Pension Commencement Lump Sum (PCLS): Tax-Free Cash Recycling

Tax-free cash recycling can happen when a tax-free lump sum is taken and used to increase contributions to a registered pension scheme. The below is a summary of the rules and is not a complete technical guide.

When the recycling rule applies, the tax-free lump sum is treated as an unauthorised member payment for tax purposes.

When does tax-free cash recycling apply?

It can only apply when ALL of the following conditions are met:

1. Your client receives a tax-free lump sum
2. The amount of the lump sum, taken together with any other such lump sums taken in the previous 12-month period, exceeds £7,500
3. The cumulative amount of the additional contributions exceeds 30% of the lump sum
4. The additional contributions are made by the individual or by someone else, such as an employer
5. The recycling was pre-planned
6. Because of the lump sum, the amount of contributions paid into a registered pension scheme by the individual is significantly greater than it otherwise would be

Conditions 1 - 4 can easily be determined by the facts of a case. For further guidance on conditions 5 and 6, see below.

HMRC does not expect many tax-free cash payments to be caught by this rule. Tax-free lump sums paid as part of your client’s normal retirement planning will not be caught.

Pre- Planning

HMRC must prove that pre-planning has taken place – it is not up to your client to prove the absence of pre-planning.

Your client must have intended to take a lump sum to enable significantly greater contributions to be paid, directly or indirectly, into a registered pension scheme. Where they take a lump sum and subsequently decide to use it to pay greater contributions, there is no pre-planning.

What is a ‘significant increase’ in contributions?

A ‘significant increase’ in the amount of contributions applies to any one or more of the following contributions:

• By your client to any registered pension scheme (not just the one from which the lump sum was paid)
• By an employer(s) of your client to any registered pension scheme
• Third-party contributions on behalf of your client (such as the client’s spouse making contributions on their behalf)

HMRC typically accept that a significant increase does not occur unless the amount of the additional contributions is more than 30% of the contributions, that might otherwise have been expected to be paid. The value of additional contributions is measured on a cumulative basis to determine whether a significant increase has occurred.

Your client cannot avoid the significant increase test by gradual increases. HMRC rules stipulate that the test for a significant increase is calculated over a 5 year period with the intention of making significantly increased contributions; the 2 years before the tax year the lump sum is paid, the tax year it is paid in and the 2 years following the tax year it is paid. 

The basic principle to determine whether or not there is a significant increase is to establish the amount of contributions that might have been expected to be paid in the absence of receiving the lump sum and then compare that with the contributions that have been paid as a result of receiving the lump sum.

The fact there has been a significant increase in contributions in conjunction with the taking of a pension commencement lump sum will not always mean the recycling rule will be triggered.

Contributions might already vary from year to year because they’re based on a percentage of a variable income but the basis on which those contributions are calculated is not changing. Similarly, an increase due to a pay rise where contributions are based on a percentage of salary will mean pension contributions naturally increase. Another example is where there is an increase in the contractual contributions, your client is required to make these to the scheme which is outside your control.

Further information can be found in HMRC guidance here. 

For more information, speak to your usual Aviva contact.