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Pension investment options and restrictions

Registered pension schemes can, in theory, invest in almost any kind of asset. But, of course, pension scheme trustees and product providers may limit the investment options available under some pension schemes or products.

Typically, small occupational pension schemes and most personal pensions invest mainly in insured funds. Larger occupational schemes, and more specialist schemes such as SIPP and SSAS, will often invest in a wider range of assets. Common investments for such schemes include:

Investment controls and restrictions

There are, however, statutory controls that restrict some schemes' investment options. These are intended to encourage sensible investment behaviour and reduce the scope for abuse of the tax breaks available.

The controls are generally built around the principle that abuse is most likely to take place where investments connected with the pension scheme, or its members, are involved. So they focus on areas where certain kinds of pension scheme might otherwise have scope, and the temptation, to bend the rules. The key controls relate to:

• Connected parties: Transactions with connected parties must take place at the market rate - non-commercial, or value stripping, transactions may result in tax charges. And there are limits on some kinds of connected party investment (including, in some cases, complete bans).
• Employer-related investments: There are limits on how much occupational pension schemes can invest in employer-related investments (such as buying shares in, making loans or leasing property to the employer or associated companies).
• Taxable property: Where investment regulated pension schemes (like SIPP or SSAS) invest in taxable property, both the scheme and the member face heavy tax charges.  

Taxation of pension investments

Investments by registered pension schemes are held in a very tax-advantaged environment. In particular:

• income from investments or deposits is normally exempt from income tax
• investment gains are normally exempt from capital gains tax

However, these exemptions don’t apply to income or gains from investments or deposits held by the scheme as a member of a property investment limited liability partnership.

Tax charges can also arise if an investment regulated pension scheme (like a SIPP or SSAS) invests in taxable property.

More information on the taxation of pension scheme investments is available at PTM121000 in HMRC's Pensions Tax Manual.

Trading

These tax breaks are given to registered pension schemes on the basis they're there to provide retirement and death benefits for the members and their beneficiaries.

Although there aren't any rules to stop pension schemes from entering into trading activities, it's not compatible with the grounds for giving them tax breaks. So, if a pension scheme is trading:

• any realised gains on scheme assets used for trading purposes and
• any income from a scheme's trading activity

are subject to tax in the same way as would apply to any other trading vehicle. Details of any trading activity by a registered pension scheme should be reported to HMRC on a self-assessment tax return.

• Property - There's a risk that pension scheme property investments could be treated as trading activities if a scheme routinely buys and sells properties within a relatively short timescale. The risk is even higher if the scheme has developed the properties before selling them.
• Shares - Although there aren't any hard and fast rules about when share ownership will be regarded as trading by a pension scheme, it's commonly believed that holding more than 30% of a company's shares poses a risk of the scheme being treated as a trading vehicle.

Connected party investment transactions

Pension schemes can buy, sell or lease most kinds of asset directly from or to scheme members or other connected parties. But HMRC are conscious this investment freedom could bring temptation, so there are rules to control such transactions and heavy tax penalties if these rules are broken.

There are two basic controls over registered pension scheme transactions with connected parties:

• limits on some kinds of investment (including, in some cases, complete bans) and
• a requirement for transactions to take place at the market rate

Connected party - definition

The full legal definition of 'connected' is set out in section 993 of the Income Tax Act 2007. But, where pension scheme investment transactions are concerned, connected parties can generally be taken to mean connected individuals or other connected parties as set out below.

Connected individual means:

• a member of the pension scheme
• a member's spouse or civil partner
• relatives of a member or a member's spouse or civil partner

Relative means:

• brother or sister
• parent or grandparent
• son or daughter
• grandson or granddaughter or
• any spouse or civil partner of the above.

Other connected party means:

• a trustee of a settlement where a member, and/or a member's spouse, civil partner or relatives, is a settlor
• a business partner of a member, or the business partner's spouse, civil partner or relatives
• a company which a member, and/or a member's spouse, civil partner or relatives, controls*
  
  * A person controls a company if they exercise, or is able to exercise, direct or indirect control over the company's affairs. This doesn't necessarily mean holding a majority of the shares. One or more persons acting together to exercise control of a company are connected with each other (and with the company).

Investment Controls

To make it harder for connected parties to take unreasonable advantage of the investment rules, there are restrictions and controls on some kinds of investment transaction involving connected parties. The key areas subject to special controls are:

• employer-related investments by occupational pension schemes
• pension scheme loans or borrowing and 
• pension scheme investments in shares of a connected company

Market Rate

HMRC expect any transaction between a registered pension scheme and a connected party to take place on normal commercial terms at the market rate that would apply to an arms-length transaction. If not, the difference between the market rate and the amount actually paid will be taxed as an unauthorised payment.

For example, if a connected company rents property from a registered pension scheme, HMRC will expect the market rent to be paid. Similarly, if a registered pension scheme borrows money from a connected party, HMRC will expect the market rate of interest to be paid on the borrowing.

In general, the market value of an asset should be determined as set out in Section 272 of the Taxation of Chargeable Gains Act 1992.

Similar rules apply where a scheme member, or any of their immediate family or household, makes personal use of scheme assets. For example, scheme members might stay at a hotel owned by their SIPP.

Again, HMRC will expect the market rate to be paid for using the asset. If not, the difference between the market rate and the amount actually paid to the scheme will be treated as a benefit in kind provided to the member and the cash equivalent will be taxed as an unauthorised payment. This charge, however, doesn't apply to any assets which are classed as taxable property (as these will already be subject to unauthorised payment tax charges under the taxable property rules).

Immediate family and household are defined in Section 721 Income Tax (Earnings and Pensions) Act 2003 (ITEPA).

Immediate family means the member's:

• spouse (or civil partner)
• parents
• dependants and
• children (and their spouses or civil partners)

Household means the member's:

• domestic staff and
• guests

OPS employer-related investments

Because HMRC don't regard any kind of personal pension as an employer sponsored pension scheme (even if the employer contributes to it) they don't treat any kind of personal pension investment as an employer-related investment.

But some kinds of investment by occupational pension schemes are treated as employer-related investments, which are subject to special investment rules. These include:

• loans to
• shares in (or securities issued by)
• property (including land) leased to and 
• collective investment schemes with investments in

the sponsoring employer or associated companies (or parties connected with them).

Limits on OPS employer-related investments

Occupational pension schemes can't invest more than 5% of their assets in employer-related investments, or make any employer-related loans, unless:

• the scheme has less than 12 members
• all members are trustees of the scheme and
• the scheme rules need all members to agree in writing before any employer-related investment is made

In practice, this effectively means that the only occupational pension schemes able to meet the above rules and make significant employer-related investments are SSAS. However, the taxable property rules for investment regulated pension schemes may rule out some investments in employer-related shares or employer loans, even for SSAS.

It should be noted that there's a separate limit on investment in shares of the sponsoring employer or associated companies, even if the pension scheme meets the above conditions.

Occupational pension schemes (even SSAS) can only invest a maximum of 5% of the fund in the shares of any single sponsoring employer or associated company. Also, in total, occupational pension scheme investments in employer-related shares can't be more than 20% of the fund value. For example, a SSAS could invest 5% of the fund in shares of the sponsoring employer plus a further 15% in the shares of three associated companies (5% in each).

There's no statutory limit on the size of the shareholding - the only limit is on the maximum percentage of the pension fund that an occupational pension scheme can use to invest in employer-related shares. So, in theory, an occupational pension scheme could wholly own its sponsoring employer if 5% of the pension fund was big enough to buy the entire share issue of the company. However, this could result in the pension scheme being reclassified as a trading vehicle, with the knock-on tax implications.

Taxable property – SIPP and SSAS investments

Where investment regulated pension schemes (like SIPP or SSAS) invest in taxable property both the scheme, and the member, face heavy tax charges.

Investment regulated pension schemes - definition

Broadly speaking, investment regulated pension schemes are any pension schemes where a member has a say over which real assets their pension fund is invested in. The precise legal definition is, however, slightly different depending on whether the pension scheme is an occupational pension scheme or not.

• Occupational pension schemes are investment regulated pension schemes if either:
  
  (i) the scheme has less than 50 members and a member (or someone related to a member*) can direct, influence or advise on which assets the scheme invests in
   
  or
  
  (ii) a member (or someone related* to a member) can direct, influence or advise on investments linked to an arrangement under the scheme relating to the member
  
  
• Pension schemes that aren't occupational pension schemes are investment regulated pension schemes if a member (or someone related* to a member) can direct, influence or advise on which assets the scheme funds relating to that member are invested in

* Someone is related to a member if they and the member are connected parties or if they act on behalf of the member or a connected party.

These definitions mean both SIPP and SSAS are investment regulated pension schemes and, while other kinds of pension scheme can fall within these definitions too, its likely SSAS and SIPP schemes will make up the vast majority of the investment regulated pension scheme market.

Many insured pension schemes offer members a choice of funds to invest in (for example, covering different investment sectors or risk profiles). However, even though the members can choose how their pension pots are invested, because they can't influence which real assets their chosen funds actually invest in, these insured schemes are not investment regulated pension schemes.

Investments treated as taxable property

Taxable property means investments by investment regulated pension schemes (such as SIPP or SSAS) in:

• residential property (either in the UK or overseas) or
• tangible moveable property

Tangible moveable property means any asset that can be touched and moved. This is a very broad definition, covering a wide range of assets.

Some examples of the kinds of tangible moveable property that might have been considered as suitable investments for self-invested pension schemes had it not been for the taxable property rules are:

• machinery
• works of art
• jewellery
• antiques
• gem stones
• postage stamps
• autographs
• fine wines
• vintage cars
• yachts

HMRC can decide that some kinds of asset won't be treated as tangible moveable property. Gold bullion is the only asset that HMRC have specifically excluded from the definition so far. However, an item of tangible moveable property is excluded if:

• it's valued at no more than £6,000 and
• is not held directly by the scheme and
• is held solely for the purposes of administration or management of the vehicle's business

Indirect investment in taxable property

Investment regulated pension schemes can invest indirectly in taxable property without tax charges, but only if the investment is made via a genuinely diverse commercial vehicle that meets HMRC rules. For example, investment regulated pension schemes can invest indirectly in taxable property via:

• shareholdings in trading companies - but with severe restrictions on investments in connected companies or
• pooled investment vehicles (for example, unit trusts, OEICs or REITs), so long as the investment regulated pension schemes and connected parties don't own 10% or more of the vehicle (or hold 10% or more of its voting or income rights)*, and it:
  
  
  • isn't a close company and
  • doesn't hold animals for sporting purposes (either directly or indirectly) and
  • either holds assets worth at least £1M or holds at least three residential properties and, in either case, no single directly held taxable property asset is worth more than 40% of the total value of the vehicle's assets

* For occupational investment regulated pension schemes, like SSAS, this 10% limit applies to the scheme. So a SSAS can never own 10% of a residential property REIT without breaking the taxable property rules.

But for personal pension investment regulated pension schemes, like SIPP, the limit applies separately to each unconnected member. So, in theory, a SIPP could own 100% of the REIT, as long as ownership was split amongst at least 11 unconnected members (with no one owning 10% or more). Where connected parties are members of the same SIPP, their total holdings are tested against the limit.

In addition, any indirect investment must not be held for the purpose of allowing a scheme member, or connected party, to use the taxable property.

Investments held before 6 April 2006

In general, the taxable property rules don't apply to assets that were legitimately held by investment regulated pension schemes before 6 April 2006. If these investments were allowed by HMRC at that time, they can be kept without generating the tax charges normally related to the holding of taxable property.

However, this protection is lost if:

• substantial changes are made to the asset after 5 April 2006 (or 5 December 2005 for SIPP or SSAS) - unless they're made to meet legal requirements such as health and safety rules or
• any changes are made to the asset that wouldn't have been allowed under the HMRC rules in place on 5 April 2006

Also, there's no protection for taxable property held before 6 April 2006 by investment regulated pension schemes given mandatory approval under Section 590 of ICTA 1988 after 5 December 2005.

Tax charges for breaking the taxable property rules

If investment regulated pension schemes invest in taxable property there will normally be heavy tax charges:

• The member will have to pay an unauthorised member payment tax charge of 40% of the value of the taxable property
• The scheme will have to pay a scheme sanction tax charge of 15% of the value of the taxable property.
• If the cost of the asset reaches 25% of the member's fund value, the member will have to pay a further unauthorised payments tax surcharge of 15% of the value of the taxable property
• The scheme will have to pay tax on any income or gain from the asset

To cap it all, if more than 25% of the scheme funds are invested in taxable property the scheme could be de-registered. This would mean a further tax bill for the scheme of 40% of its total assets.

In practice, this makes it very unlikely that SIPP or SSAS providers will allow investment in taxable property.

Residential property

Residential property quite simply means any property that is, or could be, lived in. It also means the garden, or grounds, of the property (and any building on this land related to the property, such as a garage or other outbuilding).

This means that, as well as traditional houses or flats, residential property includes buildings such as:

• holiday homes (including beach huts)
• timeshare accommodation (or rights to such accommodation)
• converted commercial buildings (these will be treated as being residential when the conversion work has reached the stage where the building can be lived in - namely the issuing of the Habitation Certificate)

Disused property

If a property isn't currently in use, it'll be classified as commercial or residential based on the purpose it was last used for.

If a property has never been used, it'll be classified as commercial if it's to be used for commercial purposes - even if it could have been lived in. Of course, any new building intended to be lived in will be classified as residential property.

SIPP and SSAS

Although some pension schemes can invest directly in residential property, this isn't the case for SIPPs or SSASs. This is because HMRC's taxable property rules normally treat direct investments by investment regulated pension schemes (such as SIPP or SSAS) in residential property as investments in taxable property that are subject to heavy tax charges - but there are some exceptions.

Residential property held by a scheme before 6 April 2006 can, subject to certain conditions, continue to be held without attracting tax charges.

It's possible for SIPP and SSAS to invest indirectly in residential property without tax charges, using pooled vehicles such as property unit trusts, open ended investment companies (OEICs) or real estate investment trusts (REITs), but only if the investment is made via a genuinely diverse commercial vehicle that meets HMRC rules.

Exemptions from taxable property residential property definition

There are exemptions which mean that some kinds of property that would normally be regarded as residential are not treated as residential property for the purposes of the taxable property rules. These exemptions cover buildings such as:

• hotels (and hotels rooms) - unless the member has a right to use it
• institutional homes providing care for children, the elderly or those with disabilities or mental health, or drug or alcohol dependency problems
• student halls of residence (but not houses, or flats, let to students)
• hospitals or hospices
• prisons or other detention centres

Similar exemptions apply to some kinds of work-related residential property. To qualify for these exemptions, the person living in the property:

• must either be required to live there as a condition of their employment
  or
• be using it in connection with the use of business premises owned by the investment regulated pension scheme

and

• must not be a member or connected to a member (and, if living there as a condition of employment, must not be connected to the employer)

For example, this exemption could apply to:

• a caretaker's flat in a factory or office block or
• a flat above a shop that is used by the shop manager

Residential parts of buildings

Where a building is split into different parts, the way the building is treated under the taxable property rules depends on the nature of the building and the way it is divided. The basic rule is that if a property (or part of it) is suitable, or mainly used, for living in then it'll be treated as residential property.

It's possibly easiest to show how this works by looking at some examples:

• A shop with a flat above it will be treated as two separate properties if they have separate access and aren't interconnected. In this case, only the flat will be treated as residential property. However, shop premises which contain an internal, or interconnected, flat or bed-sitting room will be treated as a single residential property
• A house which has had the main reception rooms converted for use as a veterinary surgery will be treated as residential property, because it's a single property and it could be lived in
• A garage next to a house will be treated as residential property, because its primary use is to provide parking facilities in connection with the residency of the house. However, a barn next to a farmhouse is likely to be treated as commercial property because it's primarily intended for use in connection with the farming of the land rather than the residential occupation of the farmhouse

Of course, an investment regulated pension scheme could still buy some of the above "residential" properties if they qualify for the exemptions for work-related residential property.

The decision about whether parts of buildings are treated as being residential under the taxable property rules follows the principles HMRC use to work out whether an individual qualifies for capital gains tax private residence relief. Guidance on this is set out in HMRC's Capital Gains Tax Manual.