Retirement Annuity Contract (RAC)

Self-Employed Retirement Annuity (SERA)

Self-Employed Deferred Annuity (SEDA)

The terms above were interchangeable, although the types of contract may have differed.

Background

In 1950 the Millard Tucker Committee was convened, chaired by Mr Millard Tucker KC, to look into the provision of pensions for the self-employed. The result of the work and recommendations of the Committee were subsequently incorporated in sections 22 and 23 of the Finance Act 1956, which introduced self-employed pension plans, and set limits of contributions for tax relief at £750 or 10% of ‘net relevant earnings’ (with higher limits for those born before 1916). The provisions of that Act were then contained in sections 226 to 229 of the Income and Corporation Taxes Act 1970.

Section 20 of and Schedule 2 to the Finance Act 1971 introduced what was known as the cash commutation, the option to take part of the pension as a tax free cash lump sum and increased the maximum amount of contribution from £750 or 10% of net relevant earnings, to £1,500 or 15%. It also enabled provision to be made, within the total allowable contributions, for a widow’s pension or lump sum to be paid in the event of the policyholder’s death before age 75 (originally age 70).

From 1971 15% of net relevant earnings remained in force with the overall maximum contributions increased to £2,250 in the Finance Act 1976, and to £3,000 in the Finance Act 1977. In the Finance Act 1980 the overriding monetary limit of £3,000 was abolished and the maximum contribution level was increased to 17.5% of net relevant earnings.

Section 26 of the Finance Act 1978 permitted the open market option for the self-employed, giving them more parity with the benefits provided under executive pension plans.

Eligibility

Although these plans (approved under section 226 of the Income and Corporation Act 1970 (ICTA 1970)) were often called ‘self-employed’ pension plans, they were not restricted to the self-employed. Many Life Offices came to provide “personal pension plans” as anyone who had earned income from a non-pensionable occupation (called relevant earnings) was eligible to take out one of these plans. This trend to call these contracts personal pension plans caused considerable confusion when actual personal pension plans were introduced on 1 July 1988. Some confusion remains 20 years later. Those eligible fell into three essential categories:

The self-employed (who formed the largest part of the market for these schemes) including;
Partners in a partnership (professional or business) or
Directors or employees whose employment was non-pensionable.

‘Pensionable employment’ was defined as any occupation held by an employee or director who was a member of a sponsored superannuation scheme, more commonly known as an ‘occupational pension scheme’. Pensionable employment did not therefore count towards an individual’s relevant earnings. One of the consequences of the abolition of the overriding limit on pension contributions was that various complications for the individual with pensionable earnings as well as relevant earnings disappear. For 1980-81 such an individual might pay up to 17.5% of net relevant earnings (or the higher percentage for an older age) in just the same way as any other individual with relevant earnings.

A married woman’s relevant earnings were not treated as those of her husband for the purpose of determining eligibility for a RAC. If both husband and wife were eligible for a plan, their maximum contribution for tax relief purposes was related to their own individual relevant earnings and did not depend on the other’s income (except on occasion where losses were involved). This applied whether the husband and wife were taxed on a joint basis or had chosen separate taxation or assessment under section 23 of the Finance Act 1971.

Maximum contributions and tax relief

Retirement Annuity Contracts

Following changes introduced by the Finance Act 1980, the maximum percentage of net relevant earnings which might be paid to a pension policy, and on which tax relief was given, was as follows:

Year of birth	% of net relevant earnings
1907 or earlier	32.5%
1908 or 1909	29.5%
1910 or 1911	26.5%
1912 or 1913	23.5%
1914 or 1915	20.5%
1916 or later	17.5%

If an individual was receiving or would receive a pension arising from previous full-time employment, the limit was 17.5% whatever the date of birth. The above limits applied from the year of assessment 1980-81 onwards, and did not affect the limits for 1979-1980 or any earlier year of assessment.

‘Net relevant earnings’ (defined in section 227 of the ICTA 1970) was an individual’s relevant earnings (which left out of account any earned income which carries pension rights) less certain deductions. The Finance Act 1980 amended the definition of net relevant earnings. It was then no longer necessary to deduct personal mortgage interest from relevant earnings when calculating net relevant earnings, but Stock Relief (if applicable) had to be deducted.

Life assurance cover

Section 226A of the ICTA 1970 (inserted by Schedule 2 to the Finance Act 1971) provided that part of the maximum contributions could be used to provide the equivalent of an employee’s death in service benefits, an annuity for the widow, widower, or dependants of an individual after his or her death, or to provide a lump sum in the event of death before a stipulated age (not later than 75).

The limit of premiums payable for these policies was 5% of net relevant earnings. These premiums were, like those for the self-employed, eligible for full relief of tax at the highest rate paid by the individual on his earned income (unlike ordinary life assurance policies, which attracted tax relief at 15%).

However, it should be remembered that contributions towards such policies had to be deducted from the maximum amount available to contribute towards the RAC.

Tax relief on the contributions

Income tax relief on premiums for a RAC was granted at the highest rate(s) of income tax paid by the individual excluding only the investment income surcharge, i.e. up to 60%, in 1980-81 or 1981-82.

Subject to the carry forward and carry back provisions set out below, tax relief was obtained against earnings assessed to tax in the year in which the premium was paid:

Schedule E. If the policyholder was a director or employee taxed under Schedule E, then contributions paid during the year ended 5 April 1981 would have been allowed against earnings during the year ended 5 April 1981. The same principle applied to premiums paid during the then current tax year ended 5 April 1982 and so on.
Schedule D. If however, the policyholder were self-employed taxed under Schedule D, he would normally be taxed each year on the earnings for the accounting period ending in the preceding year. For example, if your accounting year ended on 31 December, you would normally be taxed on tax year ended 5 April 1982 on your earnings in your accounts for the year ended 31 December 1980. Thus contributions made by you between 6 April 1981 and 5 April 1982, the then current tax year, would be offset against assessment to tax based on your earnings in the accounting period for the year ended 31 December 1980.

Carry forward of unused relief

A new style of carry forward was introduced in the Finance Act 1980 relating to the carry forward of unused relied from previous years, i.e. where a lower premium was paid than the limits allowed, there would be a certain amount of premium relied available which was unused.

Unused relief might be carried forward for up to six years 1980-81 onwards. For example, in 1981-1982 premiums might be paid with reference to any unused relief carried forwards from the six years 1975-76 to 1980-81 inclusive, in addition to the premiums calculated by reference to the percentage limit for 1981-82; the sum total of such premiums might be deducted from relevant earnings in 1981-82, i.e. tax relief is obtained in 1981-82.

The Finance Act 1980 specified the order in which the various bits of relief were to be used. The relief calculated by reference to the relevant earnings for the current year was to be used first. If the premium in the then current year exceeded that figure, and if there were a carry forward of unused relief available, then the unused relied from an earlier year was to be used before the unused relief from a later year of the six. Special provisions applied where a relevant assessment became final and conclusive more than six years after the end of the year of assessment to which it related. (There was nothing to stop the new carry back of premiums being used in conjunction with the carry forward of unused relief. For instance in 1981-82 a premium could be paid in respect of unused relief from 1974-75.)

New carry back of premiums

Following the Finance Act 1980, a new form of carry back was introduced, whereby a premium paid in a year of assessment might be treated as paid in the previous year of assessment, if the individual so elected (or, in the absence of net relevant earnings in that previous year, the year before it). The election had to be made in the year of assessment in which the premium was paid.

Old carry back of premiums

The old carry back provisions only applied up to and including 5 April 1981, but see below for the possible inter-relation with the new carry back.

Where an assessment to tax became final and conclusive on a date after 5 October in the year of assessment to which it related, a premium under an approved contract paid:

After that year of assessment, and
Not more than six months after that date

might, if the individual so elected not more than six months after that date, be treated as paid in that year of assessment.

Abolition of old carry back and inter-relation of old and new carry back rules

It should be noted that the old carry back, (which is in section 227(3) of ICTA 1970) and the new carry back (section 227(IBB)) might in some circumstances be used in conjunction with each other. It should also be noted that 5 April 1981 was not any special cut-off point in relation to the election for the old carry back. Here is an example of how that works:

Assessment for 1977-78 became final and conclusive on 15 April 1981, no premium having been paid until then. Election under section 227(3) might be made at any time up to 14 October 1981. If a premium is paid in 1981-82 (or exceptionally in 1982-83) and an election made under section 227(IBB), relief in accordance with section 227(3) will then be available.

Treatment of proceeds

Benefits at retirement

The commutation of part of the pension benefits taken as a cash sum was entirely free of tax in the hands of the policyholder.

The pension would be treated as earned income of the annuitant, whether the annuitant was the policyholder or a widow, widower or other dependant, to the extent to which it was payable in return for premiums on which tax relief had been given. If there were any annuity relating to premiums on which relief was not allowed, that part of the annuity would be taxable as investment income.

Capital Transfer Tax (CTT)

Note that the Capital Transfer Tax (CTT) position was that which in our opinion would have applied if the then current law applied at the relevant time, namely the time of death giving rise to the possibility of charge to tax.

Death of the policyholder before commencement of annuity
If a cash benefit (premiums plus compound interest) was payable, it was aggregable in the deceased’s estate unless it was in trust as made possible by the Finance Act 1980. However, there was no CTT liability on either a cash sum or an annuity where it passed to the surviving spouse; if it were renounced in favour of an annuity for a dependant under the terms of the policy, there was no CTT liability.
Death during guaranteed period
If the policyholder chose to take his retirement annuity in a form which continued for a certain number of years in any event, and if he died during that guaranteed period, the market value of the remaining guaranteed instalments was aggregable in his estate.
Death of either annuitant during payment of last survivor annuity
No capital transfer tax was payable.

Life assurance contracts

Following provisions of the Finance Act 1980, it was then possible to write section 226A term assurance policies in trust. In practice, the Inland Revenue was also allowing old policies (which would specify that the sum assured was payable to the life assured’s personal representatives) to be placed in trust. Briefly the advantages of suitable trust provisions were:

The avoidance of capital transfer tax arising from aggregation of the sum assured with the estate, which was only a real advantage if the beneficiary were other than the spouse; and
The life office being able to pay the sum assured without having to wait for the grant of representation.

Conclusion

With the advent of the changes made by the Finance Act 1980 to the premium levels and taxation aspects of section 226 RACs, the taxation situation of these policies had become more complex, especially with the transitional arrangements which had to be made with the new provisions coming into force.

It is not the objective of this page to give a definitive explanation of all the taxation implications of section 226 RACs, but to set out the main taxation aspects of the premiums and pensions arising from the policies.

For more information, please contact us.