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FB 2011: disguised remuneration

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The long-awaited draft legislation on disguised remuneration, published on 9 December 2010, will have a wide-ranging impact on arrangements involving trusts used to reward employees after 6 April 2011. An immediate income tax charge will arise where ‘‘relevant steps’’ are taken by a third party to provide a reward or loan for an employee. Although there are some exclusions, many deferred remuneration and pension arrangements that operate through employee benefit trusts and Employer Financed Retirement Benefit Schemes, will be adversely affected. Anti-forestalling rules apply in some circumstances to benefits provided between 9 December 2010 and 5 April 2011.

HMRC has long been known to be hostile to the use of trusts in circumstances that enable tax to be avoided or deferred. During the course of 2009 and 2010, this was highlighted by the publication of two ‘Spotlights’ which focused on particular uses of Employer Financed Retirement Benefit Schemes (EFRBS) and employee benefit trusts (EBTs) and HMRC Brief 61/09 which set out HMRC's view on the Inheritance Tax position in relation to EBTs (see ‘EBTs and EFRBS’ by the same authors, Tax Journal, 12 April 2010).
While practitioners found much to criticise in these, it was generally accepted that HMRC might challenge arrangements that claimed to accelerate corporation tax relief or provided potentially non-taxable benefits for employees and their families through the allocation of funds to sub-trusts.
The June 2010 Budget announced that legislation would be introduced to tackle ‘arrangements using trusts and other vehicles to reward employees which seek to avoid, defer or reduce tax liabilities’. The consultation on restricting pension tax relief also mentioned ‘unacceptable’ uses of EFRBS so as to avoid potential tax charges on pensions contributions in excess of the statutory limits or to defer tax charges on retirement benefits.
Following much speculation, the draft clauses published on 9 December 2010, which impose an income tax charge where an employer takes ‘relevant steps’ to provide benefits to employees through a third party or intermediary, in many respects, represent a heavy-handed clampdown on trust-based remuneration planning and may spell the end of the road for many EFRBS.
The draft clauses are invariably complex and there are various exclusions and potential pitfalls that need to be considered.
The draft legislation
If a company takes steps to allocate, or earmark, cash or other assets, including shares, for future delivery to employees (or to anyone connected with or nominated by an employee) through an EBT or an EFRBS or any other third party, from 6 April 2011 there will be an immediate income tax and NICS liability on the value of the cash or assets. The clauses are drafted sufficiently widely so as to include sums allocated through trusts, within escrow funds or held in other group companies.
The legislation applies where:
  • a person is either:
  • an employee;
  • a former employee; or
  • a prospective employee
  • (together, an ‘Employee’); and
  • there is an arrangement in place which provides rewards, recognition or loans to the Employee in connection with his employment; and
  •  the third party operating the arrangement takes a ‘relevant step’ (new ITEPA 2003 s 554A).
The legislation will not apply if income tax has been paid previously in connection with the same relevant step and the same employment (new s 554A(4)). There will not be a double tax charge if taxed income, such as a net cash bonus, or shares acquired with taxed income are transferred to a an EBT, for example, under a deferred bonus plan.
Where the legislation does apply, the value of the cash or assets transferred will be treated as ‘employment income’ for the tax year in which the relevant step is taken (or, if the relevant step is taken before employment starts, for the tax year in which that employment commences) (new s 554J).
The value of a relevant step taken in respect of a sum of money will be its cash value. In all other case, the value will be the market value of the asset in question at the date on which the relevant step is taken, or, if higher, the cost of the expenses incurred in taking that relevant step (sew s 554K).
A new  ITEPA 2003 s 687A will provide that where the relevant step involves a cash payment, the employer is treated as making a payment of PAYE income for the purposes of the PAYE Regulations and should operate PAYE (and NICs) accordingly (para 25). Similarly, a new ITEPA 2003 s 695A will provide that where payment is made in any other form, the employer should operate PAYE unless the trustee, or other third party, does so (para 27).
What are ‘relevant steps’?
These are set out in new ITEPA 2003 ss 554B-554D:
Earmarking of money or assets
It is a relevant step where a third party earmarks cash or assets for the benefit of an Employee, with a view to a later relevant step being taken either by the third party or any other person.
The terms of the later step need not be determined at the time the asset or money is earmarked, even if it is unclear what the sum of money or asset will be, by whom or in whose favour the later step will be taken, or how/when it will be taken.
This applies even if neither the Employee, nor any person linked with the Employee, has any legal right to insist upon the relevant step being taken in the future and also where the Employee has not received the assets, and may never do so.
This provision is a very widely drafted provision and will adversely affect many common remuneration structures. Not only do the new rules catch family benefit trusts/sub-funds but will also cover other arrangements that have not historically been seen as aggressive. For example, a bonus may be awarded in the form of cash and/or shares on the basis that some of it will be deferred until future performance and/or service conditions are satisfied. The assets are usually held in a trust and once the further conditions are satisfied, transferred to the employee. Previously, tax has not been triggered until the vesting conditions are satisfied and the deferred cash and/or shares transferred. In future, the full amount of the bonus will be immediately taxed even though it is partially held in the trust and may never all be received by the employee.
This acceleration of tax could cause significant cash flow issues for employees and comes at a time when financial institutions in particular face new regulatory requirements to defer up to 60% of variable remuneration in accordance with the FSA's Remuneration Code and equivalent European pronouncements. Traditional deferral mechanisms will come into direct conflict with the draft rules.
Where employers continue to use trusts or other third parties to hold deferred and previously untaxed elements of bonus payments, they will need to make employees aware of the adverse tax implications. Alternatively, employers should consider whether there is another way to achieve an effective deferral on an unfunded basis.
This provision will also catch EFRBS where assets are set aside for a particular individual's retirement. Previously, there was no income tax charge on contributions to an EFRBS while benefits paid from EFRBS have been exempt from NICs to the extent that they are taken 25% as a lump sum and the remainder as a pension. It is hoped that pensions paid from existing ERRBS will continue to benefit from this but clarification is required.
Payment of sum, or transfer of asset
It is a relevant step where a third party takes steps to pay money or transfer an asset to an Employee, a person linked to or nominated by an Employee, or within a class of people nominated by an Employee (a ‘relevant person).
A payment or transfer to a relevant person includes the acquisition of securities, securities options or other interests in securities, the making available of a sum of money as security for a loan or the grant of a lease for a term likely to exceed 21 years.
This is intended to prevent loans or other benefits being provided to an Employee or his family by a third party in circumstances where they may have otherwise have been only taxed under the benefits-in-kind regime or as a beneficial loan. In future, they will be taxed upfront on their full value.
A loan made to an Employee directly by an employer rather than through an intermediary, does not appear to be caught by the legislation.
Making an asset available
A relevant step will also occur where, without transferring the property in an asset to an Employee or relevant person, a third party makes the asset available so that the Employee or relevant person benefits as if the property had been transferred outright.
Where an asset is made available for the Employee or relevant person during or after a period of 2 years following cessation of the Employee's employment, the relevant step will be considered to have taken place at the end of that 2 year period. If the asset is made available within a shorter time frame, new s 554D(2) will deem a relevant step where the Employee is able to continue to benefit from it after the end of the 2 year period.
This catches arrangements where trust assets have been used to purchase items such as property for the continuing use of an Employee or his family – again, the application of funds in this way will be treated as giving rise to fully taxable employment income.
There will be no charge where:
  • Relevant steps are taken pursuant to an HMRC approved company share option scheme, savings related share option scheme, share incentive scheme or enterprise management incentive scheme or in respect of a registered pension scheme (including QROPs – Qualifying Registered Overseas Pension scheme) or compassionate benefits on death or ill-health  (new s 554E)
  • A loan is made on commercial terms similar to terms which are made available to the public (new s 554F). This is of limited benefit to EBTs and EFRBS as they do not make loans to the public.
  • A relevant step is part of a benefits package for Employees that is offered to a substantial proportion of the company's employees, the particular offer to the Employee is on the same terms as offers made to other employees and benefits are not solely or mainly conferred on directors or higher paid employees of the company or a group company (new s 554G). Again, as this exemption relies on a substantial part of the business of the third party making the loan involving making similar loans to the public, this is unlikely to apply to most EBTs and EFRBS.
  • Employment related securities or options are acquired where there would not ordinarily be an income tax charge – for example, the acquisition of securities subject to a restriction that lasts for less than 5 years (ITEPA 2003 s 425) or the grant of an option (ITEPA 2003 s 475) (new s 554H).
Anti-forestalling provisions
Anti-forestalling measures apply from 9 December 2010 to catch any existing arrangements where sums are paid (including loans) or assets are provided between 9 December 2010 and 5 April 2011. These will be subject to a tax charge on 6 April 2012, unless the sum is repaid, the asset returned, or a tax charge otherwise arises before that date. PAYE will apply to the tax due (para 48(7)).
Implications for employees' share schemes
As indicated above, there are specific exemptions for arrangements that support HMRC approved schemes. In addition, the rules will not apply in relation to the acquisition of restricted securities, convertible securities or options, or where a charge arises under ITEPA 2003 Part 7 Chapter 3C or 3D of (new s 554H(4)).
HMRC has indicated that it does not intend to bring EBTs that operate in conjunction with employees' share schemes within the scope of the legislation. However, HMRC is aware that long term incentive plans, performance share plans and deferred share plans may involve shares being set aside in an EBT for particular employees to satisfy contingent awards and it is hoped that it will respond by clarifying that these arrangements will not constitute the ‘earmarking’ of assets for the purposes of the legislation.
In addition, companies that operate phantom share option plans or grant restricted share units may hedge the future cash costs of these by acquiring shares which can then be sold to generate the required cash values. It is not currently clear whether arrangements such as this, where assets are notionally allocated against employees' awards, will be affected.
What future for EBTs and EFRBS?
  • Any contributions to, or allocation of funds by trusts before 9 December 2010 should be outside the legislation and will not be caught by the anti-forestalling rules.
  • Any contribution to a trust after 9 December 2010 should not generate an income tax charge in itself unless further steps are then taken that would bring it within the anti-forestalling rules, Such further steps are those that involve a payment of money (including a loan) or transfer of an asset to an Employee after 9 December 2010 and a charge will then become due on 6 April 2012.
The following uses of EBTs and EFRBS will cease to hold any tax benefit once they face an immediate income tax charge:
  • The allocation of funds within an EBT to sub-funds;
  • The provision of loans or non-cash benefits from an EBT;
  • The payment of funds to an EFRBS for the provision of retirement benefits to an Employee; and
  • The deferral of amounts into a trust with any kind of member account or allocation;
The effect on some other activities is more uncertain, such as:
  • The notional allocation of shares in an EBT against future share awards;
  • The use of an unfunded ERFBS where there is simply an unfunded promise to provide retirement benefits in the future, which may not be commercially acceptable to employees.
Overall, we are left with some potentially draconian legislation and a number of unanswered questions at this stage. HMRC has indicated that it will publish Frequently Asked Questions in due course and it is hoped that, following dialogue with HMRC, more helpful guidance will become available.
Karen Cooper, Partner, Osborne Clarke
Natalie Smith, Senior Associate, Osborne Clarke