Not so easy for Government to take a hammer to your lump

Taxing pension lump sums – a measure hinted at during last week's budget – would not be easy to implement, writes CAROLINE MADDEN

BRIAN LENIHAN’S Budget speech last week contained a thinly-veiled threat designed to encourage public servants to apply for the new early retirement scheme.

The Minister for Finance dropped a broad hint that pension lump sums taken at retirement, which are currently tax-free, may become taxable in the December budget.

However, for public servants who oblige the Government in their pursuit of savings in public sector spending by signing up for the new scheme, their lump sum entitlements will not be taxable, even if tax legislation changes in the future.

Dangling the threat of taxing what for many people represents the only windfall they will ever receive, may succeed in panicking some public sector workers into retiring before the normal age of 60 or 65, but whether such a change can be easily implemented is debateable.

According to solicitor Dr Eamonn Hall, who is an examiner in constitutional law for the Law Society of Ireland, a “blanket taxation” of pension lump sums may be open to legal challenge.

“The strongest legal basis for challenging the taxation of pension lump sums may be grounded on the doctrine of ‘legitimate expectation’,” he says. This doctrine is intended to protect citizens from unfair changes in administrative practices and policies of the State.

If an individual made decisions to their detriment, for example borrowing money on the basis their pension lump sum would not be taxed, and a change to the tax treatment of that lump sum was suddenly imposed (without being flagged several years in advance), they could have grounds for taking a case against the State on the basis of “legitimate expectation”.

Other factors such as contract law – especially if the individual is employed be the State – would also be relevant, he says.

Although there is no guarantee that such a case would be successful, Dr Hall said that he would “relatively optimistic” about the outcome.

Aside from the legal question marks hanging over this issue, pensions ombudsman Paul Kenny points out that there are a number of other factors that would complicate the imposition of tax on pension lump sums. “I’m not so sure how easy it will be to do that, because you can’t just, at the stroke of a pen, make a tax-free lump sum taxable without interfering with a lot of things that have happened in the past,” Kenny says.

For example, there is the relationship between tax-free pension lump sums and the taxation of severance payments to consider.

When calculating the tax relief available to an individual in receipt of a redundancy package, one of the reliefs that may apply is SCSB (Standard Capital Superannuation Benefit). The amount of SCSB relief granted is reduced by any tax-free pension lump sum received or receivable by the individual.

Fred Kerr, tax partner with Ernst Young, makes the point that if the individual’s pension lump sum subsequently became taxable, this would effectively amount to double-taxation.

Furthermore, many people earmark their pension lump sum for specific purposes years in advance, and spend or borrow accordingly.

Kerr feels that it would be grossly unfair – and anyone close to retirement would agree with him – if a person contributed to their pension for, say, 40 years in the expectation of receiving a tax-free lump sum, and the law changed just before they retired and “suddenly [they’re] hit with a huge tax bill”.

“People have taken steps in the past that were influenced by the expectation of a tax-free lump sum in the future,” Kenny says.

According to Michael Madden, a pensions expert with Mercer, it is common practice among self-employed people to take out pension mortgages on properties. This means that they only service the interest on the mortgage until they retire, at which point they hope to use the facility to take up to one-quarter of their pension fund as a tax-free lump sum to pay off the original capital sum.

“If this is now taxable, people who might have funded these kind of property [investments] through pension mortgages could find that it’s not enough to repay the capital in the end,” he says.

“Like anything, when you have a tax regime in place and then you change it, it affects people’s long-term planning [ability],” he says.

Pensions, in particular, are supposed to be long-term planning vehicles. Therefore such a change could make people reluctant to save through a pension at all, he says.

The Minister for Finance has stated that he will await the outcome of the deliberations of the Commission on Taxation before deciding on changes.

The commission is considering all aspects of pension policy and taxation among a range of other areas of existing and potential sources of tax income.

Speculation as to what form the taxation of pension lump sum could take ranges from the imposition of an exit tax, to the lowering of the amount that can be drawn down tax-free by an individual, which is currently capped at €1.25 million.

Private sector employees can choose whether or not to surrender some of their pension pot in return for a lump sum upon retirement, but their public sector peers must receive a set portion of their pension in the form of a lump sum (calculated on the basis of 3/80ths of the individual’s final salary per year of service to a maximum of 120/80ths.)

This, coupled with the recent introduction of the pensions levy, means that the public sector is unlikely to take such changes lying down.

Some commentators suspect that the Government dropped hints about taxing pension lump sums to sound out the public reaction.

“If people don’t . . . voice their opinion now it could end up happening,” Mr Kerr warns.

Mr Kenny feels that the Government was very sensible in deciding to wait for the Commission on Taxation to make its recommendations this summer before introducing any changes to the taxation of pensions, instead of “shooting from the hip” and running into unforeseen complications down the line.