Tax on Pension [ 中文 ]

TAX PLANNING ON PENSION

​How do private pensions work?

Private pensions work similarly to a defined contribution workplace pension. This means that you’ll get out what you put in, plus tax relief and any investment gains. One of the key differences between workplace pensions and personal pensions is tax relief. With a workplace pension, your contribution is taken before tax that will reduce the overall tax you pay on your salary. However, with a personal pension, your contributions typically happen after tax. See more at the bottom of this page. See more [here].

 

Part A - Active Income

Setting Up Tax‑Exempt Pensions as a Tax Planning Tool

 

[1] Introduction

 

Migrating from a high‑tax jurisdiction to a low‑tax jurisdiction generally does not require complex tax planning. Conversely, migrating from a low‑tax jurisdiction to a high‑tax jurisdiction (for example, the UK) can significantly reduce after‑tax income.

 

However, by making use of safe harbours provided by high‑tax jurisdictions, it is possible to legally reduce tax exposure. Establishing a tax‑registered or tax‑exempt pension scheme approved by the tax authority is one such safe harbour for tax savings.

 

A safe harbour is a form of tax incentive. Cross‑border tax planning must satisfy at least the following three requirements:

 

Compliance and legality

1. The income must not be exempt in the host country while taxable in the home country (if that situation arises, the planning is not worthwhile).
2. The arrangement must not be challenged under the General Anti‑Avoidance Rule (GAAR) by either the host or home country, which could otherwise result in additional tax or penalties.
3. These three requirements are particularly important for individuals holding Australian, Canadian, or U.S. citizenship or permanent residency.

 

[2] Tax Planning Tool

A pension used as tax planning tool applies both in Hong Kong and the U.K.

 

[a] Deduction or Non‑Inclusion Mismatch (D/NI)

 

Recently, more attention has been paid to UK tax issues, while pension tax planning has received comparatively less focus. Pension planning mainly uses legislative allowances to reduce tax burdens, including income tax, capital gains tax, and inheritance tax.

 

Tax planning aims to reduce tax, and there are various methods. According to the OECD, the most basic scenario involves a Deduction and/or partial Non‑Inclusion mismatch (simply D/NI), where one party claims a full deduction while the other party does not include the income for taxation at all, or included in part only.

 

A familiar example of D/NI is housing allowance paid by Hong Kong companies to employees.

 

• Assume an employee receives HKD 60,000 per month: HKD 30,000 salary and HKD 30,000 housing allowance.
• The company deducts HKD 60,000 as an expense.
• The employee’s salaries tax is calculated as HKD 30,000 plus 10% of HKD 30,000.
• This creates a D/NI mismatch, resulting in HKD 27,000 of tax‑free income per month (HKD 60,000 − HKD 33,000).

 

Another example is Mandatory Provident Fund (MPF) contributions: employer contributions are deductible, and employees are not taxed on them.

 

[b] Deduction or Non‑Inclusion Mismatch (Asymmetric Deduction and Non‑Inclusion)

 

For individuals who migrate to the UK and operate a business as a director or self‑employed person, one of the most effective methods is to establish a UK limited company and simultaneously set up a Small Self‑Administered Scheme (SSAS) for directors.

 

From 6 April 2024, a company may contribute up to GBP 60,000 per year (previously GBP 40,000 in 2022/23) as the maximum tax‑free contribution to an SSAS.

 

Contributions are not subject to income tax at the time of contribution.

Investment income and capital gains within the SSAS are exempt from income tax and capital gains tax, year after year.

 

SSAS pension benefits are not subject to income tax until the director begins drawdown at retirement age (currently age 55). Most importantly, SSAS assets are exempt from inheritance tax (IHT), which can be as high as 40%.

 

If both spouses are directors, both may benefit from inheritance tax exemption. If the main residence forms part of the estate, an additional £175,000 inheritance tax allowance will be available, making up the IHT-exempt amount to £500,000 (£1,00,000 for a couple). This is a highly favorable arrangement.

 

[3] Tax Policy Background

 

3.1 [Pre‑2025]

 

From a macroeconomic perspective, the objective of UK public finance policy is to incentivize individuals to save for retirement, thereby reducing the government’s burden in providing public pensions.

 

Setting up a pension does not mean that UK income tax is never paid; rather, it is tax deferral.

 

Contributions are tax‑free when the individual is young and earning income. Withdrawals are taxed during retirement. The benefits include:

 

• Deferral of tax, and
• Lower overall tax, typically because contributions are made when income of a young person is taxed at the higher rate (40%), and withdrawals are taxed at the basic rate (20%) during retirement.

 

Additionally, when benefits are crystallized, one quarter of the pension may be withdrawn tax‑free, subject to a maximum of GBP 268,275 (25% of GBP 1,073,100). The remaining three quarters are taxed at 20% upon drawdown.

 

From contribution (tax‑free) at start, to investment growth (tax‑free), to retirement (partially taxable), or death (inheritance‑tax free), the entire process follows the Exempt‑Exempt‑Taxed (E‑E‑T) model.

 

3.2 [Post‑2025]

 

The Lifetime Allowance (LTA) was formally removed from legislation on 6 April 2024. At the same time, the UK introduced two new functional limits:

 

(a) Lump Sum Allowance (LSA)

A lifetime personal allowance of GBP 268,275, applicable to:

• Pension Commencement Lump Sum (PCLS), and Un-crystallized Funds Pension Lump Sum (UFPLS).
• Amounts exceeding this limit are no longer tax‑free and are taxed at the individual’s marginal rate.

 

(b) Lump Sum and Death Benefit Allowance (LSDBA)

A standard amount of GBP 1,073,100, covering:

• PCLS, Other tax‑free lump sums, and Certain death benefits.

 

3.3 [Post‑2025]

From a fiscal perspective, D/NI mismatches represent permanent tax leakage, and therefore cannot be unlimited. The government must impose lifetime cumulative limits tied to individuals.

 

After 2025:

• Employer pension contributions remain deductible.
• Individuals and beneficiaries remain exempt at the contribution stage.
• All income and capital gains within pension accounts remain tax‑free.
• GBP 268,275 of retirement benefits remain permanently tax‑free (permanent D/NI).
• Any excess is taxed at the individual’s marginal rate upon withdrawal (tax deferral with future inclusion).

 

Hong Kong residents holding Australian or Canadian citizenship may apply to the Australian or Canadian tax authorities to enjoy UK pension tax exemptions or sparing credits, under:

• UK–Australia and UK–Canada double taxation agreements, and
• The Multilateral Instrument (MLI) for preventing base erosion and profit shifting.

 

The above discussion applies to individuals earning active income in the UK. Individuals earning passive income must adopt a different arrangement in line with UK public finance policy.

 

Note 1: From 6 April 2024, the Lifetime Allowance of £1.07 million has been abolished. Please refer to HMRC: Abolition of the Lifetime Allowance (LTA) – GOV.UK.