How to tax interest paid by public service pensions schemes

If this article is supporting your professional development, it can count towards your verifiable CPD hours. Use the pop up at the bottom right corner of your screen to add reading this article as an activity to your online CPD record.

In its Pension Schemes Newsletter 156, HMRC reports receiving several queries about the tax treatment of interest paid under the public service pensions remedy. Public service pension schemes have to pay interest at the rate of 8% under the remedy.  

This could be a single payment of interest, or a number of separate amounts. HMRC states that the tax treatment of those amounts may differ depending on the reason why the interest was paid. HMRC’s guidance is summarised below. 

Interest paid on compensation 

Interest paid under a provision to pay compensation in the Public Service Pensions and Judicial Offices Act 2022 is exempt from income tax and capital gains tax. This is the case no matter at what rate the interest is paid. 

Interest on authorised pensions 

Interest may be paid where a pension has been underpaid and the scheme administrator pays arrears of pension. Where the interest meets the definition of a scheme administration member payment, it is taxable as interest. Interest paid in excess of a commercial rate is an unauthorised payment (see below) and is not a scheme administration member payment.  

This is covered in detail in HMRC’s Pension Schemes Newsletter 140. 

Interest on authorised top-up lump sums

The pension scheme may be required to make a top-up lump sum payment plus interest where, due to the member’s choice, the value of their lump sum benefit has increased. In this case, the tax treatment is determined in part by whether the interest is paid separate to, or together with, the top-up lump sum.

If it is a separate payment, it is treated in the same way as interest paid on pension arrears (see above). If it is paid with the top-up lump sum, it is taxed in the same way as that lump sum. However, complicated rules apply where, together with the original and top-up lump sums, it exceeds the maximum limit for the lump sum to remain an authorised payment. The rules are summarised in HMRC’s guidance, and an example is provided. 

Interest on unauthorised payments

Interest paid on an unauthorised payment is itself an unauthorised payment. The unauthorised payment should be reported to HMRC under the normal processes.  

ICAEW’s Tax Faculty is recognised internationally as a leading authority and source of expertise on taxation. The faculty is the voice of tax for ICAEW, responsible for all submissions to the tax authorities. Join the Faculty for expert guidance and support enabling you to provide the best advice on tax to your clients or business.