers’ Terms and Conditions include provision that the pension fund itself will indemnify them and pay the charge unless professional negligence is proven.  

There are ‘good faith’ protections in place to limit impact on any Pension Administrator who is misled by incomplete or false information.  Consequently, unless the Administrator is negligent, there is a good prospect of negotiating the scheme sanction charge (which is a penalty) down to nil.  

In practice therefore, it is almost always the pension fund that pays the penalty for any error.  This means less value retained in the fund to pay out pension benefits on retirement.

The Commercial Impact of an Unauthorised Payment

The real-world effect of these tax charges is generally to make the underlying transaction commercially unviable.  What starts out as a good idea can become unwound by the time the tax consequences are factored in.

From the perspective of a Pension Administrator, whose role is to make sure that the fund operates within ‘the rules’, the unauthorised payment is a useful lever for nudging members to take actions that might sometimes feel ‘against’ their own interest but are necessary to preserve the overall tax benefits attached to the pension.

In short, it almost always pays to avoid the unauthorised payment.

If you would like to discuss the VAT requirements on a proposed transaction please call our Associate Director, Iain Harris on (+44) 0131 364 4191 or email iain.harris@ae-ca.co.uk. Iain is a tax adviser and VAT specialist for unauthorised payments in pension schemes. 

Disclaimer: This article is for general informational purposes only and does not constitute financial, tax, or legal advice. Pension rules are complex and depend on the specific facts of each transaction. You should seek independent professional advice tailored to your circumstances before taking any action.